Joining the Eighth and Ninth Circuit Courts of Appeals, the Fifth Circuit Court of Appeals recently held that a debtor or trustee can sell its avoidance actions to third-party, non-estate representatives.   See Briar Capital Working Fund Capital, L.L.C. v. Remmert (In re South Coast Supply Company), No. 22-20536 (5th Cir. Jan. 22, 2024) (Dennis, J).  While the opinion specifically addresses preference actions, the rationale in the opinion applies equally to fraudulent transfer actions.  Thus, all avoidance actions should be covered by this holding.

The opinion highlights that there are different mechanisms in the Bankruptcy Code to liquidate estate assets.  One method involves appointing an estate representative, like a liquidating trustee, to liquidate assets; another method, a 363 sale, does not.

The facts of the case further illustrates that the sale of avoidance actions can be utilized in cases where a debtor or trustee are attempting to create value for constituencies who would otherwise not be entitled to a recovery.  In South Coast, with the ability to sell its avoidance action, the debtor was able to raise $700,000 for unsecured creditors from sale proceeds that were otherwise fully encumbered.

Facts

South Coast Supply Company (the “South Coast” or “Debtor“) was an industrial parts distributor that began experiencing financial trouble in 2016.  As a result, it was forced to borrow $800,000 from its then Chief Financial Officer, Robert Remmert (the “CFO“), pursuant to a loan agreement.  Prior to filing bankruptcy, South Coast had repaid the CFO $320,628.04 on the loan, leaving a remaining loan balance of $578,199.04. The CFO eventually resigned from South Coast and subsequently demanded that the Debtor pay, at least, 70% of the remaining loan balance, in satisfaction of this debt.  Days later, South Coast filed for chapter 11 bankruptcy relief.

After filing, the Debtor commenced an avoidance action against the CFO, seeking to avoid and recover approximately $300,000 in prepetition payments made on the CFO’s loan as preferential transfers to an insider.  South Coast later found value in this lawsuit in a nontraditional fashion.

As further context, at the time South Coast filed bankruptcy, Briar Capital Working Fund Capital, L.L.C. (“Briar Capital“) was the sole secured lender, asserting a claim of approximately $2.6 million, which was secured by collateral estimated to be worth approximately $3.9 million.  Thus, Briar Capital was oversecured, entitling it to recover postpetition interest and legal fees pursuant to section 506(b) of the Bankruptcy Code.

Five months into the bankruptcy, South Coast sought postpetition, secured financing (the “DIP Financing“), because it was not generating enough cash to remain liquid and cash-flow positive.  Finding that Briar Capital was adequately protected under section 364(d) of the Bankruptcy Code, the bankruptcy court approved the DIP Financing on terms that gave (a) Briar Capital lien priority over property obtained by the Debtor before the DIP Financing and (b) the DIP Financing lender lien priority over property obtained after the DIP Financing.

South Coast subsequently filed a chapter 11 plan that proposed to sell its intangible assets, including intellectual property, to the DIP Financing lender for approximately $700,000, $500,000 of which would be distributed to unsecured creditors and the remainder to administrative priority claims.  The original plan also proposed to surrender certain of Briar Capital’s collateral to satisfy its secured claim, but did not otherwise propose to reimburse Briar Capital administrative expenses incurred in participating in the bankruptcy proceeding, notwithstanding the mandates of section 506(b).

After Briar Capital objected to the plan’s treatment of its secured claim, the Debtor modified its plan to provide that (a) Briar Capital would abandon its security interest in the $700,000 of sale proceeds and waive its administrative claims and (b) in return, the Debtor would transfer its preference claim against the former CFO to Briar Capital.  This plan settlement allowed the Debtor to provide a $700,000 distribution to unsecured creditors and administrative claimants (other than Briar Capital).

The bankruptcy court ultimately confirmed the modified plan, entering an order that (a) assigned and conveyed to Briar Capital the preference claims against the former CFO, (b) authorized Briar Capital to prosecute such claims on behalf of the bankruptcy estate and (c) conferred to Briar Capital 100% of any recoveries from the preference action.

Shortly before the trial on the preference action, the district court granted the former CFO’s motion to dismiss the action based on a lack of standing, because Briar Capital was not an estate representative and any recovery thereof would not benefit the Debtor’s estate or its unsecured creditors.

Analysis

On appeal, acknowledging the lack of precedence in the Fifth Circuit, the Court ultimately held that preference actions can be sold to third-party, non-estate representatives pursuant to the plain language of the Bankruptcy Code.

The Fifth Circuit started its analysis by reasoning that, as a general matter, section 363(b)(1) of the Bankruptcy Code allows a debtor in possession to sell “property of the estate.”  The main restriction under this provision is that a bankruptcy sale maximize value to creditors.

The Court then found that section 541(a)(1) of the Bankruptcy Code, which construes “property of the estate,” is a very broad provision that is intended to cover all types of prepetition property rights and interests of a debtor, including “any property made available to the estate by other provisions of the Bankruptcy Code” and causes of action.  Citing In re Kemp, 52 F.3d 546, 550 (5th Cir. 1995) (finding section 541 covers all types of property interests); In re Greenshaw Energy, Inc., 359 B.R. 636, 642 (Bankr. S.D. Tex. 2007) (citing In re Equinox Oil Co., 300 F.3d 614, 618 (5th Cir. 2002) (“Section 541 is read broadly and is interpreted to ‘include all kinds of property, including tangible or intangible property’ [and] causes of action[.]”)).

