Eighth Circuit: Avoidance Causes of Action 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 9, 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 Eighth Circuit examined the circumstances under which estate avoidance claims can be sold in Pitman Farms v. ARKK Food Co. LLC (In re Simply Essentials LLC), 78 F.4th 1006 (8th Cir. 2023). In affirming an Iowa bankruptcy court's ruling that avoidance causes of action can be sold as property of the estate, the Eighth Circuit rejected the argument that such causes of action cannot constitute estate property because avoidance claims "belong" only to the trustee or the DIP. In so ruling, the Eighth Circuit adopted the broad majority view that estate property includes a debtor's "inchoate or contingent" interests.
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 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.), 2022 WL 5245633 (S.D.N.Y. Oct. 6, 2022) (customer contracts).
Avoidance Actions
An indispensable tool available to a bankruptcy trustee or DIP 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 (or DIP, by operation of section 1107(a)) "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). Due to the difficulty in proving actual fraud based on an avoidance defendant's subjective state of mind, some courts consider "badges of fraud" in assessing whether a transfer or obligation was made or incurred with intent to defraud, including, among other things, the adequacy of the consideration involved, the relationships between the parties, whether the transferor continued to use the property even after the transfer, and the transferor's financial condition at the time of and after the transfer. See, e.g., In re TransCare Corp., 81 F.4th 37 (2d Cir. 2023); see generally Collier at ¶ 548.04[1][b][i] (citing cases); see also Section 4(b) of the Uniform Fraudulent Transfer Act (the "UFTA") and its successor, the Uniform Voidable Transfer Act (the "UVTA") (listing 11 separate badges of fraud to be applied in determining whether an actual fraudulent transfer should be avoided under state law) (discussed below).
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 UFTA or its successor, the UVTA, 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.
Simply Essentials
Simply Essentials, LLC (the "debtor") operated a chicken processing facility in Iowa. In March 2020, disgruntled creditors filed an involuntary chapter 7 petition against the debtor in the Northern District of Iowa. The bankruptcy court entered an order for relief and appointed a chapter 7 trustee. Creditors Pitman Farms ("Pitman") and ARKK Food Co. LLC ("ARKK") filed claims against the estate.
The trustee concluded that the estate had colorable claims to avoid transfers made by the debtor pre-bankruptcy to Pitman. However, after determining that the estate lacked sufficient funds to litigate the avoidance claims, the trustee sought court approval of a settlement of ARKK's claims as well as a sale of the avoidance claims against Pitman free and clear of all interests, pursuant to section 363 of the Bankruptcy Code. Both ARKK and Pitman bid for the avoidance claims, but the trustee chose ARKK's bid as the highest and best offer.
Pitman objected to both the proposed sale and settlement. It contended that the avoidance claims could not be sold because avoidance actions generally are not part of the bankruptcy estate under section 541(a). The bankruptcy court disagreed. It held that avoidance causes of action are property of the debtor's estate that can be sold under appropriate circumstances. The bankruptcy court later certified a direct appeal by Pitman of its ruling to the Eighth Circuit. The court denied a motion for a stay pending the appeal, but directed that, even absent a stay, the appeal would not be mooted by section 363(m) of the Bankruptcy Code.
The Eighth Circuit's Decision
A three-judge panel of the Eighth Circuit affirmed the bankruptcy court's decision, ruling that avoidance actions are property of the estate under either section 541(a)(1) or section 541(a)(7) of the Bankruptcy Code.
Writing for the Eighth Circuit panel, Circuit Judge Michael J. Melloy reasoned that the Supreme Court's "broad" interpretation of 541(a)(1) in Whiting Pools clearly encompasses avoidance causes of action. This interpretation, he explained, is bolstered by the Eight Circuit's earlier decision in Whetzal, where the court wrote that the scope of section 541(a) "is very broad and includes property of all descriptions, tangible and intangible, as well as causes of action." Simply Essentials, 78 F.4th at 1008 (quoting Whetzal, 32 F.3d at 1303).
According to Judge Melloy, a plain reading of section 541(a)(7) dictates that an avoidance cause of action qualifies as an "interest in property that the estate acquires after the commencement of the case."
To a point, the Eighth Circuit panel was receptive to Pitman's argument (but only to a point) that a reading of either section 541(a)(1) or 541(a)(7) to include avoidance causes of action would cause "surplusage." According to Pitman, because section 541(a)(6) of the Bankruptcy Code can fairly be read to include the "proceeds" from an avoidance action as property of the estate, and sections 541(a)(3) and 541(a)(4) each specify property recovered from particular kinds of avoidance actions, defining "property of the estate" to include an avoidance cause action itself would be duplicative. The Eight Circuit agreed that its holding appeared to create surplusage. However, it explained that the "canon against surplusage is not an absolute rule." "[G]iven the drafting history and the complex nature of the Bankruptcy Code," Judge Melloy wrote, "the possibility of our interpretation creating surplusage does not alter our conclusion that avoidance actions are part of the estate." Id. at 1010.
The Eighth Circuit panel noted the apparent absence of any decisions in which a court denied a motion to sell an avoidance cause of action because the claim was not estate property. According to Judge Melloy, the case "most contrary to this conclusion" is the Third Circuit's ruling in In re Cybergenics Corp., 226 F.3d 237 (3d Cir. 2000). However, he emphasized, in Cybergenics, the Third Circuit held that avoidance actions are not "assets" of the debtor, but it did not decide whether such actions were "property of the estate." Simply Essentials, 78 F.4th at 1010 (citing Cybergenics, 226 F.3d at 246). Judge Melloy explained that, "evidenced in part by the numerous provisions in the Bankruptcy Code that distinguish between property of the estate and property of the debtor, or refer to one but not the other," the terms "assets" and "property of the estate" have different meanings. Moreover, he noted, Cybergenics's value on this point is undercut by a subsequent Third Circuit ruling in which the court stressed that "Cybergenics does not hold that trustees cannot transfer causes of action." Id. at 1010–11 (quoting In re Wilton Armetale, Inc., 968 F.3d 273, 285 (3d Cir. 2020)).
The Eighth Circuit panel concluded that, "[e]ven if there were any ambiguity in the statutory language we are persuaded by the consensus of courts across the country: avoidance actions are property of the estate." Id. at 1010. Given the potential value of the litigation claims and the absence of sufficient value in the estate to fund the litigation, the Eighth Circuit found no error in the bankruptcy court's decision to approve the sale of the estate's avoidance claims to ARKK.
Outlook
There are a few key takeaways from the Eighth Circuit's decision in Simply Essentials. 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, such as cases like Simply Essentials, 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 Eighth Circuit's decision in Simply Essentials is therefore a positive development for bankruptcy trustees, DIPs, or other parties seeking to maximize estate value.
