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New Court Ruling on Whether Avoidance Powers Require Benefit to Creditors

The Bankruptcy Code grants the power to avoid certain transactions to a bankruptcy trustee or debtor-in-possession.  See, e.g., 11 U.S.C. §§ 544, 547–48.  Is there a general requirement that these avoidance powers only be used when doing so would benefit creditors?  In a recent decision, the United States Bankruptcy Court for the District of New Mexico addressed this question, concluding, in the face of a split of authority, that there was such a requirement.  In re U.S. Glove, Inc., No. 21-10172-T11, 2021 WL 2405399 (Bankr. D.N.M. June 11, 2021).

U.S. Glove, Inc. (“Plaintiff”) is a manufacturer of gymnastic grips and wrist supports.  Michael J. Jacobs (“Defendant”) was once the sole owner of Plaintiff but, in October 2018, had 57% of his stock redeemed for a $2,140,000 promissory note and a $1,250,000 promissory note.  The larger note is secured by Plaintiff’s property, but for unknown reasons, the security interest was not perfected until June 2020, 20 months after the buyout closed.  Plaintiff filed for bankruptcy in February 2021.  Plaintiff’s two principal creditors are Defendant, with claims totaling $3,545,000, and the Small Business Administration (“SBA”), with a claim of $149,143.  By mutual agreement, Defendant’s lien is subordinate to the SBA’s.  Plaintiff filed an adversary proceeding in March 2021, seeking, among other things, to avoid Defendant’s security interest as a preference.  Plaintiff moved for summary judgment on this issue in April 2021.

The Court first concluded that Plaintiff had met the requirements for a preference claim under section 547.  The security interest was a transfer to Defendant; the transfer was on account of antecedent debt, the promissory note associated with the buyout; Plaintiff was insolvent at the time of the transfer; the transfer occurred within eight-and-a-half months of the bankruptcy filing, which is within the one-year preference period for insiders like Defendant; and the security interest would enable Defendant to recover more than he would recover in chapter 7 liquidation absent the security interest. 

Defendant did not contest these contentions.  Instead, Defendant argued that Plaintiff lacked standing to bring the avoidance action because avoiding Defendant’s security interest would not benefit creditors, only Plaintiff. 

The Court noted that in cases decided under the Bankruptcy Act, the predecessor to the Bankruptcy Code, courts uniformly held that the purpose of the avoidance powers was to benefit creditors and that avoidance powers could not be used to benefit the debtor exclusively.  The Court further noted that Bankruptcy Code section 550, which governs the liability of transferees for property transferred in avoided transfers, requires that recovery be “for the benefit of the estate,” which courts have read as a requirement that it be for the benefit of creditors.  Here, however, where Plaintiff simply sought to avoid a lien, section 550 was not pleaded, and the avoidance provisions themselves do not contain the “for the benefit of the estate” language.  The Court noted a split in authority under this question, with some cases requiring a benefit to the estate even absent section 550, and some cases not imposing such a requirement.

The Court sided with the cases imposing a requirement that the use of the avoidance powers benefit the estate.  The Court emphasized the principle in Supreme Court case law that a clear indication is required before concluding that Congress intended to depart from past bankruptcy practice, such as the uniform approach requiring benefit to creditors under the Bankruptcy Act.  The Court further emphasized that it would be arbitrary to distinguish between lien avoidance cases and cases seeking recovery of property, and held that, in any event, section 550 should apply since a security interest is a grant of property and avoiding it is a recovery of property.  Finally, the Court noted that Congress’s purpose in enacting the avoidance powers in the Bankruptcy Code was to help creditors collect fairly and equitably and not to generate windfalls for debtors.

The Court held that the question of whether avoiding Defendant’s lien would benefit the estate depended on a case-by-case, fact-specific analysis, and therefore denied Plaintiff’s summary judgment motion.