Fifth Circuit: Preference Claims Are Property of the Bankruptcy Estate that Can Be Sold
A debtor's non-exempt assets (and even the debtor's entire business) are commonly sold during the course of a bankruptcy case by the trustee or a chapter 11 debtor-in-possession ("DIP") as a means of augmenting the bankruptcy estate for the benefit of stakeholders or to fund distributions under, or implement, a chapter 11, 12, or 13 plan. However, it is less well understood that causes of action that become part of the bankruptcy estate in connection with a bankruptcy case (e.g., fraudulent transfer, preference, or other litigation claims) may also be sold or assigned by a trustee or DIP during bankruptcy to generate value. The U.S. Court of Appeals for the Fifth Circuit considered this question in Matter of South Coast Supply Co., 91 F.4th 376 (5th Cir. 2024). The court of appeals joined the Eighth and Ninth Circuits in concluding that avoidance actions (in this case, a preference claim) are property of the estate that can be sold to creditors as a means of generating value.
Broad Scope of Property of the Estate
When a debtor files a bankruptcy petition, the filing creates an "estate" that consists of, among other things, "all legal or equitable interests of the debtor in property as of the commencement of the case" (with certain exceptions) as well as all property that the estate acquires "after the commencement of the case." 11 U.S.C. § 541(a)(1) and (a)(7). Also included in "property of the estate" is "[a]ny interest in property that the trustee [or DIP] recovers" under various provisions of the Bankruptcy Code (see 11 U.S.C. § 541(a)(3)), including section 550, which authorizes the trustee or DIP to recover any property (or its value) that has been fraudulently or preferentially transferred by the debtor during a specified period prior to its bankruptcy filing. The estate also includes any property interest that a bankruptcy court orders to be transferred to the estate or preserved for the estate's benefit because it is either a lien securing an equitably subordinated claim (see 11 U.S.C. § 510(c)) or an avoided transfer (see 11 U.S.C. § 551). In addition, under section 541(a)(6) of the Bankruptcy Code, estate property includes any "[p]roceeds, product, offspring, rents, or profits of or from property of the estate," with certain exceptions.
Section 541 "is intended to include in the estate any property made available to the estate by other provisions of the Bankruptcy Code." City of Chicago, Illinois v. Fulton, 141 S. Ct. 585, 589 (2021). Carefully defining the scope of estate property in a given case may be critical to the outcome of the bankruptcy. Property of the estate is protected (with certain exceptions) by the automatic stay under section 362; it may generally be sold, used, or leased under section 363, and, if unencumbered or non-exempt, it is generally available to stakeholders for distribution under a chapter 9, 11, 12, or 13 plan.
Given the importance of estate property, courts have found that a wide variety of interests of the debtor qualify as property of the estate. See United States v. Whiting Pools, Inc., 462 U.S. 198, 204 (1983) ("Both the congressional goal of encouraging reorganizations and Congress' choice of methods to protect secured creditors suggest that Congress intended a broad range of property to be included in the estate."); see, e.g., ACandS, Inc. v. Travelers Cas. & Sur. Co., 435 F.3d 252 (3d Cir. 2006) (insurance policies were estate property); Whetzal v. Alderson, 32 F.3d 1302 (8th Cir. 1994) (causes of action); Windstream Holdings, Inc. v. Charter Commc'ns Inc. (In re Windstream Holdings, Inc.), 634 F. Supp. 3d 99 (S.D.N.Y. Oct. 6, 2022) (customer contracts), appeal filed, No. 22-2891 (2d Cir. Nov. 3, 2022) (argument held on Sep. 7, 2023).
Avoidance Actions
An indispensable tool available to a bankruptcy trustee (or DIP, by operation of section 1107(a)) is the power to augment the estate by avoiding and recovering certain transfers or obligations incurred by the debtor prior to filing for bankruptcy that either are fraudulent or unfairly prefer certain creditors. With respect to the former of these categories, section 548 of the Bankruptcy Code provides in part that the trustee "may avoid any transfer … of an interest of the debtor in property, or any obligation … incurred by the debtor, that was made or incurred within 2 years before the date of the filing of the petition." 11 U.S.C. § 548(a)(1).
