Seventh Circuit: No Avoidance of Preferential or Fraudulent Transfer Absent Diminution of the Estate

In Mann v. LSQ Funding Group, L.C., 71 F.4th 640 (7th Cir. 2023), reh'g denied, 2023 WL 4684702 (7th Cir. July 21, 2023), the U.S. Court of Appeals for the Seventh Circuit affirmed the entry of summary judgment by a Wisconsin bankruptcy court dismissing litigation commenced by a chapter 7 trustee seeking to avoid as a fraudulent and preferential transfer a pre-bankruptcy payment made by a third party to satisfy the debtor's obligation under a factoring agreement because the transferred funds were never "an interest of the debtor in property." The Seventh Circuit reasoned that the transferred funds did not diminish the amount available for distribution to the debtor's creditors because the funds were not estate property. 

Avoidance of Preferential and Fraudulent Transfers

In bankruptcy cases, a trustee has the "paramount duty … to act on behalf of the bankruptcy estate, that is, for the benefit of the creditors." In re Cybergenics Corp., 226 F.3d 237, 243 (3d Cir. 2000). In furtherance of this duty, the Bankruptcy Code provides trustees with an array of tools that they can wield to fulfill this mandate. Among these tools are the "statutorily created powers, known as avoidance powers, which enable trustees to recover property on behalf of the bankruptcy estate." Id. Each avoidance power has a specific application. Two of the most commonly invoked avoidance powers are the ability to avoid preferential and fraudulent transfers made (or obligations incurred) by debtors prior to filing for bankruptcy. 

Preferential Transfers. A preference generally "exists when a debtor makes a payment or other transfer to a certain creditor or creditors and not others." Kenan v. Fort Worth Pipe Co. (In re George Rodman, Inc.), 792 F.2d 125, 127 (10th Cir. 1986). Section 547(b) of the Bankruptcy Code establishes the trustee's power to avoid preferential transfers, providing in part: 

Except as provided in subsections (c) and (i) of this section, the trustee may, 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), avoid any transfer of an interest of the debtor in property …. 

11 U.S.C. § 547(b) (emphasis added). A preferential transfer may be avoided under section 547(b) only if: 

1.  The transfer was made to or for the benefit of a creditor (§ 547(b)(1));

2.  The transfer was for or on account of an antecedent debt owed by the debtor (§ 547(b)(2));

3.  The transfer was made while the debtor was insolvent (§ 547(b)(3));

4.  The transfer was made either: (i) on or within 90 days before the date of filing of the petition; or (ii) between 90 days and one year before the filing of the petition if the creditor at the time of the transfer was an insider (§ 547(b)(4)); and

 5. The transfer enables the transferee to receive more than it would have received in a chapter 7 liquidation had it not received the transfer (§ 547(b)(5)). 

Section 547(c) contains nine defenses or exceptions to avoidance. These include, among other things, contemporaneous exchanges for new value, ordinary course business transfers, transfers involving purchase-money security interests, and transfers after which the transferor subsequently provides new value to the debtor.

There are also certain other nonstatutory defenses to preference liability. One of these is the judge-fashioned "earmarking doctrine," which provides that the debtor's new borrowing of funds to satisfy a preexisting debt is not deemed a transfer of property of the debtor and therefore is not avoidable as a preference. That is, if a third party provides funds for the specific purpose of paying a creditor of the debtor, hence "earmarking" them for that purpose, the transfer of the funds to the creditor may not be recoverable as preference. The doctrine rests on the idea that the funds are not within the control of the debtor, and because one debt effectively is exchanged for another, there is no diminution of the debtor's bankruptcy estate. See generally Collier on Bankruptcy ("Collier") ¶547.03[2][a] (16th ed. 2023).

Fraudulent Transfers. Section 548(a)(1) of the Bankruptcy Code empowers a bankruptcy trustee to avoid pre-bankruptcy fraudulent transfers. It provides in part that:

The trustee may avoid any transfer (including any transfer to or for the benefit of an insider under an employment contract) of an interest of the debtor in property, or any obligation (including any obligation to or for the benefit of an insider under an employment contract) incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition …. 

