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7th Cir. Rejects Bankruptcy Trustee’s Challenges to Pre-Petition Sale of Debtor’s Debts

bankruptcyThe U.S. Court of Appeals for the Seventh Circuit recently rejected a bankruptcy trustee’s avoidance and fraudulent transfer claims, holding that a debt purchase and sale agreement between a bankrupt debtor, its original creditor, and its new creditor was not avoidable because it did not qualify as a transfer of “an interest of the debtor in property.”

Specifically, the Seventh Circuit determined that the transaction had no effect on the bankruptcy estate and the Bankruptcy Code’s avoidance provisions played no role.

A copy of the opinion in Douglas F. Mann v. LSQ Funding Group LC is available at:  Link to Opinion.

The original creditor here provided invoice-factoring services to a now bankrupt debtor business. Weeks before the debtor declared bankruptcy, its CEO orchestrated an agreement between the original creditor and a new creditor. Pursuant to the agreement, the new creditor paid off the debt owed to the original creditor and took the original creditor’s place. In exchange, the original creditor released all of its interest in the debtor’s accounts, which immediately went to the new creditor.

Once the debtor filed for bankruptcy, the trustee of its estate sued the original creditor in an attempt to avoid the payoff, alleging that the accounts the new creditor purchased were worthless and that the original creditor conspired with the debtor to leave the new creditor with the accounts. The trustee argued that the payoff agreement was avoidable as both a preferential and a fraudulent transfer.

The bankruptcy court dismissed the trustee’s suit, holding that the payoff agreement was not avoidable because it did not qualify as a transfer of “an interest of the debtor in property.” 11 U.S.C. § 547, 548. The trustee timely appealed.

Section 547 provides a mechanism for the trustee of a bankruptcy estate to “avoid” transactions that favored certain creditors over others in the months before the debtor filed for bankruptcy. But Section 547 only allows “the trustee … [to] avoid … transfer[s] of an interest of the debtor in property.”

The Seventh Circuit noted two tests it uses to determine whether a transfer had affected “an interest of the debtor in property”: (1) whether the debtor can exercise control over the funds transferred; and (2) whether the transfer diminishes the property of the estate. See 966 F.2d 1527, 1535 (7th Cir. 1992). The Court reasoned that the goal of the two tests is to determine whether the transfer took something from the pool of assets that would otherwise have gone to creditors. See Matter of Wagenknecht, 971 F.3d 1209, 1213 (10th Cir. 2020).

Although it was confident that a reasonable jury could find that the debtor chose the original creditor as the beneficiary of its new financing, the Seventh Circuit also concluded that there was little evidence in the record that the debtor had the ultimate ability to “determine[] the disposition of the funds” or of the accounts themselves.

At any rate, the Seventh Circuit determined that it did not need to decide the exact question of control here because a diminution of estate analysis showed that the transaction at issue did not involve “an interest of the debtor in property.” The parties agreed that the accounts sold would not have been part of the debtor’s estate, the funds never actually passed through the debtor’s accounts, and the change in creditors was instantaneous.

Thus, because the transfer at issue did not involve “an interest of the debtor in property,” the Seventh Circuit held that it could not be avoided as a preferential transfer under Section 547.

Nevertheless, the trustee contended that fraudulent transfers under Section 548 do not require control over the transferred property or diminution of the estate, and that fraud alone is enough to make them avoidable. However, the Seventh Circuit rejected the trustee’s argument by looking to the plain language of Section 548.

Just like Section 547’s avoidance provision for preferential transfers, Section 548(a)(1) permits “[t]he trustee [to] avoid any transfer … of an interest of the debtor in property” that meets certain fraudulent criteria. Therefore, the Seventh Circuit examined whether the payoff agreement constituted an “interest of the debtor in property.” The Court concluded that Section 548’s phrase “an interest of the debtor in property,” consistent with its reading of the phrase in Section 547, has generally been held to be the equivalent of “property of the estate,” encompassing only those transfers that affect property that would have been property of the estate but for the transfer. 5 Collier on Bankruptcy ¶ 548.03 (16th 2023).

Because the transaction in this case had no impact on the property of the debtor, the Seventh Circuit held that this was not the type of fraud governed by the Bankruptcy Code. If fraud occurred, the new creditor’s relief should have come from damages in a separate fraud suit.

Accordingly, the Seventh Circuit concluded that the trustee failed to show that the transfer at issue involved “an interest of the debtor in property,” and he could not avoid the transaction. Thus, the Court affirmed the rulings of the trial court and the bankruptcy court.

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The attorneys of Maurice Wutscher are seasoned business lawyers with substantial experience in business law, financial services litigation and regulatory compliance. They represent consumer and commercial financial services companies, including depository and non-depository mortgage lenders and servicers, as well as mortgage loan investors, financial asset buyers and sellers, loss mitigation companies, third-party debt collectors, and other financial services providers. They have defended scores of putative class actions, have substantial experience in federal appellate court litigation and bring substantial trial and complex bankruptcy experience. They are leaders and influencers in their highly specialized area of law. They serve in leadership positions in industry associations and regularly publish and speak before national audiences.

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