Chapter 7 Avoidance

• Jurisdiction: United States

Chapter 7: Avoidance

Michelle M. McGreal, Stephen D. Piraino and Damian S. Schaible

The Bankruptcy Code vests a bankruptcy trustee⁶⁶² with the powers to avoid certain pre-petition and post-petition transfers that diminish the bankruptcy estate. These powers, known as avoidance powers, take different forms. Some are purely creatures of the Bankruptcy Code, while others allow the trustee to pursue state law creditor rights. The purpose of the trustee's avoidance powers is to increase the amount of estate assets that can be distributed to creditors.⁶⁶³ In seeking to protect their rights in their collateral, secured creditors should be aware of these powers and the risk of avoidance litigation. In addition, post-petition secured lenders may seek to enhance their rights by requesting a lien on the debtor's interest in the avoidance actions of the estate.

This chapter will describe the various avoidance powers, explain how parties can defend against them, and give an overview of issues that arise in avoidance action litigation.

A. Strong-Arm Powers

1. Assuming Hypothetical Statuses

Section 544(a) of the Bankruptcy Code gives the trustee the power to avoid transfers that, under state law, could be avoided by a bona fide purchaser or by a creditor with a judicial lien or unsatisfied execution. This power is known as the trustee's "strong-arm power." The applicable state law is the law of the state where the property subject to the trustee's strong-arm power is located.⁶⁶⁴

Upon the commencement of a bankruptcy case, the trustee gains the rights of a bona fide purchaser. Thus, whatever interests a bona fide purchaser could defeat, the trustee can also defeat. Similarly, the trustee also gains whatever state law rights a creditor with a judicial lien on the debtor's property or an unsatisfied execution judgment against the debtor would have as of the petition date.⁶⁶⁵ The trustee succeeds to these hypothetical statuses regardless of whether a similarly situated creditor actually exists. As one court described the trustee's hypothetical status as a bona fide purchaser: "It is as though [the trustee] were shopping for a place to live, saw a classified ad, bought the condo after doing a title search, and recorded the deed, all at the instant the petition was filed."⁶⁶⁶ By assuming these hypothetical roles, the trustee can avoid unperfected liens on property of the estate.⁶⁶⁷

2. Avoiding Statutory Liens

In addition to the trustee's general strong-arm powers, § 545 provides the trustee with a specific strong-arm power to avoid statutory liens.⁶⁶⁸ Statutory liens "aris[e] solely by force of a statute on specified circumstances or conditions."⁶⁶⁹ Statutory liens include mechanics' liens and tax liens.⁶⁷⁰ Under § 545, a trustee can avoid three types of statutory liens. First, the trustee can avoid a statutory lien that:

[F]irst becomes effective against the debtor —

(A) when a case under [the Bankruptcy Code] concerning the debtor is commenced;
(B) when an insolvency proceeding other than under [the Bankruptcy Code] concerning the debtor is commenced;
(C) when a custodian is appointed or authorized to take or takes possession;
(D) when the debtor becomes insolvent;
(E) when the debtor's financial condition fails to meet a specified standard; or
(F) at the time of an execution against property of the debtor levied at the instance of an entity other than the holder of such statutory lien.⁶⁷¹

Second, the trustee can avoid a statutory lien that is not perfected or would not be enforceable against a bona fide purchaser that had purchased the property on the petition date.⁶⁷² Third, the trustee can avoid liens for rent or distress of rent.⁶⁷³

A trustee can only avoid a statutory lien under § 545(2) as a hypothetical bona fide purchaser if applicable law permits it. If a lien arises under state law and defeats the rights of a bona fide purchaser, the trustee cannot avoid such lien.⁶⁷⁴ Similarly, if the lien arises under federal law, federal law determines whether the trustee qualifies as a bona fide purchaser and whether the statutory lien defeats the rights of a bona fide purchaser.⁶⁷⁵

3. Asserting the Rights of an Unsecured Creditor

The last of the trustee's strong-arm powers is the ability to assert the rights of an unsecured creditor. Section 544(b) gives the trustee the power to avoid any transfer that would be voidable under applicable law by a creditor holding an unsecured claim. That applicable law is usually state law because state law provides specific remedies to unsecured creditors for the debtor's fraudulent transfers.⁶⁷⁶ Trustees will often use § 544(b) to assert state law fraudulent-conveyance claims. In addition, if an unsecured creditor has rights under federal law to void a transfer, then § 544(b) gives the trustee those rights as well.⁶⁷⁷ Unlike the strong-arm powers in § 544(a), the trustee can only use this strong-arm power if there actually is an unsecured creditor that could have brought such a claim.⁶⁷⁸ However, the benefit of the recovery from the trustee's § 544(b) claim inures to the benefit of all creditors, not just the unsecured creditor that could have brought the claim.⁶⁷⁹