Fraudulent transfers that can be avoided include both: (i) actual fraudulent transfers, which are transfers made with "actual intent to hinder, delay, or defraud" creditors (see 11 U.S.C. § 548(a)(1)(A)); and (ii) constructive fraudulent transfers, which are "transactions that may be free of actual fraud, but which are deemed to diminish unfairly a debtor's assets in derogation of creditors." Collier on Bankruptcy ("Collier") ¶ 548.05 (16th ed. 2023); 11 U.S.C. § 548(a)(1)(B).
A transfer is constructively fraudulent if the debtor received "less than a reasonably equivalent value in exchange for such transfer or obligation" and was, among other things, insolvent, undercapitalized, or unable to pay its debts as such debts matured. See Collier at ¶ 548.05; 11 U.S.C. § 548(a)(1)(B).
Fraudulent transfers may also be avoided by a trustee or DIP under section 544(b) of the Bankruptcy Code, which provides that, with certain exceptions, "the trustee may avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim that is allowable under section 502 of [the Bankruptcy Code] or that is not allowable only under section 502(e) of [the Bankruptcy Code]." 11 U.S.C. § 544(b)(1). This provision permits a trustee to step into the shoes of a "triggering" unsecured creditor that could have sought avoidance of a transfer under applicable non-bankruptcy law (e.g., the Uniform Fraudulent Transfer Act or its successor, the Uniform Voidable Transactions Act, which has been enacted in many states). See generally Collier at ¶ 544.06. Section 544(b) is an important tool, principally because the reach-back period for avoidance of fraudulent transfers under state fraudulent transfer laws (or even non-bankruptcy federal laws, such as the Internal Revenue Code) is typically longer than the two-year period for avoidance under section 548. Id.
Section 547(b) of the Bankruptcy Code provides that, with certain exceptions, a trustee or DIP, "based on reasonable due diligence in the circumstances of the case and taking into account a party's known or reasonably knowable affirmative defenses under subsection (c)," may avoid "any transfer" made by an insolvent debtor within 90 days of a bankruptcy petition filing (or up to one year, if the transferee is an insider) to a creditor for or on account of an antecedent debt, if the creditor, by reason of the transfer, receives more than it would have received in a chapter 7 liquidation and the transfer had not been made. 11 U.S.C. § 547(b).
Section 547(c) sets forth nine defenses or exceptions to avoidance. These include, among other things, contemporaneous exchanges for new value, ordinary course of business transfers, transfers involving purchase-money security interests, and transfers after which the transferor subsequently provides new value to the debtor.
Unauthorized postpetition transfers of estate property may be avoided under section 549, and other provisions of the Bankruptcy Code authorize the trustee or DIP to avoid certain other kinds of transfers. See 11 U.S.C. § 545 (certain statutory liens); 11 U.S.C. § 553(b) (certain setoffs); 11 U.S.C. § 724(a) (avoidance of liens securing certain claims for damages, fines, penalties, and forfeitures).
If a transfer is avoided under any of these provisions, section 550 of the Bankruptcy Code authorizes the trustee or DIP to recover the property transferred or its value from the initial or subsequent transferees, with certain exceptions.
South Coast Supply
South Coast Supply Co. ("South Coast) is an industrial products distributor that began experiencing financial troubles in 2016. Needing extra cash, South Coast borrowed $800,000 from its then-CFO. Under the loan agreement, South Coast made 47 separate payments to its CFO totaling approximately $321,000. After resigning, the former CFO demanded that South Coast pay $405,261.87 to satisfy the outstanding balance of the loan. Then, in October 2017, South Coast filed a chapter 11 petition in the Southern District of Texas. Five months later, South Coast brought an avoidance action under section 547 of the Bankruptcy Code to avoid as preferential the $321,000 in prepetition payments it made to the former CFO.
