Chapter Six Avoidance Actions

• Jurisdiction: United States

Chapter Six Avoidance Actions

In plenary bankruptcy cases in the U.S., trustees, debtors in possession and estate representatives, including authorized statutory creditors' committees or liquidation trustees appointed under a confirmed plan of liquidation in a chapter 11 case, often obtain recovery for creditors by prosecuting avoidance actions under chapter 5 of the Bankruptcy Code. Avoidance actions vest in a trustee, a debtor in possession or a debtors' authorized representative the power and ability to cancel and recover a transfer made or obligation incurred by the debtor during a statutorily fixed time period prior to the commencement of an insolvency proceeding. These powers vary, but they consist of, among others, turnover actions (§§ 542 and 543), so-called "strong arm" actions that allow a trustee to bring actions under state law that the estate was entitled to bring as of the date it commenced its insolvency proceeding (§ 544),⁴¹⁷ lien avoidance (§§ 522(f), 545 and 724(a)), preferences (§ 547),⁴¹⁸ fraudulent transfers, both actual fraud and constructively fraudulent transfers, sometimes called "clawback actions" (§ 548),⁴¹⁹ and setoffs (§ 553). If a trustee is successful in avoiding a transaction, then a separate statutory provision (§ 550) permits recovery of the property transferred or its value from the initial transferee or any immediate or mediate transferee of the initial transferee (unless the mediate or immediate transferee receives the property in good faith and pays value for it, in which case the transferee will not be liable). In other words, the ability to avoid a transfer arising before the bankruptcy case is separate from recovering from the transferee, which is a second step in the analysis.

The use of avoidance powers can provide significant recovery for creditors, and often these actions provide the only unencumbered asset in a debtor's bankruptcy estate, becoming bargaining chips in plan negotiations and throughout the case. It is not unusual for a chapter 7 or liquidation trustee to commence an "avoidance action program," sending out demand letters to hundreds or thousands of creditors and commencing litigation against those that do not provide defenses or return allegedly avoidable transfers.⁴²⁰ Often, these actions in the U.S. are prosecuted by firms specializing in this area of law and on a contingent-fee basis. Many bankruptcy courts have specific local rules that create special procedures for these mass avoidance action programs that often include mandatory mediation or other special procedures for regular status conferences and reports, and specific forms of scheduling orders.⁴²¹ It is typical for bankruptcy courts to have literally thousands of these cases pending at any one time, and during periods of recession these avoidance actions clog a court's docket, affecting its ability to administer its regular insolvency docket in an efficient fashion.

I. History and Development of Avoidance Actions in Ancillary Proceedings

As discussed in Chapter 2, prior to chapter 15,⁴²² former § 304 of the Bankruptcy Code governed ancillary proceedings.⁴²³ Former § 304(b)(3) allowed bankruptcy courts to "order other appropriate relief" and granted courts broad discretion to grant equitable relief to a foreign representative.⁴²⁴ In granting relief under the former § 304(b) of the Bankruptcy Code, bankruptcy courts were to be

guided by what will best assure an economical and expeditious administration of [the bankruptcy] estate, consistent with (1) just treatment of all holders of claims against or interests in such estate; (2) protection of claim holders in the United States against prejudice and inconvenience in the processing of claims in such foreign proceeding; (3) prevention of preferential or fraudulent dispositions of property of such estate; (4) distribution of proceeds of such estate substantially in accordance with the order prescribed by this title; (5) comity; and (6) if appropriate, the provision of an opportunity for a fresh start for the individual that such foreign proceeding concerns sustained avoidance claims brought by foreign representatives based on foreign law."⁴²⁵

In many of the early cases that arose under § 304, courts permitted a foreign representative to commence avoidance actions under U.S. avoidance law.⁴²⁶ Foreign representatives also sought authority under § 304 to commence an adversary proceeding under the laws of the foreign state where the main insolvency proceeding was pending. The cases that allowed a foreign representative to assert claims under U.S. avoidance law were criticized under the theory that § 304 was designed to assist with the implementation of the foreign court's decrees in the U.S. and to assist the foreign representative, but it was not intended to provide a foreign representative with substantive rights of action arising under U.S. law.⁴²⁷

