WHAT ARE AVOIDANCE POWERS OF BANKRUPTCY TRUSTEE UNDER CHAPTER 11 BANKRUPTCY ?
Avoidance and abandonment are two distinct powers that may be exercised during a corporate Chapter 11 case in order to protect, administer and maximize the value of the bankruptcy estate. Avoidance powers enable the debtor in possession or, where appointed, the trustee to challenge and recover certain pre-petition or post-petition transactions that diminish the estate or improperly prefer particular creditors. Abandonment, in contrast, concerns property that is burdensome to the estate or of inconsequential value and permits such property to be removed from the estate under the conditions prescribed by the Bankruptcy Code.
The avoidance provisions are principally contained in Chapter 5 of the Bankruptcy Code, particularly §§544, 545, 547, 548, 549 and 550, while abandonment is principally governed by §554. In a Chapter 11 case, the debtor in possession generally exercises the avoidance powers of a trustee pursuant to §1107(a), subject to the provisions of the Bankruptcy Code. These powers are therefore an important part of Chapter 11 administration and may result in the recovery of assets or value for distribution under the plan.
AVOIDANCE POWERS OF THE DEBTOR IN POSSESSION
Section 1107(a) generally confers upon a debtor in possession the rights, powers and duties of a trustee serving in a Chapter 11 case, subject to specified limitations. Consequently, a corporate debtor in possession may ordinarily exercise the trustee’s avoidance powers under Chapter 5 of the Bankruptcy Code. These powers are intended to protect the collective interests of creditors by permitting the estate to challenge transactions that fall within the statutory avoidance provisions.
Avoidance powers should be distinguished from ordinary causes of action belonging to the debtor. An avoidance action arises from federal bankruptcy law and is directed toward transactions or transfers that the Bankruptcy Code permits the estate to avoid. The Supreme Court in Hartford Underwriters Insurance Co. v. Union Planters Bank, N.A., 530 U.S. 1, 7–8 (2000), emphasized that the Bankruptcy Code’s text controls the identification of the parties authorized to exercise particular statutory powers. Accordingly, the authority of a debtor in possession to pursue an avoidance action must be grounded in the specific provisions of the Bankruptcy Code.
AVOIDANCE OF PREFERENTIAL TRANSFERS
Section 547 permits the trustee to avoid certain transfers of an interest of the debtor in property made to or for the benefit of a creditor on account of an antecedent debt, subject to the statutory requirements and exceptions contained in the section. The provision principally addresses transfers made within the applicable preference period before the commencement of the bankruptcy case that enable a creditor to receive more than it would have received in a Chapter 7 liquidation, subject to the requirements of §547(b).
In a corporate Chapter 11 case, the preference provisions may be particularly significant where the debtor made substantial payments to selected creditors shortly before filing. The purpose is not simply to recover money for its own sake but to preserve the principle of equality among similarly situated creditors by preventing a prepetition transfer from improperly improving one creditor’s position at the expense of the creditor body as a whole.
Section 547 also contains several important defenses and exceptions. These include, among others, transfers made in the ordinary course of business under §547(c)(2), substantially contemporaneous exchanges for new value under §547(c)(1), and transfers supported by subsequent new value under §547(c)(4). The application of these provisions requires examination of the particular transaction and the surrounding commercial circumstances.
The Supreme Court has addressed the scope and interpretation of §547 in several important decisions. In Union Bank v. Wolas, 502 U.S. 151, 158–59 (1991), the Court held that the ordinary-course exception in §547(c)(2) was not limited to transactions made within the preference period and emphasized the importance of giving effect to the statutory language enacted by Congress.
In Barnhill v. Johnson, 503 U.S. 393, 397–400 (1992), the Supreme Court considered when a transfer by check occurs for purposes of §547 and held that the transfer occurs when the drawee bank honors the check rather than when the check is delivered. The decision illustrates the importance of determining precisely when a transfer occurred before applying the preference provisions.
These decisions demonstrate that avoidance litigation frequently turns upon the precise statutory requirements governing the transaction. The debtor in possession must therefore establish each element necessary for avoidance and must also consider the defenses and exceptions available to the transferee.