South Coast's sole secured lender was Briar Capital Working Fund Capital, L.L.C. ("Briar Capital"). After objecting to South Coast's first proposed chapter 11 plan, Briar Capital settled its issues with South Coast and agreed to a second, modified plan. Under the modified plan, Briar Capital would abandon a security interest it held in the proceeds of a sale of certain "intangible assets" valued at $700,000. South Coast would then distribute the proceeds to unsecured creditors. Briar Capital also agreed to waive a claim that it asserted against South Coast for administrative expenses. In exchange, Briar Capital would receive South Coast's interest in the pending avoidance action against the former CFO. The bankruptcy court approved the sale of the preference claim and confirmed the modified plan.
Briar Capital was substituted for South Coast in the preference action. With Briar Capital as the plaintiff, the adversary proceeding was withdrawn to the district court. The former CFO filed a motion to dismiss the complaint, arguing that Briar Capital lacked standing to prosecute the preference action. The district court agreed, holding that Briar Capital lacked standing to bring the preference claim against the former CFO because: (i) a successful recovery would not benefit South Coast's estate, and (ii) Briar Capital was not a "representative of the estate" under section 1123(b)(3)(B) of the Bankruptcy Code, which states that a chapter 11 plan may provide for the "retention and enforcement" of any claim belonging to the estate "by the debtor, by the trustee, or by a representative of the estate appointed for such purpose." Central to its decision, the district court noted an absence of explicit authorization in the Fifth Circuit for the sale of avoidance actions under section 547, as distinguished from avoidance actions under section 548, which the Fifth Circuit previously held could be sold in In re Moore, 608 F.3d 253 (5th Cir. 2010). Briar Capital appealed to the Fifth Circuit.
The Fifth Circuit's Decision
In a three-judge panel, with U.S. Circuit Court Judge James L. Dennis penning its opinion, the Fifth Circuit reversed the district court. South Coast's appeal, Judge Dennis wrote, turned on "whether preference claims—a type of avoidance action—may validly be sold." South Coast Supply, 91 F.4th at 382.
The Fifth Circuit panel first considered whether a preference action qualifies as "property of the estate" under the broad, general definition found in section 541(a)(1) of the Bankruptcy Code. Quoting the Supreme Court's broad holding that property of the estate "is intended to include in the estate any property made available to the estate by other provisions of the Bankruptcy Code," the Fifth Circuit found that avoidance actions must qualify. Id. at 381–382 (citing Whiting Pools, 462 U.S. at 205). "Preference actions," Judge Dennis explained, "are a mechanism in the Bankruptcy Code by which additional property is made available to the estate, fitting squarely within the Whiting Pools definition." Id. at 382.
Next, the Fifth Circuit considered whether preference actions qualify as estate property under section 541(a)(7), which provides that property of the estate includes "any interest in property that the estate acquires after the commencement of the estate." Guided by a previous Fifth Circuit decision, the panel found that section 541 was intended by Congress to be an "all-embracing definition" of "property of the estate" and that all "property interests created with or by property of the estate are themselves property of the estate." Id. (quoting In re TMT Procurement Corp., 764 F.3d 512, 525 (5th Cir. 2014)). Therefore, the Fifth Circuit panel concluded, preference actions "clearly qualify" as property of the estate under section 541(a)(7). Id.
The Fifth Circuit panel cited similar holdings by the Eighth and Ninth Circuits. Id. at 383 (citing Pitman Farms v. ARKK Food Co. LLC (In re Simply Essentials LLC), 78 F.4th 1006, 1011 (8th Cir. 2023) ("Chapter 5 avoidance actions are property of the estate"); In re P.R.T.C., Inc., 177 F.3d 774, 780-81 (9th Cir. 1999) ("Although no provision of the bankruptcy code similarly authorizes others to exercise [the trustee's] powers, '[i]t is a well-settled principle that avoidance powers may be assigned to someone other than the debtor or trustee pursuant to a plan of reorganization' under 11 U.S.C. § 1123(b)(3)(B)") (citation omitted); In re Prof'l Inv. Props. of Am., 955 F.2d 623, 625–26 (9th Cir. 1992) (ruling that a trustee's strong-arm powers were transferable to a purchaser of the estate's claim to proceeds from sale of property and noting that "[i]f a creditor is pursuing interests common to all creditors or is appointed for the purpose of enforcement of the plan, he may exercise the trustee's avoidance powers"); In re Lahijani, 325 B.R. 282, 288 (9th Cir. BAP 2005) ("While there is some disagreement among courts about the exercise by others of the trustee's bankruptcy-specific avoiding power causes of action, the Ninth Circuit permits such actions to be sold or transferred.").
