28: AVOIDING POWERS –
OVERVIEW, TRUSTEE AS
SUCCESSOR, STRONG ARM
CLAUSE
© CHARLES TABB 2010
WHAT IS “AVOIDANCE”?
Set aside, invalidate
 A transfer by or obligation of Dr


Based on one of the powers given trustee in 544549
EFFECTS: AVOID OUTRIGHT TRANSFER

If avoidance is of an outright transfer of property,
then the trustee will then seek to recover the
property transferred or its value
EFFECTS: AVOID A LIEN


If lien is avoided, then effect is simple: the
lienholder loses its lien, and becomes unsecured
The property is no longer subject to the lien
WHAT IS “RECOVERY”?


“Recovery” is the trustee’s attempt to recover the
transferred property, or its value, following the
avoidance of the transfer
Under 550
FROM WHOM MAY TRUSTEE RECOVER?
Under 550(a)(1):
 1st : from the “initial transferee” of the avoided
transfer, or, alternatively,
 2nd, from the entity for whose benefit that
transfer was made




For example, if Dr pays off a guaranteed debt, also
“benefits” the guarantor, who is no longer liable
Trustee has choice – but of course only a single
satisfaction possible, 550(d)
Liability absolute under 550(a)(1)
FROM WHOM?

Under 550(a)(2): from a subsequent transferee


i.e., Not the initial transferee, but down the line
More protections for subsequent transferees:

1st – if took in good faith, for value, and w/o
knowledge that transfer was voidable – immune from
recovery, 550(b)(1)

2nd –if take from a protected transferee – and if in
good faith, also immune, 550(b)(2)

Concept of derivative title
502(H) CLAIM



If entity is subjected to recovery of an avoided
transfer, then it has a general unsecured claim in
bankruptcy case is that amount, 502(h)
Restores status quo ante
Example: Cr paid $10K preference – avoided &
recovered in bk case – so now Cr has $10K claim
again (just as it would have if had not been paid
preference in the 1st place)
WHAT IS “PRESERVATION”?


“preservation” of avoided transfer ensures that the
estate actually will capture the economic value of that
avoided transfer by stepping into the transferee’s
shoes
Example:
property worth $20K, subject to two liens: a senior lien for
$10K, and junior lien for $25K
 senior lien, but not the junior lien, is avoided
 Without preservation, nothing would be left for the estate,
b/c 2nd lien of $25k would take entire $20K value
 With preservation under 551,though, the estate takes the
place of the avoided senior lien. I.e., estate steps into 1st
lien’s shoes and is entitled to the first $10K of value in the
property (the amount of the senior lien avoided), and the
junior lien takes the residue.

VOIDABLE, NOT VOID



Avoiding powers must be exercised by trustee
bringing a lawsuit in the bankruptcy case
Are not self-executing
i.e., transfers subject to avoidance are “voidable”
and not “void”
STATUTES OF LIMITATIONS
Under avoiding powers for pre-petition transfers
(e.g., 544, 545, 547, 548, 553):
 General rule (546(a)(1))  Later of:


2 years after bk filing,
Or


One year after trustee 1st appointed, if appointed
before 2 years is up --
Absolute cutoff (546(a)(2)) – when bk case is
closed or dismissed
LIMITATIONS, CONT.
For avoidance of a post-petition transfer (549):
 Two years after the date of that transfer, and
before the case is closed or dismissed (549(d))

LIMITATIONS, CONT.

For a recovery action – one year after transfer
avoided, and before case closed or dismissed,
550(f)
VIDEO DEPOT –RECOVERY FROM WHOM?

Facts:






Jeffrey Arlynn Prez of Video Depot, Ltd.
Arlynn, personally, ran up huge gambling debts at
Las Vegas Hilton
June 1990 – Arlynn caused Video Depot to purchase
a cashier’s check for $65K payable to Hilton – check
shows Video Depot as the purchaser of the check
Arlynn delivered cashier’s check to Hilton
Sept. 1990 Video Depot filed bankruptcy
Trustee sought to avoid transfer of cashier’s check as
a fraudulent transfer, and to recover the $65k from
Hilton
ISSUE IN VIDEO DEPOT

Was the Hilton the “initial” transferee of the
cashier’s check, and thus absolutely liable under
550(a)(1), or was it a subsequent transferee
under 550(a)(2), and thus potentially protected if
a good faith transferee for value and without
knowledge under 550(b)(1)?
INITIAL VS SUBSEQUENT TRANSFEREE
Initial transferee – absolute liability
 Subsequent transferee – protected if innocent
and gave value

Reason? Ability to monitor – put duty of inquiry
(and risk) on the party who deals with the
fraudulent transferor
 But not hold downstream transferees to same
duty, b/c (i) would interfere with free flow of
commercial transactions and (ii) not in a position
to monitor original fraud

HILTON ARGUED?