11 U.S.C. § 548(a)(1) (emphasis added). 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 at ¶ 548.05; see 11 U.S.C. § 548(a)(1)(B). Under section 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. Id. 

Section 548(c) provides a defense to avoidance of a fraudulent transfer for a "good faith" transferee who gives value in exchange for the transfer involved.

Fraudulent transfers may also be avoided by a trustee 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) (emphasis added). 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 bankruptcy law (e.g., the Uniform Voidable Transfer Act enacted in many states). See generally Collier at ¶ 544.06. 

What Is an Interest of the Debtor in Property?

Notably, the plain language of sections 544(b), 547(b), and 548(a)(1) contains a fundamental limitation on their application: Only a transfer "of an interest of the debtor in property" is avoidable. The Bankruptcy Code does not define the phrase "an interest of the debtor in property." The U.S. Supreme Court, however, provided guidance on this point, concluding that "an interest of a debtor in property" is "best understood as that property that would have been part of the estate had it not been transferred before the commencement of bankruptcy proceedings." Begier v. IRS, 496 U.S. 53, 58 (1990). Thus, the Court viewed "property of the estate" as an appropriate postpetition analog to "interest of the debtor in property." Id. at 59. Consistent with the Supreme Court's analysis, courts have construed "an interest of the debtor in property" very broadly, mirroring the reach of property of the estate to "all legal and equitable interests of property." See In re Moses, 256 B.R. 641, 645 (B.A.P. 10th Cir. 2000). 

Courts have developed two tests to analyze whether a transfer is avoidable as an interest of the debtor in property. The first test focuses on a debtor's dominion/control over the property prior to the transfer. See In re Marshall, 550 F.3d 1251, 1255 (10th Cir. 2008) ("Under [the dominion/control test], a transfer of property will be a transfer of 'an interest of the debtor in property' if the debtor exercised dominion or control over the transferred property."); accord In re Clink, 643 B.R. 522, 526 (Bankr. D. Mass. 2022). The dominion/control tests is grounded in the concept that a debtor's "right to use an item or control its use" is a property interest. Marshall, 550 F.3d at 1255. Therefore, courts find that sufficient dominion or control over an item is all that is required to establish a property interest in the item. See, e.g., Gladstone v. U.S. Bancorp., 811 F.3d 1133, 1139 (9th Cir. 2016); Riley v. Nat. Lumber Co. (In re Reale), 584 F.3d 27, 31 (1st Cir. 2009); MBNA Am. Bank, N.A. v. Meoli (In re Wells), 561 F.3d 633, 635 (6th Cir. 2009). 

A second test, the diminution of the estate test, states that a transfer is of "an interest of the debtor in property" where the transfer "diminished the resources from which the debtor's creditors could have sought payment." Southmark Corp. v. Grosz (In re Southmark Corp.), 49 F.3d 1111, 1116–17 (5th Cir. 1995); Moses, 256 B.R. at 645. The diminution of the estate test seeks to ensure that certain creditors do not obtain a windfall from funds that otherwise would have been available to other creditors. See Adams v. Anderson (In re Superior Stamp & Coin Co.), 233 F.3d 1004, 1007 (9th Cir. 2000).

Although some courts assert that only one of the two tests needs to be satisfied, other courts often apply both tests in their analysis. See, e.g., Walters v. Stevens, Littman, Biddison, Tharp & Weinberg, LLC (In re Wagenknecht), 971 F.3d 1209, 1214 (10th Cir. 2020) ("We apply Marshall's dominion/control and diminution of the estate tests to determine whether [the debtor] had a legal or equitable interest in the payment to the law firm … [and] we conclude that neither the dominion/control test nor the diminution of the estate test is satisfied here."); In re Smith, 966 F.2d 1527, 1531–35 (7th Cir. 1992) ("The real question here is whether the Debtor was actually able to exercise sufficient dominion and control over the funds …. We conclude in the present case that the Debtor's estate was diminished by the transfer."); Gray v. Travelers Ins. Co. (In re Neponset River Paper Co.), 231 B.R. 829, 833–34 (B.A.P. 1st Cir. 1999) (concluding that, under either test, transfers of funds that a lender deposited into the account of the debtor's attorneys in order to pay the debtor's antecedent debt to its insurer were transfers of an "interest of the debtor in property"). The majority of courts appear to support this two-factor analysis.