FRAUDULENT TRANSFERS
Section 548 permits the trustee to avoid certain transfers or obligations incurred by the debtor within the statutory period before the filing of the bankruptcy petition. It addresses both transfers made with actual intent to hinder, delay or defraud creditors and certain transfers for which the debtor received less than reasonably equivalent value while satisfying the financial-condition requirements specified in the statute.
The actual-fraud provision focuses upon the debtor’s intent, while the constructive-fraud provisions address transactions in which the debtor received insufficient value and was in a specified financial condition or was rendered financially vulnerable as a result of the transaction. In a corporate Chapter 11 case, §548 may therefore be relevant to transactions involving asset transfers, guarantees, dispositions to related parties and other prepetition arrangements.
The Supreme Court in BFP v. Resolution Trust Corp., 511 U.S. 531, 545–46 (1994), considered the relationship between foreclosure sales and the fraudulent-transfer provisions and held that a non-collusive, regularly conducted foreclosure sale conducted in accordance with applicable state law establishes “reasonably equivalent value” for purposes of §548. The decision demonstrates the importance of distinguishing ordinary commercial transactions from transfers that fall within the statutory avoidance framework.
AVOIDANCE UNDER SECTION 544
Section 544 provides the trustee with important avoidance powers commonly described as the “strong-arm” powers. Section 544(a) permits the trustee, subject to the statutory requirements, to avoid certain transfers that would be avoidable by specified hypothetical creditors or purchasers under applicable non-bankruptcy law. Section 544(b) also permits the trustee to avoid certain transfers that an actual unsecured creditor could avoid under applicable law, subject to the requirements of the provision.
These powers are particularly relevant where state or other applicable non-bankruptcy law provides creditors with rights that can be exercised for the benefit of the bankruptcy estate. The debtor in possession may therefore be able to challenge transactions that would be vulnerable to avoidance by a hypothetical lien creditor or by an actual unsecured creditor under applicable law.
The Supreme Court’s decision in Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co., 549 U.S. 443, 450 (2007), although not itself an avoidance case, illustrates the Court’s general approach of giving effect to the Bankruptcy Code’s treatment of state-law rights unless the Code provides otherwise. The same principle is relevant to §544 because the extent of the strong-arm power may depend upon rights created under applicable non-bankruptcy law.
POST-PETITION TRANSFERS
Section 549 permits the trustee to avoid certain transfers of property of the estate made after the commencement of the bankruptcy case that are not authorized under the Bankruptcy Code or by the court. The provision therefore complements the prepetition avoidance provisions by addressing unauthorized postpetition dispositions.
In a Chapter 11 case, the debtor in possession normally controls the estate and is authorized to conduct its business. Consequently, not every postpetition transaction is subject to §549. Transactions properly undertaken in the ordinary course or otherwise authorized by the Bankruptcy Code or by court order will generally fall outside the avoidance power.
Section 549 nevertheless provides protection against unauthorized postpetition transfers that improperly remove estate property or diminish the estate. The provision is particularly relevant where property is transferred without the authority required by the Bankruptcy Code or a bankruptcy-court order.
REOVERY OF AVOIDED TRANSFERS
Avoidance under §§544, 545, 547, 548, 549 or other applicable provisions is generally followed by the question of recovery. Section 550 establishes the principal framework for recovering property or its value after a transfer has been avoided. Depending upon the circumstances, the trustee may recover the property transferred or, in appropriate cases, the value of the property from an initial transferee or other party specified by the statute.
The distinction between avoidance and recovery is important. Avoidance establishes that the transfer is subject to being set aside under the applicable provision, while §550 provides the mechanism for recovering the transferred property or its value. Section 551 further provides for the automatic preservation of certain avoided transfers for the benefit of the estate.
The Supreme Court in Hartford Underwriters Insurance Co. v. Union Planters Bank, N.A., 530 U.S. 1 (2000), emphasized that the Code’s statutory text determines who may exercise the rights created by the Bankruptcy Code. Accordingly, the authority to pursue and recover on an avoidance claim must be considered within the statutory framework governing the particular avoidance action.
ABANDONMENT OF ESTATE PROPERTY
Avoidance and abandonment serve different purposes. While avoidance seeks to bring value into the estate by recovering property or challenging transfers, abandonment permits property to leave the estate when retaining it would not benefit the estate or would impose an undue burden.