Hilton said it was a subsequent transferee (from
Arlynn), and was innocent of the fraud, and gave
Arlynn value (the debt was paid)
i.e., Hilton theory:

Video Depot  Arlynn  Hilton
HILTON “INITIAL” TRANSFEREE

Court held: Hilton initial transferee and thus
absolutely liable

Video Depot  Arlynn  Hilton
WHY?

Why did court hold that Hilton was initial transferee
and thus absolutely liable?
FORM:
Cashier’s check

Video Depot  Arlynn  Hilton

Monitoring – didn’t Hilton wonder why it
got a $65K cashier’s check from Video
Depot to pay Arlynn’s debt??
IS ARLYNN ALSO LIABLE?
Note that the bankruptcy trustee ALSO could
have gotten recovery from Arlynn under 550(a)(1)
 He was the entity “for whose benefit” the transfer
from Video to Hilton was made


b/c his debt was getting paid off!
CHECK TO ARLYNN 1ST?

Would result be different if Video Depot wrote a
check payable to Arlynn, who then endorsed it
over to Hilton?
check

endorsed
Video Depot  Arlynn  Hilton
CHANGES RESULT



If instead Video Depot had written check payable
to Arlynn (not the Hilton) and Arlynn then
endorsed over to the Hilton, then for sure Arlynn
would be the initial transferee, and Hilton a
subsequent transferee (from Arlynn)
Arlynn would have had “dominion and control”
over the check made payable to him
And policy served as well – now Hilton is getting
a check from Arlynn (their Dr) and not from
Video Depot – so less (no?) reason for them to
monitor the Video Depot-to-Arlynn transfer
OVERVIEW OF AVOIDING POWERS

Basic premises & goals:
 1st, facilitate & maintain integrity of
bankruptcy as a collective proceeding – protect
Crs from each other
 Preserve equality paradigm
 Avoid transfers that undermine, recover
value
 invalidate secret liens & transfers

2nd, protect creditors from Dr (fraudulent
transfer law)
OVERVIEW
 “equality”
based avoiding powers

The most fundamental aspect of bankruptcy as a
collective proceeding is to promote equal treatment
of all similarly situated parties – rather than the
“race” of non-bankruptcy law
 So if some creditors get paid (especially if see
bankruptcy coming), and others don’t, have to
unwind those transfers and restore equality

Avoiding powers:
 Preferences (547) – paid in 90 days before bk
 Setoff (553(b)) – within 90-day period
 Post-bankruptcy (549)
 Statutory liens (545(1))
OVERVIEW



“Secret” transfers & principle of ostensible
ownership
If parties could deal with Dr in private, but not record
liens or property transfers in public records, and yet
later enforce those liens or transfers anyway, then
other creditors of Drs would potentially be misled to
their detriment as to the true state of Dr’s finances
Avoiding powers:
Strong-arm clause (544(a)) – not filed in public records at
time of bankruptcy
 Preference (547) – not in public records until last 90 days
 Statutory liens (545(2)) - unrecorded

OVERVIEW

Independent of collective proceeding (cr v cr) –
focus is on protecting creditors as a group from a
naughty Dr

Fraudulent transfer law

Avoiding powers:
548 – bankruptcy fraudulent transfer law
 544(b) – incorporate state fraudulent transfer laws

TRUSTEE AS SUCCESSOR, 544(B)

Criteria

1st, an actual unsecured Cr who has standing to bring
an avoidance power under non-bk law (typically state
law)

2nd, that Cr still has an unsecured claim in the
bankruptcy case
 In short – Trustee under 544(b) takes over that
avoidance power from the unsecured cr and exercises
for benefit of the estate
544(B) ROLE


Most important application – bring state
fraudulent transfer laws into the trustee’s
avoidance arsenal
Biggest difference in state fraudulent transfer
laws and bk law (548) – much longer reachback
period (e.g., 4 years, not 2)
MOORE V BAY



Cryptic & much-maligned – but reaffirmed by
Congress in 1978 – decision of the Supreme Ct by
J. Holmes in 1931 (at age 90 – and it showed!)
Problem is what to do when a transfer is
avoidable under non-bk law by some -- but not all
– of the unsecured creditors
2 questions:
1st – extent of avoidance?
 2nd – who shares in the distribution of recovery?