Judge Dennis commented that broad interpretations of "property of the estate," now endorsed by three Circuits, best serve both the estate itself and its creditors. In this case, while "Briar Capital does not owe any percentage of the possible recovery in this case to the estate, its waiver of the right to collect administrative expenses and its release of its claim to $700,000 are concrete benefits to the estate." Id. at 383.
The Fifth Circuit panel rejected the former CEO's argument that, because "Briar Capital would be pursuing claims only for itself," it "would be potentially allowed to recover more than rightfully due to it." According to Judge Dennis, the court previously addressed this policy concern in Moore. Although Moore addressed the sale of fraudulent transfer rather than preference claims, Judge Dennis explained, "its underlying policy arguments apply with equal force in this case"—namely, that the sale of avoidance claims "will not necessarily undermine core bankruptcy principles," and in approving such sales, "bankruptcy courts must ensure that fundamental bankruptcy policies of asset value maximization and equitable distribution are satisfied." South Coast Supply, 91 F.4th at 383-84 (citing Moore, 608 F.3d at 262 n. 18) (internal quotation marks omitted). Moreover, he wrote, "[a]llowing the sale of preference actions will grant bankruptcy courts more flexibility in distributing assets, maximize the value of the bankruptcy estate, and in turn, allow for more equitable distribution of assets." Id. at 384.
Judge Dennis further noted that allowing for the sale of preference claims as property of the estate may be the "most equitable option." Id. This rule, he explained, allows for increased flexibility in distributing remaining assets and allows a trustee or DIP to maximize the bankruptcy estate. Id.
Finally, the Fifth Circuit panel rejected the argument by the former CFO that a party must be a "representative of the estate" to pursue a validly purchased preference claim. Id. at 384–385. According to Judge Dennis, "[w]hether Briar Capital is a 'representative of the estate' is irrelevant to this appeal." Id. at 385. He explained that this conclusion is supported by: (i) section 1123(b)(3), which, as noted previously, states that a chapter 11 plan may provide for the "settlement or adjustment of any claim or interest belonging to the debtor or the estate" or "the retention or enforcement by the debtor, by the trustee, or by a representative of the estate appointed for such purpose of any such claim"; and (ii) the fact that section 363(b) of the Bankruptcy Code, which authorizes the use, sale, or lease of estate property outside the ordinary course of a debtors' business, does not expressly require that the purchaser of estate property also be a representative of the estate, but only that the trustee provides notice of the sale and an opportunity for a hearing before the court. Id.
Outlook
There are a few key takeaways from the Fifth Circuit's decision in South Coast Supply, First, when lawmakers enacted the Bankruptcy Code in 1978, they intended that the scope of "property of the estate" would be quite broad to ensure that all of a debtor's assets could be administered in a bankruptcy case. Second, the expansive definition of "estate property" in section 541 of the Bankruptcy Code encompasses pre-bankruptcy causes of action belonging to the debtor as well as causes of action or claims that spring into existence on the petition date (e.g., avoidance causes of action under the Bankruptcy Code, including claims that a trustee or DIP can assert on behalf of creditors). Third, under appropriate circumstances, where the estate lacks sufficient resources to prosecute colorable claims or causes of action, the trustee or DIP can sell such claims or causes of action to generate value for the estate. The Fifth Circuit's decision in South Coast Supply is therefore a positive development for bankruptcy trustees, DIPs, or other stakeholders seeking to maximize estate value.
Finally, with South Coast Supply, the Fifth Circuit joins the Eighth and Ninth Circuits in applying a broad and flexible definition of "property of the estate" to encompass avoidance actions (which the Fifth Circuit had previously considered only in the context of fraudulent transfer claims in Moore).