B. Avoiding Preferences

In addition to its strong-arm powers, the trustee can also avoid certain pre-bankruptcy transfers, known as preferences. In the legislative history of the Bankruptcy Code, Congress provided two policy reasons for the trustee's power to avoid preferences. First, it prevents creditors "from racing to the courthouse to dismember the debtor during his slide into bank-ruptcy."⁶⁸⁰ Second, it promotes equality of distribution to creditors.

1. Elements of a Preference

The elements of a preference are that the transfer "(1) benefit a creditor; (2) be on account of antecedent debt; (3) be made while the debtor was insolvent; (4) be made within 90 days before bankruptcy;⁶⁸¹ and (5) enable the creditor to receive a larger share of the estate than if the transfer had not been made."⁶⁸² As a result of this last requirement, fully secured creditors are generally free from preference risk. Given that a secured creditor is entitled to receive the value of its collateral up to the amount of its debt in a chapter 7 liquidation, a pre-petition payment does not provide the secured creditor with a greater distribution than they would have received in a liquidation. However, an undersecured creditor should be aware of preference risks, because a pre-petition payment within the preference period may have improved such party's position in a hypothetical liquidation.

2. Transfers that Cannot Be Avoided as Preferences

Even if a transfer satisfies the elements of a preference under § 547(b), § 547(c) provides creditors with various affirmative defenses.⁶⁸³ A creditor seeking the protections of § 547(c) must prove each element of the desired defense by a preponderance of the evidence.⁶⁸⁴

a. Substantially Contemporaneous Exchange

Under § 547(c)(1), if the debtor made a pre-petition transfer to a creditor, but at the same time or nearly the same time received new value from that creditor, then the transfer could be excepted from the trustee's power to avoid preferences. The creditor that received the transfer bears the burden of proving that (1) the parties intended for the transfer to be a contemporaneous exchange, (2) a substantially contemporaneous exchange actually occurred, and (3) the creditor gave new value to the debtor.⁶⁸⁵ The legislative history of § 547(c)(1) provides that the "classic exception ... intended by Congress ... in section 547(c)(1) is the exchange of goods or other value for a check."⁶⁸⁶ Because payment by check is typically a credit transaction, and therefore creates an antecedent debt, § 547(c)(1) protects parties that intended the character of a transaction to be that of a cash sale.⁶⁸⁷ The policy behind the contemporaneous-exchange exception is twofold. First, it protects transactions whose cumulative effect does not harm the estate.⁶⁸⁸ Second, it "encourages creditors to deal with troubled businesses in the hope of rehabilitation."⁶⁸⁹

b. Ordinary Course of Business

Another type of pre-petition transfer that could be excepted from avoidance as a preference is a transfer made by the debtor in the ordinary course of business. Section 547(c)(2) shields from avoidance the repayment of a debt incurred in the ordinary course of the business of a debtor where such repayment was itself made in the ordinary course of business of the parties or "made according to ordinary business terms."⁶⁹⁰ The test has a subjective (i.e., between the parties) and an objective (i.e., industry standard) component, but, unlike an earlier version of § 547(c)(2) that required a transferee to prove both the subjective and objective element, the test is disjunctive, and the transferee does not have to satisfy both elements.⁶⁹¹ The ordinary-course defense is a highly fact-intensive inquiry.⁶⁹²

c. Enabling Loan Exception

Section 547(c)(3) provides transferees with the defense of the "enabling loan exception," which protects certain purchase-money security interests from being avoided as preferences.⁶⁹³ The pre-petition transfer of a security interest to a creditor will be protected by the enabling loan exception if (1) the debtor received new value from the creditor to acquire property, (2) the debtor actually acquired the property and (3) the creditor perfects its security interest in the property within 30 days from when the debtor takes possession.⁶⁹⁴ State law governs perfection, so the enabling loan exception only applies if the creditor has completed all steps necessary under applicable law to perfect its security interest within 30 days.⁶⁹⁵ Creditors should be aware that all states have lien laws that may differ in the manner in which a creditor creates, perfects and/or enforces a lien.

d. New Value Exception

If the debtor makes a pre-petition transfer to a creditor that would otherwise be a preference, but then receives new value from...