LSQ Funding

Engstrom, Inc. (the "debtor") was an agency that provided temporary staffing services to its clients. Throughout its history, the debtor relied upon accounts receivable factoring agreements under which it obtained financing for operations by collateralizing future funds anticipated from operations. The debtor and one of its factors—LSQ Funding Group, L.C. ("LSQ")—entered into factoring agreements beginning as early as December 2014.

In 2018, LSQ and the debtor entered into a new invoice factoring agreement. This agreement was supposed to work as a typical factoring agreement: The debtor would issue invoices to customers, after which it would submit the receivables to LSQ for purchase; LSQ would pay the debtor some portion of the face value of the invoices, and LSQ would pay the debtor the outstanding balance, less agreed-upon fees, when LSQ collected from the customer. 

Unbeknownst to LSQ, the agreement was all part of a Ponzi scheme devised by the debtor's CEO, Cheri Campion ("Campion"). Rather than submit legitimate invoices to LSQ, the debtor created sham invoices in the name of real customers that were sent to LSQ for payment. The debtor would then funnel some of the funds it received from LSQ to pay LSQ on account of old invoices.

Eventually, LSQ learned of the debtor's scheme. It then terminated the factoring agreement and demanded that the debtor pay $10.3 million to repurchase all unpaid invoices that LSQ had purchased. To address this, Campion and the debtor sought out another victim. This role fell to Millennium Funding ("Millennium"), another factoring company that the debtor selected to replace LSQ. The debtor convinced Millennium to enter into a factoring agreement and buy out the $10.3 million in unpaid invoices that LSQ had previously purchased. LSQ, at the debtor's request, provided Millennium with a pay-off letter for all unpaid invoices and accrued fees but made no efforts to alert Millennium to the underlying scheme.

Millennium wire-transferred $10.3 million to LSQ in January 2020. The debtor had agreed with Millennium that the funds transferred would be used only to pay the debtor's obligation to LSQ. After the transfer, the debtor was indebted to Millennium in the amount of $10.3 million, which debt was secured by the same collateral that previously secured the debt to LSQ.

Shortly after entering into the factoring agreement, Millennium discovered that the invoices were worthless. Millennium confronted the debtor and learned of LSQ's participation in the scheme.

In April 2020, the debtor filed a chapter 11 petition in the Eastern District of Wisconsin. The debtor then commenced an adversary proceeding to avoid the $10.3 million payment by Millennium to LSQ as a preferential and/or fraudulent transfer.

The bankruptcy court converted the case to a chapter 7 liquidation and substituted the chapter 7 trustee as the plaintiff in the avoidance litigation. LSQ moved for summary judgment, arguing that the trustee could not establish that "any transfer of an interest of the debtor in property" occurred.

The bankruptcy court found that the debtor did not exercise dominion and control over the funds transferred from Millennium to LSQ and that the payment did not diminish the estate. The court also concluded that, although most of the case law on the earmarking doctrine arises in the context of preference claims, the doctrine also may be applied to a fraudulent transfer claim. It accordingly ruled that the earmarking doctrine applied, and that the payment from Millennium to LSQ was not avoidable because it did not represent a transfer of "an interest of the debtor in property." The district court affirmed, and the chapter 7 trustee appealed to the Seventh Circuit. See In re Engstrom, Inc., 648 B.R. 617 (Bankr. E.D. Wis. 2021), aff'd, 2022 WL 2788437 (E.D. Wis. July 15, 2022), aff'd, 71 F.4th 640 (7th Cir. 2023).

The Seventh Circuit's Ruling

A three-judge panel of the Seventh Circuit affirmed. 