Section 554(a) permits the trustee, after notice and a hearing, to abandon property of the estate that is burdensome to the estate or of inconsequential value and benefit to the estate. Section 554(b) permits a party in interest to request that the court order abandonment of property if the statutory requirements are satisfied. Section 554(c) provides for abandonment of property scheduled under §521(a)(1) that is not otherwise administered at the time the case is closed, subject to the statutory conditions.
In a corporate Chapter 11 case, abandonment may become relevant where the estate owns obsolete equipment, contaminated property, unprofitable real estate, burdensome interests or assets whose expected value is less than the costs and liabilities associated with retaining them.
Abandonment and the Reorganization Process
Abandonment may serve the objective of maximizing the value of the estate by eliminating assets that consume resources without providing a corresponding benefit. A debtor in possession may therefore determine that continued ownership of a particular asset is inconsistent with the interests of the estate.
The fact that property has little or no value to the bankruptcy estate does not necessarily mean that no party has an interest in it. Secured creditors, governmental authorities, environmental regulators, landlords or other parties may have rights connected with the property. The court must therefore consider the statutory requirements of §554 and the interests of affected parties before authorizing abandonment where court approval is required.
Abandonment should also be distinguished from a sale under §363. A sale transfers property to another party, generally in exchange for consideration, whereas abandonment removes property from the estate without a sale of the property. Section 363 is therefore primarily concerned with the use, sale or lease of estate property, while §554 addresses property that the estate should no longer retain.
Abandonment of Property Subject to Environmental Liabilities
Environmental liabilities can make abandonment particularly significant in corporate bankruptcy. A parcel of real estate may have substantial cleanup obligations or regulatory consequences that exceed its economic value to the estate. The debtor may therefore seek abandonment under §554.
The Supreme Court addressed the relationship between abandonment and environmental obligations in Midlantic National Bank v. New Jersey Department of Environmental Protection, 474 U.S. 494, 507 (1986). The Court held that a trustee may not abandon property in contravention of certain state and local laws reasonably designed to protect public health or safety from imminent and identifiable harm. The decision established an important limitation on the otherwise broad abandonment power.
Midlantic is particularly relevant to corporate Chapter 11 cases because corporations may hold industrial properties, chemical facilities, waste sites or other assets carrying environmental obligations. Abandonment therefore cannot always be determined solely by comparing the asset’s economic value with its carrying costs; applicable health and safety requirements may restrict the ability to abandon the property.
Abandonment and Secured Creditors
Abandonment may also affect secured creditors because the property being abandoned may constitute collateral securing a creditor’s claim. Once property is abandoned, it generally ceases to be property of the bankruptcy estate, although the creditor’s lien or other rights in the property are not thereby extinguished.
The Supreme Court in Midlantic distinguished the bankruptcy estate’s abandonment power from the underlying rights of parties with interests in the property. Abandonment therefore does not ordinarily constitute a transfer of the debtor’s title to another party; rather, it removes the property from administration by the estate, subject to applicable non-bankruptcy rights and limitations imposed by law.
Accordingly, before abandoning significant property, the debtor in possession should consider the existence of liens, environmental obligations, taxes, regulatory restrictions and other liabilities associated with the property.
COURT SUPERVISION AND NOTICE
Avoidance and abandonment proceedings may require different forms of judicial involvement. An avoidance action ordinarily proceeds as litigation, often through an adversary proceeding where required by the Bankruptcy Rules. Abandonment under §554(a) generally requires notice and a hearing, while §554(b) permits a party in interest to seek a court order requiring abandonment.
Court supervision is particularly important where the proposed action may materially affect creditors or third parties. In an avoidance proceeding, the court determines whether the statutory requirements for avoidance have been established and whether any defenses apply. In an abandonment proceeding, the court considers whether the property is burdensome or of inconsequential value and whether statutory or public-policy limitations affect the proposed abandonment.
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Mukesh Suman is a lawyer based at Delhi, India. He also provides bankruptcy paralegal services to clients based in USA. He may be contacted at mukesh_suman@outlook.com or +91 9717864570.
