Under the US Bankruptcy Code, various powers are granted to debtors, creditors, and other parties involved with the bankruptcy process. One such power is found in section 544, which grants individuals the ability to avoid some interactions with bankruptcy trustees or debtors-in-possession. Questions, however, have lingered about whether 

avoidance powers can only be exercised when making a decision provides creditors with a benefit. In the recent landmark case of U.S. Glove, a New Mexico bankruptcy court tackled this question and determined that when authorities are split, such a requirement exists.

The Role of Bankruptcy Section 544

How much a creditor can recover in a bankruptcy case often is influenced by the outcome of lawsuits that place trustees under the boundaries of bankruptcy law. Trustees are permitted to file claims based on bankruptcy law because section 544(b) permits them to assert claims. This regulation often lets trustees attack transactions that occurred years before a bankruptcy filing.

Section 544(b) permits trustees to avoid a transfer of an interest of the debtor that is voidable under applicable law by a creditor holding an unsecured claim. This regulation is both broader and narrower than 544(a). The regulation is more expensive because it grants rights to creditors with any qualifications rather than simply to the small class of “lien creditors” like 544(a). The regulation, however, is narrower because to utilize this power, the trustee must prove the existence of an actual creditor by whom the transfer might have been avoided. If the trustee fails to prove the existence of such a creditor, they will lose the claim. There are countless cases in which a trustee has identified what looks like a fraudulent transfer avoidance action only to discover because the case is lost because the trustee cannot link to an actual creditor who is negatively impacted under state law.

How the Case Arose

The plaintiff, U.S. Glove Incorporated, manufactures gymnastic supports for the wrists. The defendant once solely owned the company. In the autumn of 2018, 57% of defendant’s stock was traded in for an approximately $2.1 million promissory note as well as a $1.2 million promissory note. The greater of these two amounts was secured by the plaintiff’s property. 20 months later, the security interest was perfected. 

The plaintiff later filed for bankruptcy in the winter of 2021. Two of the plaintiff’s original creditors are the defendant who is owed by the company approximately $3.5 million and the Small Business Administration who is owed approximately $149,000. In accordance with an agreement between the defendant and plaintiff, the defendant’s lien was less of a priority than the debt owed to the Small Business Administration. Later, the plaintiff pursued a lawsuit seeking to avoid the defendant’s security interest. In April 2021, the plaintiff attempted to obtain summary judgment. 

The Bankruptcy Court’s Ruling

The court that heard the case first ruled that the plaintiff had satisfied the elements necessary for a preference claim. The court noted that after all, the interest had been transferred to the defendant, the transfer addressed the account of an antecedent debt, and the note was connected to the buyout. Additionally, the plaintiff was insolvent at the time of transfer, this event happened soon (less than nine months) after the bankruptcy filing, and interest permitted the defendant to recover greater than was available to be recovered under Chapter 7 bankruptcy. The defendant accepted these points, but alleged that the plaintiff did not have adequate standing to pursue this claim because the security interest only benefitted creditors and not the plaintiff. 

Further interpreting the matter, the court found that in matters that are decided by the Bankruptcy Act (which was the body of regulation before its previous bankruptcy laws), courts found that the reason avoidance powers exist is to provide an advantage to creditors. The court also noted that these advantages are only capable of being used by the debtor. The court additionally noted that under the bankruptcy code, recovery after a transfer of property, recovery exists for the advantage of the estate. 

This means that courts have consistently found this element exists for the gain of creditors. The court, however, found that in this case, the plaintiff was attempting to avoid a debt, had not pleaded section 550, and that avoidance provisions lack language stating that they exist for the benefit of the estate. Consequently, the court found that a split between legal minds currently exists involving this question. 

While some cases require the estate to have a benefit, other cases have found that no such requirement exists. 

Forced to decide between these two sides, the court found that a requirement exists involving the use of avoidance powers. The court noted that one Supreme Court case clearly held that clear indication must exist before it can be found that Congress made an effort to leave previous bankruptcy habits. 

The court also noted that no valuable difference existed when courts examined the difference between cases involving lien avoidance and other cases where parties sought the recovery of property. Subsequently, the court held that section 550 applied to the case because a security interest includes a grant of property and that attempting to bypass this grant represents a recovery of property. Lastly, the court found that Congress’s reason for enacting these avoidance powers was to enable creditors in an equitable manner instead of merely creating substantial profits for debtors. 

In conclusion, the court found that when tasked with the issue of whether avoiding a lien constitutes a benefit to an estate, the outcome would depend on a detailed analysis. Consequently, the court denied the plaintiff’s motion for summary judgment. 

Contact an Experienced Bankruptcy Lawyer

Bankruptcy is one of the most complex areas of law, which is why you have questions or concerns of any type about this area, it is a good idea to speak with a skilled attorney. Contact attorney Melanie Tavare today to schedule a free case evaluation.