Writing for the panel, U.S. Circuit Judge Amy St. Eve noted that, unlike the courts below, the Seventh Circuit "need not focus on the 'earmarking doctrine' because a careful reading of the Bankruptcy Code's text and the application of our precedent resolve this case." LSQ Funding, 71 F.4th at 645. Starting with the avoidance of preferential transfers under section 547, Judge St. Eve closely examined section 547's plain language, noting that it only allows "the trustee … [to] avoid … transfer[s] of an interest of the debtor in property." Id. According to Judge St. Eve, this phrase was the key to the resolution of the case. Id.

The Seventh Circuit panel emphasized that, in interpreting this phrase, the Supreme Court, in Begier, had explained that "the purpose of the avoidance provision is to preserve the property includable within the bankruptcy estate—the property available for distribution to creditors." Id. Thus, Judge St. Eve noted, an "interest of the debtor in property is 'best understood as that property that would have been part of the estate had it not been transferred before the commencement of the bankruptcy proceedings.'" Id. (quoting Warsco v. Preferred Tech. Grp., 258 F.3d 557, 564 (7th Cir. 2001)). 

According to the Seventh Circuit panel, whether a transfer affects "an interest of the debtor in property" requires either that the debtor exercise dominion/control over the transferred funds, or that the transfer diminished the property of the estate. Id. Judge St. Eve explained that a debtor exercises dominion/control over transferred funds where the debtor can "determine the disposition of the funds and designate the creditor to whom payment is made." Id. (quoting Matter of Smith, 966 F.2d at 1535). Under this framework, the Seventh Circuit panel found that, in this case, although a reasonable jury could find that the debtor could designate to whom payment was made, there was "scant evidence in the record" to find that the debtor could "determine the disposition of the funds or accounts themselves." Id. 

Next, the Seventh Circuit panel concluded that the "diminution of the estate analysis shows plainly that the transaction at issue here did not involve 'an interest of the debtor in property.'" Id. at 646. Importantly, the panel highlighted that the parties agreed that "neither the $10.3 million nor the accounts sold would have been part of the Debtor's estate." Id. The panel further noted that the debtor never possessed the funds, the funds never passed through its accounts, and that creditors were substituted instantaneously. The Seventh Circuit panel accordingly determined that the transfer between Millennium and LSQ could not be avoided as a preference because it did not involve "an interest of the debtor in property." Id. 

Like the lower courts, Judge St. Eve rejected the trustee's argument that the dominion/control and diminution of the estate analyses apply only to avoidance of preferences and not the avoidance of fraudulent transfers. Drawing on the parallel use of "an interest of the debtor in property" in sections 547 and 548, Judge St. Eve explained that avoidance of fraudulent transfers turns on the same question: "whether the payoff agreement constituted an interest of the debtor in property." Id. at 646. She also pointed to the presumption in statutory construction that "identical words used in different parts of the same act are intended to have the same meaning." Id. at 646–47 (quoting White v. United Airlines, Inc., 987 F.3d 616, 623 (7th Cir. 2021)). 

The Seventh Circuit panel also rejected the trustee's contention that avoiding the transfer would somehow bring the transferred funds into the debtor's estate, finding instead that avoidance of the transfer would benefit only one creditor, Millennium, by providing it with the full $10.3 million that it paid to LSQ. That "perverse result," Judge St. Eve reasoned, "further assures us that § 548's use of 'interest of the debtor in property' is identical to its use in § 547." Id. at 647–48. 

Finally, the Seventh Circuit panel noted that its decision comports with the approach of other circuits, which have concluded that, even in the Ponzi scheme context, "outright fraud alone cannot bring a transaction within the avoiding powers of the Bankruptcy Code—the baseline avoiding requirements of the statute must still be met." Id. at 648. Accordingly, because the transfer at issue did not diminish the debtor's estate, the Seventh Circuit affirmed the ruling below. 

Outlook

The Seventh Circuit denied the chapter 7 trustee's motion for rehearing in a summary order. See Mann v. LSQ Funding Grp., L.C., 2023 WL 4684702 (7th Cir. July 21, 2023).

The Seventh Circuit's decision is consistent with the approach adopted by most courts considering whether a debtor must have an interest in property for a transfer of such property to be subject to avoidance in bankruptcy as a preferential or fraudulent transfer.

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