Strong Arm Powers: Does Sovereign Immunity Trump a Claim Based on State Law?

Kohut v. Wayne County Treasurer (In re Lewiston), 528 B.R. 387 (Bankr. E.D. Mich. 2015) –

The debtor made property tax payments on behalf of several real estate projects.  The chapter 7 trustee sought to recover those payments from the county as fraudulent transfers.  The County raised sovereign immunity as a defense.

A trustee has the power to void and recover transfers under several sections of the Bankruptcy Code, including preferences under Section 547 and fraudulent transfers under Section 548.  In addition under Section 544 the trustee may assert certain causes of action available under non-bankruptcy law – including the rights of a hypothetical creditor or purchaser of real property under Section 544(a) and the rights of an actual creditor under Section 544(b).

The Bankruptcy Code also provides that sovereign immunity is “abrogated” with respect to 59 listed sections of the Bankruptcy Code, including Sections 544, 547 and 548.  The Supreme Court has upheld the Section 106 abrogation of sovereign immunity as a valid exercise of congressional powers under the Constitution to enact “Laws on the subject of Bankruptcies.”

A typical applications of Section 544 is assertion of a state law fraudulent transfer action, as was done in this case.  There are a couple of differences between the Bankruptcy Code version of fraudulent transfer under Section 548 and state law fraudulent transfers.  Most notably, the statute of limitations for a Section 548 claim is generally two years, while state law claims are generally at least four years.  (In this case, the statute of limitations under state law was six years.)  In addition, if the trustee is asserting a claim using the rights of an unsecured creditor under Section 544(b)(1), the trustee must show that an actual creditor could have brought the claim outside of bankruptcy.

The County did not directly challenge abrogation of sovereign immunity in connection with claims under Section 544, nor did it challenge the power of Congress to do so.  Instead, it argued that the trustee was required to show that an actual unsecured creditor could have brought the claim against the County outside of bankruptcy, and contended that no such creditor existed because outside of bankruptcy the County could have asserted sovereign immunity as a defense.

The County distinguished the Supreme Court case upholding abrogation of sovereign immunity on the basis that it dealt with Section 547, which is an action created by the Bankruptcy Code.  It also argued that its interpretation did not render the reference to Section 544 meaningless since other subsections did not require the existence of an actual unsecured creditor capable of bringing the action.

Cases cited by the County in support of its position included a 7th Circuit case, In re Equipment Acquisition Resources, Inc., 742 F.3d 743 (7th Cir. 2014), which involved an action against the IRS to recover tax payments as a fraudulent conveyance using Section 544(b)(1).  Although the bankruptcy court and the district court had agreed with the debtor and ruled against the IRS, the 7th Circuit reversed.  The 7th Circuit found that this was a simple matter of the plain language of Section 544(b).  “That provision, by its very terms, requires [the debtor] to show that a creditor exists who could use a state’s ‘applicable law’ to recover the payment from the IRS.  If no such creditor exists, then the trustee cannot bring the claim.”  Since an unsecured creditor would have been barred from bringing an action against the IRS outside of bankruptcy, the 7th Circuit found that there was no such creditor.

In response to the County’s arguments, the trustee contended that the “majority” of the decisions favored his position.  In particular, the trustee looked to a recent Delaware bankruptcy case which concluded: “To require that there be a separate waiver of sovereign immunity as to a state law claim underlying a section 544 action, which state law claim is a necessary component of the complaint under section 544, would eviscerate the abrogation of sovereign immunity for section 544 actions.”

The court itself raised two other cases, one going each way.  In the case supporting the County’s position, a New Jersey bankruptcy court concluded that there were two plausible interpretations, and adopted the interpretation that allowed sovereign immunity because “when it comes to sovereign immunity, ties go to the government.”  In contrast, a Colorado bankruptcy court concluded that it was clear that Congress did not intend to carve out Section 544(b)(1) from the waiver of sovereign immunity.  “To do so would be improper and result in a judicially created amendment to an otherwise clear and unambiguous statute.”

In this case “the Court concludes that the waiver in §106(a)(1) is unequivocally expressed and unambiguous.”  As the court put it:  “The statute is susceptible to only one interpretation:  it simply eliminates sovereign immunity however and whenever it applies ‘with respect to’ the 59 sections of the Bankruptcy Code listed in §106(a)(1).  Section 544 is one of those sections.  In this case, the Complaint is brought under §544.  That ends the inquiry.”  The court acknowledged that this gave the trustee greater rights in bankruptcy than a creditor would have had outside of bankruptcy, but did not see that as a reason to change its mind.

The court characterized the County’s argument that the complaint must be dismissed since no actual creditor could ever prevail as circular:  the only reason a creditor could not prevail outside of bankruptcy was because of sovereign immunity, which has been abrogated in bankruptcy.

“In sum, the Court is persuaded that §106(a)(1)’s abrogation of sovereign immunity with respect to §544(b)(1) means just what the statute says:  sovereign immunity is abrogated with respect to §544.”  Thus, the County’s motion to dismiss was denied.

This is one more example of the widely held view that you can find a bankruptcy case to support whatever position you choose to take, and that bankruptcy courts often go their own way regardless of decisions by other courts.  The court commented that it was “not unmindful” that the only circuit court case went the other direction, but “respectfully disagrees.”  It is also interesting how often courts on both sides of an issue can each be adamant that its position is the only possible result based on the plain meaning of a statute.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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