In what would become an influential case, Metzeler v. Bouchard Transportation Co., in reliance on the law review article cited in footnote 427, the U.S. Bankruptcy Court for the Southern District of New York held that a foreign representative may assert, under § 304, avoidance actions available to him under the law applicable to the foreign estate — German law — but not under §§ 547 or 548 of the Bankruptcy Code.⁴²⁸ The bankruptcy court therefore applied German law and not U.S. law to avoid the subject transfers in Metzeler.⁴²⁹ similarly, in In re Gross, the U.S. Bankruptcy Court for the Middle District of Florida held that an ancillary proceeding was properly filed in the U.S. to set aside wire transfers made in Florida pursuant to German law.⁴³⁰

Historically, a foreign representative's ability to bring avoidance actions to recover assets from creditors was determined by balancing the broad discretion afforded in the former § 304 with the presumption against extraterritoriality, which was established by the U.S. supreme Court in E.E.O.C. v. Arabian American Oil Co. (Aramco).⁴³¹ This presumption gives rise to various issues in cross-border insolvency cases, and commentators have suggested that the presumption is dangerous and that, rather than a simple application of the presumption against extraterritoriality, courts should conduct a detailed analysis of the contacts with the U.S. before determining whether the law of avoidance is being applied extraterritorially.⁴³²

There are two cases of significance prior to the enactment of chapter 15 that, while not ancillary cases under § 304 of the Bankruptcy Code, have influenced the way in which courts think about cross-border insolvencies: In re Axona Int'l Credit & Commerce Ltd.⁴³³ and Homan v. Societe Generale (In re Maxwell Comm. Corp. plc).⁴³⁴

In Axona, a Hong Kong liquidator filed an involuntary chapter 7 in the U.S., and the appointed chapter 7 trustee commenced several adversary proceedings under the avoiding powers given to the chapter 7 trustee by the Bankruptcy Code.⁴³⁵ After settling these adversary proceedings, the chapter 7 trustee and the Hong Kong liquidator filed a joint application asking the bankruptcy court to exercise its discretion and suspend the U.S. chapter 7 case and direct the turnover of all assets of the chapter 7 estate to the Hong Kong liquidators for distribution in the primary winding-up proceeding.⁴³⁶

One defendant objected to the suspension of the U.S. proceedings and the transfer of assets because it had reserved its rights in its settlement agreement to contest the right of the chapter 7 trustee to use its avoidance powers in the context of a cross-border bankruptcy case for a variety of constitutional and jurisdictional grounds, which, had the creditor succeeded, would have resulted in a refund of the settlement it had paid.⁴³⁷ The bankruptcy court overruled this objection, approved the motion suspending the chapter 7 case, and permitted the transfer of the avoidance action proceeds to the Hong Kong liquidation.⁴³⁸ The gravamen of the objection was that it was unconstitutional for a foreign liquidator to be able to select which law to apply (namely Hong Kong law versus U.S. law), and that it was against the due process of law for the liquidators to be able to expose the objector to U.S. law when it had been dealing with a foreign debtor. The bankruptcy court determined that the statutory framework permitted a foreign liquidator to commence a full chapter 7 case and that under principles of comity, once that occurred, the bankruptcy court had the discretion and flexibility to determine the most effective and efficient fashion in which to assist the foreign liquidator in maximizing value of the estate for the benefit of all creditors, even if that meant allowing avoidance action proceeds arising under U.S. law to be sent to Hong Kong for distribution.

The second pre-chapter 15 case of import, In re Maxwell Communications Corporation, also established important principles grounded in comity, deference and flexibility. Maxwell was a dual plenary case with a chapter 11 case pending in the U.S., which appointed an examiner to assist the court in the conflict of law and administration issues, and an administration pending in the U.K. Maxwell's corporate group was based primarily in the U.K. but had significant assets in the U.S. In this case, after confirmation of a plan in the U.S. and approval of a scheme of arrangement in the U.K. that was similar but that did not contain provisions regarding what country's avoidance laws would govern post-confirmation litigation, a British bank filed an anti-suit injunction in the U.K. seeking an injunction prohibiting the U.S. estate's use of avoiding powers in the U.S.⁴³⁹ The U.K. court refused this application and decided to allow the U.S. court to evaluate the issues because it assumed that "[i]f it would constitute a serious injustice for the U.S. bankruptcy judge to take jurisdiction under the Bankruptcy Code, then no doubt she would not do so[,]" adding that "the British court, even...