Ninth Circuit Creates Circuit Split On Applicability of Sovereign Immunity To Fraudulent Conveyance Suits Against IRS By Bankruptcy Trustees

In an August 31, 2017 decision in In re DBSI, Inc., the United States Court of Appeals for the Ninth Circuit held that sovereign immunity did not shield the IRS from a suit by a bankruptcy trustee to avoid tax payments as fraudulent conveyances under state law.  The Ninth Circuit disagreed with 2014 decision of the United States Court of Appeals for the Seventh Circuit which had reached the opposite conclusion.  The split between the Circuits on this issue sets the stage for consideration of the issue by the United States Supreme Court.

The Bankruptcy Code provides a trustee with two potential ways in which to avoid transfers of property as fraudulent conveyances. First, Section 548 of the Bankruptcy Code provides that a trustee may avoid a transfer made by a debtor within the two years preceding the filing of a bankruptcy petition if the debtor made the transfer with actual intent to hinder, delay, or defraud a creditor or was insolvent when the transfer was made and received less than reasonably equivalent value in exchange.  Second, Section 544(b) provides that a trustee may avoid a transfer other than a charitable contribution “that is avoidable under applicable law by a creditor holding an unsecured claim” that is allowable in the bankruptcy case.  Since most, if not all, states have enacted laws permitting creditors to avoid fraudulent conveyances under circumstances similar to those provided for in Bankruptcy Code Section 548, a trustee may be able to avoid a fraudulent conveyance either: (a) under Section 548 as a matter of federal law; or (b) under Section 544 if there is a creditor who could have done so under state law.

If the circumstances under which transfers may be avoided under federal and state law are so similar, one might wonder why a trustee would choose to rely on state law rather than federal law.  The answer is timing.  As noted, the federal fraudulent conveyance law only allows a trustee to avoid transfers made within the two year period before the bankruptcy filing.  Many states, however, have statutes of limitations that are longer than two years.  In Maryland, for example, the statute of limitations applicable to fraudulent conveyance actions is three years and the statute runs from when the plaintiff knows or should know with the exercise of reasonable diligence that the transfer has been made.  Where the property transferred is money or personal property where no deed evidencing the transfer has to be recorded and unearthing the transfer can be difficult, the statute of limitations can extend well more than three years after the transfer is made.  Consequently, by relying on Section 544, a trustee may be able to avoid a transfer that cannot be avoided under Section 548 because it occurred more than two years before the bankruptcy filing.

This was the case in DBSI.  The debtor, DBSI, Inc., had paid $17 million in taxes owed by its shareholders between 2005 and 2008.  Although “satisfaction of an antecedent debt of the debtor” can be reasonably equivalent value for fraudulent conveyance purposes, DBSI paid its shareholders’ debts, not its own tax liability, and thus did not receive reasonably equivalent value.  DBSI’s bankruptcy was not filed until 2010 so the trustee could not recover the tax payments under Section 548.  Consequently, he relied on Section 544 and asserted that the tax payments were avoidable by unsecured creditors under Idaho law, which provided a four year statute of limitations.

The IRS defended on the grounds that the tax payments were not “avoidable under applicable law by a creditor holding an unsecured claim” because the federal government may not be sued under state law unless it has waived sovereign immunity with respect to the claim and the federal government has not waived sovereign immunity as to claims under Idaho fraudulent conveyance law.  The IRS had prevailed on this argument in the Seventh Circuit in 2014.

The Ninth Circuit disagreed with the Seventh Circuit for two reasons.  First, it noted that Bankruptcy Code Section 106 provides that “sovereign immunity is abrogated as to a governmental unit” with respect to enumerated sections of the Bankruptcy Code, including Section “544.”  Since it is Bankruptcy Code 544 that gives a trustee the power to avoid a transfer that is avoidable by a creditor under “applicable law,” the Ninth Circuit held that sovereign immunity had been waived.  It was not persuaded by the Seventh Circuit’s conclusion that the reference in Section 106 to Section 544 should be read so as to encompass only Section 544(a) and not Section 544(b).

Second, the Ninth Circuit noted that sovereign immunity does not insulate the federal government from claims asserted under federal law.  Sovereign immunity only insulates the federal government from claims under state and local law.  Although the trustee was relying on Idaho law to recover the payments from the IRS, it was federal law, i.e., Bankruptcy Code Section 544, that empowered him to do that.  Thus, the Ninth Circuit concluded that the trustee’s cause of action was under federal law, not state law, so that sovereign immunity would not bar the claim even if it had not been abrogated or waived.

Given the millions of dollars that the Ninth Circuit’s decision required the IRS to pay to the trustee and the countless millions, if not billions, of dollars that bankruptcy trustees may seek to recover if they are not limited to the two year pre-bankruptcy period, the IRS is virtually certain to seek review of the Ninth Circuit’s decision by the Supreme Court.  With a clear split between Circuits on the issue, the Supreme Court will likely take up the issue.