The Bankruptcy Code confers upon debtors or trustees, as the case may be, the power to avoid certain preferential or fraudulent transfers made to creditors within prescribed guidelines and limitations. The U.S. Bankruptcy Court for the District of New Mexico recently addressed the contours of these powers through a recent decision in U.S. Glove v. Jacobs, Adv. No. 21-1009, (Bankr. D.N.M. June 11, 2021), holding that any attempt to avoid such transfers must be supported by evidence that the avoidance will benefit the debtor’s estate and the debtor’s creditors—not just the debtor itself. Debtors, the court reasoned, should not be permitted to manipulate the Bankruptcy Code’s avoidance powers merely to create a windfall for themselves.

Factual Background

U.S. Glove, Inc. is a New Mexico corporation specializing in the manufacture of gymnastic wrist supports and grips. Before October 2018, Michael Jacobs owned 100% of U.S. Glove’s outstanding capital stock. On Oct. 18, 2018, Jacobs redeemed 57% of the outstanding stock he held in exchange for $3,390,000. To fund the redemption, U.S. Glove issued two separate promissory notes in favor of Jacobs: one in the amount of $2,140,000 secured by a security interest in U.S. Glove’s accounts, inventory, equipment and other tangible and intangible property; and the other in the amount of $1,250,000, which was unsecured. Jacobs, for unknown reasons, did not perfect his security interest related to the $2,140,000 note until June 1, 2020.

On May 19, 2020, U.S. Glove sought assistance from the Small Business Administration and procured a loan in the amount of $150,000, secured by a security interest in the same collateral that U.S. Glove had granted to Jacobs; however, the SBA did not perfect its security interest until July 8, 2020, over one month after Jacobs perfected his initial interest (presumably having been prompted by this borrowing). Jacobs agreed to subordinate his security interest to the  SBA’s security interest.

Following some significant financial difficulty, U.S. Glove filed for bankruptcy on Feb. 14. The company’s indebtedness to Jacobs represented 95.9% of its outstanding liabilities, and Jacobs was the company’s only unsecured creditor. On March 15, the debtor initiated an adversary proceeding seeking to, among other things, avoid Jacob’s financing statement as a preference, alleging it was a transfer to an insider of the debtor that changed Jacobs’s status to a secured creditor with a perfected security interest. In response, while substantially conceding on the fact that the debtor had pleaded a viable case for avoidance, Jacobs sought summary judgment arguing that the debtor lacked standing to bring such claims because avoiding the security interest he held would not benefit the debtor’s creditors.

The Bankruptcy Court’s Decision

The bankruptcy court initiated its review of this issue with an examination of the elements of a preference claim under Bankruptcy Code Section 547(b), which essentially allows a debtor to avoid certain transfers to creditors of money or other interests within a certain period of time following the transfer in question. In the case of “insiders” to the debtor, a transfer made within one year of the bankruptcy filing is subject to potential avoidance if the debtor was insolvent at the time of the transfer. It is important to note that Section 547, together with other sections of the Bankruptcy Code dealing with the recovery of certain proscribed transfers, does not contain any provisions for the actual recovery of improper transfers; instead, all of these code sections look to Section 550 of the code, which governs whether and to what extent an avoidable transfer can be recovered.

Notably, the debtor made no allegations and did not seek any recovery under Section 550 of the Bankruptcy Code. Instead, the debtor only alleged that the transfer of the security interest that Jacobs, the company’s majority shareholder, had perfected just eight months before U.S. Glove’s bankruptcy petition date, constituted an avoidable preference.

Jacobs did not contest any aspect of the requisite elements the debtor needed to establish in order to maintain a viable claim for an avoidable preference. He alleged in his defense, however, that the debtor lacked standing to maintain a preference action on the facts of this case. Specifically, Jacobs asserted that the avoidance of his security interest would only benefit the debtor; it would confer no benefit to the debtor’s creditors. Jacobs argued that the conferral of a benefit to the debtor’s creditors is a threshold issue to the invocation of avoidance powers under the Bankruptcy Code.

The bankruptcy court proceeded to engage in a lengthy analysis of case law decided under the Bankruptcy Act of 1938 (the predecessor to today’s Bankruptcy Code). It noted that, under the Bankruptcy Act, courts had uniformly held that the statute’s avoidance provisions were intended to benefit unsecured creditors; an action to avoid a transfer would not be sustained in cases where the debtor would be the sole beneficiary of a favorable judgment. This requirement, the court reasoned, was not based upon any specific language contained in the Bankruptcy Act, but instead on Section 342 of the act, which subjected debtors “at all times to the control of the court and to such limitations, restrictions, terms, and conditions as the court may from time to time prescribe.”

