Zazzali v. United States (In re DBSI, Inc.), 869 F.3d 1004 (9th Cir. 2017) –

A chapter 11 trustee sought to recover a debtor’s prepetition tax payments to the federal government on the grounds that they were fraudulent transfers. The government moved to dismiss based on an argument involving sovereign immunity. The bankruptcy court denied the government’s motion; the district court affirmed; and the IRS appealed to the Ninth Circuit.

This case involved the interaction of two sections of the Bankruptcy Code that deal with (1) a trustee’s avoiding powers and (2) waiver of sovereign immunity. Under section 544(b)(1):

[T]he 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 this title or that is not allowable only under section 502(e) [relating to claims for reimbursement or contribution] of this title.

Section 106(a) provides:

(a) Notwithstanding an assertion of sovereign immunity, sovereign immunity is abrogated as to a governmental unit to the extent set forth in the section with respect to the following:

(1) Sections … 544, … 550 … of this title.

(2) The court may hear and determine any issue arising with respect to the application of such subsections to governmental units.

The trustee invoked section 544(b)(1) to avoid prepetition tax payments made by the debtor to the federal government, using state fraudulent transfer law as the “applicable law” that allowed an unsecured creditor to avoid the transfer. This section requires that there be an actual unsecured creditor that could have asserted the claim outside of bankruptcy. The government’s defense was that no such creditor could exist because outside of bankruptcy the government would have been protected from any such claims by sovereign immunity.

Generally, if the actual creditor could not succeed for any reason (such as statute of limitations, res judicata, waiver or any other defense), then the trustee would be similarly barred. In this case as a matter of substantive law it was clear that outside of bankruptcy an actual unsecured creditor would not be able to pursue a fraudulent transfer claim against the government since it would be precluded by the government’s sovereign immunity.

However, in the Ninth Circuit’s view, section 544 “does not exist in a vacuum; rather, it must be read in concert with other sections of the Bankruptcy Code” and here “Section 106(a)(1)’s abrogation of sovereign immunity is absolute with respect to Section 544(b)(1) and thus necessarily includes the derivatives state law claim on which a Section 544(b)(1) claim is based.”

In interpreting the meaning of these provisions, the court found that it must look not only at the statutory language but also “the language and design of the statute as a whole.” Although the court seemed to acknowledge that the plain text supported the government’s position, it relied on the context to hold: “‘It simply does not matter how a sovereign immunity defense is invoked against [Trustee]’s claims [because] Section 106(a)(1) … eliminates the obstacle wherever it appears in ‘with respect to’ § 544 …'”

The court also noted that section 106(a)(1) was enacted after section 544(b)(1). It concluded that Congress knew what it was doing and intended to include the state law causes of action asserted under section 544 within the waiver of sovereign immunity.

After discussing several other points supporting its position, the court acknowledged that the Seventh Circuit reached the opposite conclusion. The Seventh Circuit determined that there were two distinct inquiries – whether sovereign immunity was waived with respect to section 544 and whether it was waived with respect to the underlying substantive law that was asserted under section 544. If concluded that the section 106 waiver applied to section 544 but not to the underlying substantive law. The Ninth Circuit expressed its disagreement with this analysis.

As an aside the Ninth Circuit noted that its decision was supported by equitable principles and the “object and policy” of the Bankruptcy Code. “[I]n essence, it would be unfair for a governmental unit to participate in the distributions of a bankruptcy case while at the same time shielding itself from liability.”

Accordingly, the court affirmed the judgment that sovereign immunity did not prevent the trustee from avoiding $17 million in tax payments and that the government was required to return all payments that had not already been refunded.

While it seems likely that this is the result intended by Congress, based on a literal reading of the Bankruptcy Code the Seventh Circuit’s decision that sovereign immunity barred the underlying state law claim is also not surprising.

Vicki R. Harding, Esq.