After laying down this foundation, the Fifth Circuit found that a preference action is property of a bankruptcy estate, as it is a right of action created by federal bankruptcy law to avoid a transfer of prepetition property.  Citing In re Moore, 608 F.3d 253, 257-58 (5th Cir. 2010) (“”[T]he term ‘all legal and equitable interests of the debtor in property’ is all-encompassing and includes rights of action as bestowed by either federal or state law.”).  According to the Fifth Circuit, “[p]reference actions are a mechanism in the Bankruptcy Code by which additional property is made available to the estate, fitting squarely within [the Supreme Court’s precedent for determining estate property].”  Citing United States v. Whiting Pools, Inc., 462 U.S. 198, 205 (1983).  Additionally, the Fifth Circuit found that the preference claims against the former CFO fell within the confines of section 541(a)(1), because “claims to avoid allegedly preferential transfers arise with the filing of the bankruptcy petition, making them property that the debtor has an interest in as of the commencement of the case.”  Citing In re Simply Essentials, LLC, 78 F.4th 1006 (8th Cir. 2023).

The Court also held that preference actions qualify as “property of the estate” under section 541(a)(7) of the Bankruptcy Code, which provides that estate property includes “any interest in property that the estate acquires after the commencement of the estate.”  Briar Capital argued that a right of action that accrues postpetition is estate property if it is created with or by property of the estate or related to or arises out of property that is already part of the estate.  The Fifth Circuit agreed, finding that “Congress enacted § 541(a)(7) to clarify its intention that § 541 be an all-embracing definition and to ensure that property interests created with or by property of the estate are themselves property of the estate.”  Citing In re TMT Procurement Corp., 764 F.3d 512, 525 (5th Cir. 2014).  The Court thus held that the preference actions against the former CFO squarely fell within section 541(a)(7) as well.

The Fifth Circuit bolstered its opinion by observing that both the Eighth and Ninth Circuits had previously held that avoidance actions are property of the estate that can be sold.  Citing In re Simply Essentials, LLC, 78 F.4th at 1011 (“Chapter 5 avoidance actions are property of the estate.”); In re Lahijani, 325 B.R. 282, 288 (9th Cir. 2005) (“While there is some disagreement among courts about the exercise by others of the trustee’s bankruptcy-specific avoiding power causes of action, the Ninth Circuit permits such actions to be sold or transferred.”)

While the former CFO argued that allowing the transfer of the preference action would violate the Debtor’s fiduciary duties and undermined the purpose of avoidance actions, the Fifth Circuit disagreed and found that the Debtor complied with its fiduciary duties by maximizing value to its estate through the liquidation of its avoidance action for valuable consideration.  In South Coast, this liquidation allowed unsecured creditors–who were otherwise out of the money–to receive a $700,000 recovery.

The Fifth Circuit also found that allowing the sale of avoidance actions does not necessarily undermine core bankruptcy principles, because, in approving such sales, “bankruptcy courts must ensure that fundamental bankruptcy policies of asset value maximization and equitable distribution are satisfied.”  According to the Fifth Circuit, “[b]ankruptcy courts must make those decisions on a case by case basis in light of the factual circumstances.”  In the end, the Fifth Circuit concluded that:

Allowing the sale of preference actions will grant bankruptcy courts more flexibility in distributing assets, maximize the value of the bankruptcy estate, and in turn, allow for more equitable distribution of assets.

This is particularly the case, as in South Coast, when the estate does not have sufficient funds to pursue such actions and can trade with existing creditors to free up other estate assets to provide distributions to other creditors.

The Fifth Circuit further held that the purchaser of an avoidance action does not need to be an estate representative.  The district court had previously found that Briar Capital lacked standing, because (a) section 1123(b)(3)(B) of the Bankruptcy Code required an estate representative to pursue claims belonging to an estate and (b) preference claims could not be sold in the first instance.  But, the Fifth Circuit disagreed and held that, because avoidance actions can be sold under section 363(b), purchasers of such actions have standing to pursue them, whether or not they are estate representatives.

Lastly, the Fifth Circuit found that, while section 1123(b) of the Bankruptcy Code may authorize an estate representative to pursue estate claims, that provision does not exclusively govern the liquidation of estate assets and there are different mechanisms in the Bankruptcy Code to do so.  One mechanism, independent of section 1123(b), is section 363, which has no requirement that estate property be transferred to an estate representative.

Conclusion

Not all estate assets are easily liquidated; in particular, claims belonging to an estate that may require significant and costly litigation.  In such instances, the ability to liquidate those intangible and uncertain assets in an expedient manner and provide a quick return to creditors is a valuable tool that a debtor or trustee can employ.

In South Coast the Fifth Circuit not only recognized the importance of this tool, but also found statutory support for its use in the context of the sale of avoidance actions.  By giving the Debtor authority to sell (or liquidate) its preference action to Briar Capital, a non-estate representative, the Court provided the Debtor with the ability to enter into a plan settlement with Briar Capital, release collateral that otherwise belonged to Briar Capital and immediately monetize an intangible asset, thereby maximizing the value of its assets for the benefit of unsecured creditors.