Turning next to the provisions of the Bankruptcy Code, the court acknowledged that the Bankruptcy Code’s enactment of avoidance and recovery provisions marked a “dramatic departure from its predecessor as under the act, each avoidance section contained its own recovery scheme.”  By contrast, under the Bankruptcy Code, Section 547 and the other avoidance provisions govern only the elements and defenses regarding avoidable transfers, while Section 550 governs whether and to what extent such transfers may be recovered.  Section 550 specifically provides that, to the extent a transfer is deemed avoidable under the Bankruptcy Code, “the trustee or debtor may recover for the benefit of the estate, the property transferred.”  There is no such similar language requiring a “benefit to the estate” under the other avoidance provisions of the Bankruptcy Code.

In the instant case, as noted above, the debtor sought to avoid Jacobs’ security interest under Section 547; because the intent of the debtor’s action was to undo the perfection of Jacobs’ security interest and not to recover any sum of money, the debtor did not invoke the recovery provisions of Section 550. Accordingly, the court was tasked with determining whether a transfer that could be avoided without involving Section 550 must nevertheless confer a benefit to the estate and its creditors.

The court analyzed and discussed an apparent split in decisional authority addressing this issue. Some courts have expressly held that a party seeking to avoid a transfer but not recover under Section 550 need not prove a benefit to the estate, while others hold the opposite and apply the “benefit to the estate” requirement to all actions to avoid transfers, regardless of whether Section 550 is invoked.

Following a thorough discussion on the relevant case law, the court concluded that a debtor must demonstrate a benefit to its estate and creditors in order to maintain an avoidance action, regardless of whether the debtor seeks recovery under Section 550. First, the court found persuasive the fact that, under the Bankruptcy Act, there was no question that a trustee or debtor had to demonstrate a benefit to the estate before availing itself of any avoidance powers. Second, the court acknowledged the U.S. Supreme Court’s insistence on a clear indication from Congress before approving any departure from past bankruptcy practice. In this vein, the bankruptcy court noted that the language and legislative history of the Bankruptcy Code’s avoidance and recovery sections do not evidence any Congressional intent to eliminate the “benefit of the estate” rule developed by tribunals under the Bankruptcy Act.

Furthermore, the court determined that “it makes no sense” to impose a “benefit of the estate” limitation for some avoidable transfers but not for others. The court reasoned that it made no sense to require a debtor or trustee to show benefit to the estate to recover a preferential payment of money, and not to require the same showing in connection with the undoing of a late-filed financing statement. The court also concluded that it was likely that Congress intended the “benefit of the estate” limitation in Bankruptcy Code Section 550 to apply to all avoided transactions, and that Congress simply overlooked the situation of lien avoidance in which Section 550’s recovery provisions need not be pleaded.

Finally, and perhaps most practically, the bankruptcy court found that requiring a benefit to the estate is consistent with the overall policies of the Bankruptcy Code. As a general policy matter, the court reasoned that Congress did not intend for the acts’ and the code’s avoidance provisions to be used to generate windfalls for debtors; rather, the avoidance powers were given to assist and support creditors to collect their debts fairly and equitably.

What remained unanswered for the bankruptcy court, however, was whether avoiding Jacobs’s security interest would nevertheless confer a benefit to the debtor’s estate. Accordingly, the court denied the motion for summary judgment, holding that Jacobs’ security interest would be avoidable under Code Section 547 unless the debtor lacked standing to pursue the claim. The debtor’s standing, the court concluded, hinged on whether avoiding the security interest would “benefit the estate,” and the court opined that further evidence was needed on this point.

Impact

The bankruptcy court’s decision in U.S. Glove offers clarity on essential, yet unwritten, elements of avoidance actions brought under the Bankruptcy Code. The decision acts as the indicator of a potentially emerging trend in decisional authority with respect to the unwritten requirement that a party-in-interest, in order to maintain a successful avoidance action where recovery of funds is not the intent, show benefit to the debtor’s estate and creditors.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors’ rights.

Drew S. McGehrinDrew S. McGehrin, an associate at the firm, practices in the areas of commercial finance, financial restructuring and bankruptcy.