Ninth Circuit Opens the Door A Bit Wider for Recoveries from the IRS
Avoiding a fraudulent transfer to the Internal Revenue Service (“IRS”) in bankruptcy has become easier, or at least clearer, as a result of a recent unanimous decision by a panel of the Court of Appeals for the Ninth Circuit, Zazzali v. United States (In re DBSI, Inc.), 2017 U.S. App. LEXIS 16817 (9th Cir. Aug. 31, 2017).
DBSI, the corporation that later became a debtor in bankruptcy, paid approximately $17 million to the IRS. Because it was an “S” corporation, DBSI was not liable to the IRS for the taxes it paid--they were debts of its shareholders--and therefore the payments were obvious candidates for avoidance as fraudulent transfers in DBSI’s subsequent bankruptcy case.
Fraudulent transfers can be avoided under two different sections of the Bankruptcy Code. Section 548 creates a body of federal fraudulent transfer law, while Section 544(b)(1) permits the trustee to step into the shoes of an actual creditor who has a fraudulent transfer remedy under other “applicable law”[1] and exercise that creditor’s remedies on behalf of the bankruptcy estate. Section 548 captures only transfers made in the two years preceding bankruptcy, while Section 544(b)(1) looks to the other “applicable law” for the length of the reach-back period (which, under state fraudulent transfer law, is four years in most states, six years in New York). The DBSI trustee sued the IRS under both sections (invoking Idaho’s adoption of the UFTA in so doing), but his problem was that almost all of the payments had been made more than two years before bankruptcy. Thus he had to rely principally on Section 544(b)(1) and satisfy its requirement to prove the existence of an actual creditor who could have avoided the payments outside of bankruptcy.
Absent a waiver, the IRS is protected by the doctrine of sovereign immunity from being sued to recover tax payments. Section 106(a) of the Bankruptcy Code abrogates the defense of sovereign immunity that could have been asserted by the federal government and all other governmental units “with respect to” many enumerated sections of the Code, including Sections 544 and 548. But there was no express sovereign-immunity waiver allowing a creditor of DBSI to avoid DBSI’s payments to the IRS under the Idaho UFTA. Consequently, there was no actual creditor in existence who could have avoided the payments outside of bankruptcy and therefore into whose shoes the DBSI trustee could step--literally every possible such creditor would be stymied by sovereign immunity.[2]
The Ninth Circuit resolved this conundrum by--
conclud[ing] that Section 106(a)(1) is unambiguous and clearly abrogates sovereign immunity as to Section 544(b)(1), including the underlying state law cause of action. . . . [W]e do not believe there is an alternative construction that is plausible: Congress unambiguously and unequivocally waived sovereign immunity for causes of action brought under Section 544(b)(1). To construe the statutes in the manner in which the [IRS] proposes would be to ignore the plain text of Section 106(a)(1) . . . .[3]
This issue has reached the Courts of Appeals only one other time, In re Equipment Acquisition Resources, Inc., 742 F.3d 743 (7th Cir. 2014)(“EAR”), and the Seventh Circuit saw the issue differently. It held that, while Section 106 effectively abrogated sovereign immunity for Section 544, it did not alter the underlying substantive requirement for an actual creditor who could have avoided the transfer under other “applicable law”:
We find the substantive requirements of § 544(b)(1) unambiguous, and those requirements are simply not met with respect to [the avoidance proceeding in EAR]. . . . If Congress intends to eliminate § 544(b)’s actual-creditor requirement in actions against the federal government, it must say so.[4]
The issues in DBSI and EAR being indistinguishable, the Ninth Circuit concluded,
The Seventh Circuit’s conclusion to the contrary is not persuasive. Under the Seventh Circuit’s approach, a substantive cause of action against the government would exist only if Congress also waived sovereign immunity with respect to the particular applicable law under Section 544(b)(1). To impose such a requirement . . . would be contrary to the plain text of Section 106(a)(1). . . . [W]e reach an alternate conclusion to the Seventh Circuit.[5]
And this is how so-called “circuit splits” occur which the Supreme Court may some day choose to resolve.
[1] The “applicable law” that is most often invoked in an adversary proceeding under Section 544(b)(1) is a state’s adoption of the Uniform Fraudulent Conveyance Act, the Uniform Fraudulent Transfer Act (“UFTA”) or the Uniform Voidable Transactions Act, all of which (like Section 548 itself) are lineal descendants of the Statute of 13 Elizabeth, c.5, which was enacted by Parliament in England in 1571.
[2] By contrast, Section 548 creates an entirely self-contained avoidance remedy for fraudulent transfers (just as Section 547 creates a self-contained remedy for preferential transfers) without reliance on other “applicable law,” and consequently Section 106(a) provides all the relief from sovereign immunity that a trustee needs to pursue remedies under those sections.
[3] DBSI at *16 (emphasis added).
[4] 742 F.3d at 750-51.
[5] DBSI at *19-20.