MOORE

Facts:
Delay in recording a chattel mortgage
 Under state law, creditors whose claims arose before
recordation (Group A) had priority over the mortgagee,
while those whose claims arose after (Group B) did not



The lower courts held (1) that avoidance was possible
only up to amount of claims held by Group A
creditors, and (2) that distribution should go only to
those Group A creditors
The Supreme Court reversed: (1) amount – avoid
entire mortgage, (2) distribution to groups A and B
PROBLEM 9.1

Facts:
 Dr has total of $20k in unsecured claims when it
files bankruptcy
 Three years prior to filing bankruptcy, Debtor
made a constructively fraudulent transfer of
property worth $18K to Party X
 Only remaining creditor in the bankruptcy with
standing to avoid the old transfer to X under the
state fraudulent transfer law is Creditor A (who
had a “present” claim at the time of the transfer to
X). A’s claim is just $100.
 The rest of the Debtor's creditors, with total claims
of $19,900, had “future” claims and thus could not
have avoided the transfer to X under state law.
9.1
A
$100
$18,000 transfer to
X
$19,900 unsecured claims other
than Creditor A
9.1 ISSUE ONE

How much avoid?

Options:
Just the amount A itself could avoid (e.g., $100)
 The whole transfer (e.g., $18K)


Result?
 avoid the entire transfer
Serious bummer for X!
9.1 ISSUE TWO



Who gets the distribution of the recovery?
Options:
 Just A (i.e., the only party who could have gotten
the distribution outside of bk)
 All unsecured crs
Result?
 goes to all unsecured creditors – even including
those who could not have reached the $ outside of
bankruptcy
* another of those blatant bankruptcy wealth
redistribution rules
STRONG ARM CLAUSE


General policy – set aside secret (i.e., not
recorded in the public records) liens and
transfers, as of the date the bankruptcy is filed
Implements notion of ostensible ownership

Renders actual that which was apparent
STRONG ARM – 3 PARTS



544(a)(1) – trustee as lien Cr – avoid
unperfected personal property security interests
544(a)(2) – trustee as unsatisfied execution Cr
(just ignore this one – never comes up in real
world)
544(a)(3) – trustee as bona fide purchaser of
real property – avoid unrecorded real estate
mortgages and transfers
STRONG ARM – KEY ASPECTS

1st: time frame – when bankruptcy is commenced

2nd: trustee = hypothetical lien creditor or bfp


3rd: knowledge of trustee is irrelevant


i.e., do not need an actual lien creditor or bfp, unlike
544(b)
i.e., trustee is conclusively deemed not to have
knowledge
4th: avoid under applicable nonbankruptcy law,
usually state law (e.g, Article 9 UCC)
TRUSTEE AS LIEN CREDITOR


544(a)(1) – trustee given power of lien cr
Important to knock out unperfected security
interests in personal property
REPRISE, UCC 9-317(A)(2)


Critical priority rule in Article 9 given effect in
bankruptcy via § 544(a)(1) is the rule of U.C.C. §
9-317(a)(2):
“A security interest … is subordinate to the rights
of … a person who becomes a lien creditor before
… the security interest … is perfected.”
Thus, under Article 9 a lien creditor takes
priority over an unperfected security interest
UCC RULE APPLIED IN 544(A)(1)

Applying UCC 9-317(a)(2) to strong arm clause
leads to result that bankruptcy trustee, who has
powers of “lien creditor” under § 544(a)(1), will be
able to avoid a security interest that is
unperfected at the time of bankruptcy.


