§14.4 - Strong Arm Powers of Trustee

• Jurisdiction: Washington

§14.4 STRONG ARM POWERS OF TRUSTEE

The trustee has certain powers to avoid conveyances of a debtor's property on the eve of bankruptcy. These are commonly known as "strong arm" powers.

(1) General principles

Strong policy considerations underlying the law of bankruptcy permit the trustee to avoid the dissipation of a debtor's assets by conveyances made, or obligations incurred, on the eve of bankruptcy. This policy finds expression in 11 U.S.C. §§551, by which the trustee is given three general types of avoidance powers.

First, the trustee has the power to avoid transfers made or obligations incurred by the debtor that would be avoidable by an actual unsecured creditor of the debtor under state or federal law, 11 U.S.C. § 544(b); or by a hypothetical bona fide purchaser of realty at the time of filing or a hypothetical creditor who extended credit and obtained a lien on the date of bankruptcy filing, 11 U.S.C. §544(a).

Second, the trustee has the power to avoid particular types of transfers that are "preferential" or "fraudulent" under specific criteria set forth in the Bankruptcy Code. See 11 U.S.C. §§548. Also see discussion in §14.4(4) and (5), below.

Third, the trustee has the status of a "hypothetical bona fide purchaser" with the power to avoid certain statutory liens. 11 U.S.C. § 545. For example, statutory liens that first become effective upon the bankruptcy or insolvency of the debtor—automatic insolvency liens—are avoidable. 11 U.S.C. § 545(1).

Under 11 U.S.C. §1107(a), the debtor-in-possession has the avoidance powers of a trustee. See also In re Softwaire Centre Int'l, Inc., 994 F.2d 682, 683 (9th Cir. 1993) (creditors committee has standing to bring avoidance actions when debtor-in-possession defaults in bringing action).

The Bankruptcy Reform Act of 1994 altered 11 U.S.C. §546 by placing time limits on avoidance powers. A two-year statute of limitations now exists, running from the date the order of relief was entered (generally the date of filing the petition, but it will be a different date in an involuntary case) for avoidance actions. Also, if a trustee is elected prior to expiration of the two-year limit, the trustee has the later of the two-year period or one year from appointment or election to commence the avoidance action. 11 U.S.C. §546(a)(2).

(a) The trustee as subrogee of unsecured creditors

Bankruptcy law permits the trustee to avoid any transfer of property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim. 11 U.S.C. §544(b). When, for example, absent the bankruptcy filing, a creditor could sue under Washington law to avoid a fraudulent transfer or a bulk transfer, the trustee may do so as "subrogee" of such creditor in the bankruptcy court, relying on Washington law. In re Previs, 31 B.R. 208, 211 (Bankr. W.D. Wash. 1983). But see In re Van de Kamp's Dutch Bakeries, 908 F.2d 517, 519 (9th Cir. 1990) (trustee who avoids interest succeeds to the priority that interest enjoyed over competing interests).

(b) The trustee as a hypothetical lien creditor

11 U.S.C. § 544(a)(1) and (2) give the trustee the status of a hypothetical lien creditor (including judgment liens), regardless of whether such a creditor exists at the time of the filing of the bankruptcy petition. Therefore, a creditor who fails to record a lien, or to comply with the state's Uniform Commercial Code (U.C.C.) recording requirements, risks lien avoidance by the trustee's intervening "strong-arm clause" lien. 11 U.S.C. §544(a).

(c) The trustee as a bona fide purchaser of realty

Under 11 U.S.C. §544(a)(3), the trustee stands in the shoes of a bona fide purchaser of real estate from the debtor as defined by applicable state law, regardless of whether such a bona fide purchaser exists. Thus, an unperfected security interest is subject to avoidance by the bankruptcy trustee. See In re Phillips, 21 B.R. 565, 567 (Bankr. D. Conn. 1982). Failure to perfect a security interest in a real estate contract under the U.C.C. subordinates that interest to any interest asserted by the bankruptcy trustee, affecting both real and personal property interests. In re Heide, 915 F.2d 531, 533 (9th Cir. 1990).

The result in In re Phillips may be limited to circumstances in which the trustee does not have any "constructive notice" under state law. In re Heinig, 64 B.R. 456, 457 (Bankr. S.D. Cal. 1986). 11 U.S.C. §544(a)(3) is not intended to enable the trustee to ignore constructive notice of transfer to third parties. The trustee is vested with the status of a bona fide purchaser of real property. If the trustee has constructive notice, the trustee may not avoid any transfer that could have been, but was not, perfected

(2) Statutory lien avoidance

11 U.S.C. §545 provides that a trustee may avoid the fixing of a statutory lien on property of the debtor (1) to the extent that such lien arises due to the insolvency or bankruptcy of the debtor, (2) to the extent that such lien is unperfected against a bona fide purchaser as of the date of the filing of the petition, (3) to the extent that such lien is for rent, or (4) to the extent such lien is of distress for rent. See generally In re Nucorp Energy, Inc., 902 F.2d 729, 734 (9th Cir. 1990) (unperfected statutory lien avoidable by trustee under §545(2)); In re Cummins, 656 F.2d 1262 (9th Cir. 1981).

(3) Exempt property lien avoidance

11 U.S.C. §522(f)(1)(A) provides for the avoidance of judgment liens on exempt property (e.g., the homestead exemption). The judgment lien is avoided only to the extent of the exemption, and the value of the lien that exceeds the exemption amount may still be enforced by the creditor. See In re Catli, 999 F.2d 1405 (9th Cir. 1993), for the treatment of 11 U.S.C. §522(f)(1) lien avoidance in the context of property encumbered by a divorce decree.

(4) Preference avoidance

11 U.S.C. §547(b) gives the trustee the power to avoid any transfer of property of the debtor made (1) to or for the benefit of a creditor; (2) for or on account of antecedent debt owed by the debtor before such transfer was made; (3) while the debtor was insolvent; and (4) within 90 days prior to the filing of the petition or within one year before the date of filing if the creditor is an insider, if that transfer enables the creditor to receive more than the creditor would have received if the case had been under Chapter 7, the transfer had not been made, and the creditor received payment to the extent provided under the Bankruptcy Code. The trustee benefits from a presumption that the debtor was insolvent within 90 days prior to the commencement of the bankruptcy case. 11 U.S.C. §547(f). What constitutes a transfer and when it is complete is a matter of federal law. In the absence of any controlling federal law, "property" and "an interest in property" are creatures of state law. See generally Barnhill v. Johnson, 503 U.S. 393, 398, 112 S.Ct. 1386, 118 L.Ed.2d 39 (1992) ; In re Kemp P. Fisheries, Inc., 16 F.3d 313, 315 (9th Cir. 1994).

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