By inference, under the strong arm clause the trustee
will not be able to avoid a security interest that is
perfected at the time of bankruptcy.
Decisive issue will be whether the security interest
was perfected at the instant the bankruptcy case
was filed
PURCHASE MONEY EXCEPTION

U.C.C. § 9-317(e) -- secured party has grace period of
20 days to perfect a PMSI after the debtor takes
possession of the collateral


perfection within grace period is deemed to relate back to
the time security interest attaches
Thus, if SP with PMSI has not yet perfected when
bankruptcy is filed, but is still within the applicable
relation-back grace period, SP is permitted to perfect
within the grace period and upon doing so is not
vulnerable to strong-arm avoidance

Note that the postpetition perfection of the security
interest would not violate the automatic stay. § 362(b)(3).
PROBLEM 9.2(A)

Facts:
On May 1, Debtor grants Creditor a security interest
in tangible personal property worth $10,000 to secure
a $10,000 debt
 On May 10, Debtor files chapter 7
 Creditor has not perfected its security interest by
May 10

ANALYSIS 9.2(A)

Avoid Cr’s security interest under 544(a)(1)

CR had not perfected at time of bankruptcy

Thus trustee as a hypothetical “lien creditor”
would be able to beat Cr (under 9-317(a)(2))
9.2(B)

Facts:
On May 1, Debtor grants Creditor a security interest
in tangible personal property worth $10,000 to secure
a $10,000 debt
 May 9 Creditor perfects
 On May 10, Debtor files chapter 7

ANALYSIS 9.2(B)


Not avoid
At time bankruptcy was filed, Cr was perfected,
so would defeat a “lien cr” whose rights arose at
time of bk (inference from 9-317(a)(2))
9.2(C)

Facts:
 May 1 Debtor granted Creditor a mortgage in real
property worth $10,000 to secure a $10,000 debt
 May 10 Debtor filed chapter 7
 Creditor had not recorded mortgage in real
property records by May 10, when Debtor filed
 Under state law, a bona fide purchaser for value
without actual knowledge of an unrecorded
conveyance of real estate would take free of that
conveyance, but a judgment creditor that obtains a
judicial lien on a debtor’s real property is not
considered a bona fide purchaser
ANALYSIS 9.2(C)


Not avoid under 544(a)(1)
Under the state recording statute, a “lien cr” does
NOT beat an unrecorded mortgage
9.2(D)

Facts:
May 1, Creditor sells Debtor a gizmo on credit and
Debtor grants Creditor a purchase money security
interest in the gizmo to secure the payments. Debtor
takes possession of the gizmo immediately.
 May 5, Debtor files chapter 7
 May 8, Creditor files a financing statement perfecting
the security interest

ANALYSIS 9.2(D)



Not avoid
Creditor as holder of a PMSI has 20-day grace
period of 9-317(e) to perfect, and when does so on
May 8 (which, note, may do w/o violating stay,
362(b)(3)), perfection relates back to time of
attachment on May 1
So is as if WAS perfected at time of bankruptcy
(once allow relation-back perfection)
TRUSTEE AS BONA FIDE PURCHASER


Rule: trustee is given power of a hypothetical
bona fide purchaser of real property
Important to knock out unrecorded real estate
mortgages and conveyances
ISSUES UNDER BFP CLAUSE



1st, what if Dr as DIP DOES have actual
knowledge of transfer, and state law would not
allow avoidance by party w/ knowledge
2nd, can a transferee who doesn’t record still be
protected by constructive notice?
3rd, DR holds bare legal title, subject to equitable
interests, but that limited status is not recorded
– can trustee as bfp defeat equitable interests?
Seen as possible conflict 544(a)(3) vs 541(d)
ACTUAL KNOWLEDGE OF DIP

1st case is easy – even though under state law a
bfp who had actual knowledge of an unrecorded
mortgage or conveyance could not get priority
over that unrecorded interest, the strong arm
clause invests the trustee (or DIP) with status of
a hypothetical bfp without knowledge
Even if the particular DIP happens to have actual
knowledge – which it would since it made the
transfer!
 But are treating Dr/DIP as the estate representative
 And if DID appoint a trustee, then that trustee in
fact would NOT have actual knowledge


So can still avoid – ignore actual knowledge
CONSTRUCTIVE NOTICE

What if state law would accord priority over a bfp
to a transferee who had not recorded, BUT who
had done something that would provide
constructive notice?



Example – adverse possession
Does the strong arm clause negation of
“knowledge” go this far?
NO – could not avoid – give effect to a notice that
is good against the world

In effect here have a substitute for recordation
STRONG ARM VS 541(D)??

Situation:
Dr holds just legal title to real property at time of
bankruptcy, subject to superior equitable interests.
 However, that limited title is not recorded
 And under state law, a bfp w/o knowledge could
defeat unrecorded equitable interests



Can trustee avoid equitable interests?
Concern raised – 541(d) – estate only got Dr’s
limited property interest, and this conflicts with
544(a)(3)
FALSE CONFLICT



There actually is no conflict between 541(d) and
544(a)(3)
1st, one of the functions and effects of avoiding
powers is to bring property into estate that
previously was not there
2nd, as statutory matter, have provision bringing
into property of the estate (541(a)(3)) any
property that trustee recovers under 550

Which would include strong arm recoveries
BUT ARGUABLY 544(A)(3) N/A EITHER


Note, though, that in the Dr-has-bare-legal-title
case, even though 541(d) is not a concern, it
seems that avoidance might not be warranted
under 544(a)(3) anyway.
Why not? -- the language empowers the trustee
to “avoid any transfer of property of the debtor”
and in retained legal title cases there is no
operative transfer BY the debtor

Indeed there may be a transfer TO the debtor (e.g.,
from investors)
WHY HAVE BFP STRONG ARM CLAUSE?


Effect – transfer property from holder of unrecorded
real estate interest to unsecured creditors of estate
At least plausible justification for lien cr rule
(544(a)(1)), b/c a general unsecured Cr possibly
COULD beat an unperfected security interest (by
getting a judicial lien, e.g., execution lien)


So effect of strong arm is to call it a “tie”
But unsecured creditors CANNOT defeat unrecorded
real property interests – not in the protected class
  why give “unsecured creditors” the fruits of the
powers of a bona fide purchaser?
PROBLEM 9.3(A)

Facts: (same as 9.2(c))
 May 1 Debtor granted Creditor a mortgage in real
property worth $10,000 to secure a $10,000 debt
 May 10 Debtor filed chapter 7
 Creditor had not recorded mortgage in real
property records by May 10, when Debtor filed
 Under state law, a bona fide purchaser for value
without actual knowledge of an unrecorded
conveyance of real estate would take free of that
conveyance, but a judgment creditor that obtains a
judicial lien on a debtor’s real property is not
considered a bona fide purchaser
ANALYSIS 9.3(A)

Avoid 544(a)(3)



Even though could not avoid under 544(a)(1), recall,
from 9.2(c)
Under bfp rule, though, the state law says that
an unrecorded mortgage loses to a bfp
And trustee takes those bfp powers in 544(a)(3)
9.3(B)

Facts:
Debtor conveys Blackacre to X, but the conveyance is
not recorded.
 Under state law, a bona fide purchaser for value
without actual knowledge of an unrecorded
conveyance of real estate would take free of that
conveyance.
 Debtor files chapter 7.

ANALYSIS 9.3(B)


Avoid unrecorded conveyance, recover property
(or its value) from X
Again, 544(a)(3) gives trustee bfp status, and
state law says bfp wins
9.3(C)

Facts:
Debtor conveys Blackacre to X, but the conveyance is
not recorded.
 Under state law, a bona fide purchaser for value
without actual knowledge of an unrecorded
conveyance of real estate would take free of that
conveyance.
 Debtor files chapter 11 and continues as DIP.

ANALYSIS 9.3(C)

Avoid



Same analysis exactly as 9.3(b)
No difference that Dr as DIP is avoiding
Fact that DR / DIP itself had “actual knowledge”
of transfer is ignored under 544(a)
9.3(D)

Facts:
Debtor conveys Blackacre to X, but the conveyance is
not recorded.
 However, X takes up residence on Blackacre.
 Under state law:
 a bona fide purchaser for value without actual
knowledge of an unrecorded conveyance of real
estate would take free of that conveyance.
 BUT a purchaser who establishes "clear and open
possession" provides constructive notice to the
world of the purchaser's interest.
 Debtor files chapter 7.

ANALYSIS 9.3(D)


NOT avoid
Constructive notice from possession, which is
recognized and given effect under state law,
precludes avoidance under 544(a)(3)