Another Court Adopts Majority View In Approving Bankruptcy Trustee’s Use Of Tax Code Look-Back Period In Avoidance Actions – Insolvency/Bankruptcy/Re-structuring

The ability of a bankruptcy trustee or chapter 11
debtor-in-possession (“DIP”) to avoid fraudulent
transfers is an important tool promoting the bankruptcy policies of
equality of distribution among creditors and maximizing the
property included in the estate. One limitation on this avoidance
power is the statutory “look-back” period during which an
allegedly fraudulent transfer can be avoided-two years for
fraudulent transfer avoidance actions under section 548 of the
Bankruptcy Code and, as generally understood, three to six years if
the trustee or DIP seeks to avoid a fraudulent transfer under
section 544(b) and state law by stepping into the shoes of a
“triggering” creditor plaintiff.

The longer look-back periods governing avoidance actions under
various state laws significantly expand the universe of
transactions that may be subject to fraudulent transfer avoidance.
Indeed, under a ruling recently handed down by the U.S. Bankruptcy
Court for the Western District of North Carolina, the look-back
period in avoidance actions under section 544(b) may be much
longer-10 years-in bankruptcy cases where the Internal Revenue
Service (“IRS”) or another governmental entity is the
triggering creditor. In Mitchell v. Zagaroli (In re
Zagaroli)
, 2020 WL 6495156 (Bankr. W.D.N.C. Nov. 3, 2020), the
court, adopting the majority approach, held that a chapter 7
trustee could effectively circumvent North Carolina’s four-year
statute of limitations for fraudulent transfer actions by stepping
into the shoes of the IRS, which is bound not by North Carolina law
but by the 10-year statute of limitations for collecting taxes
specified in the Internal Revenue Code (“IRC”).

Derivative Avoidance Powers Under Section 544(b) of the
Bankruptcy Code

Section 544(b)(1) of the Bankruptcy Code provides in relevant
part as follows:

[T]he trustee may avoid any transfer of an interest of the
debtor in property or any obligation incurred by the debtor that is
voidable under applicable law by a creditor holding an unsecured
claim that is allowable under section 502 of this title or that is
not allowable only under section 502(e) of this title.

11 U.S.C. § 544(b). Thus, a trustee (or DIP pursuant to
section 1107(a)) may seek to avoid transfers or obligations that
are “voidable under applicable law,” which is generally
interpreted to mean state law. See Ebner v. Kaiser (In re
Kaiser),
525 B.R. 697, 709 (Bankr. N.D. Ill. 2014); Wagner
v. Ultima Holmes (In re Vaughan)
, 498 B.R. 297, 302 (Bankr.
D.N.M. 2013).

The fraudulent transfer statutes of almost every state are
versions of the Uniform Fraudulent Transfer Act (“UFTA”),
which was recently amended and renamed the “Uniform Voidable
Transactions Act” (“UVTA”). States that have adopted
the UFTA or UVTA most commonly provide that avoidance actions are
time-barred unless brought within four years of the time the
transfer was made or the obligation was incurred. Notably, New York
adopted the UVTA effective as of December 2019, reducing its
look-back period to four years, from six under longstanding prior
law.

Longer Look-Back Period for Certain Governmental Entities

The federal government is generally not bound by state statutes
of limitations, including those set forth in state fraudulent
transfer laws. Vaughan, 498 B.R. at 304. Instead, various
federal statutes or regulations specify the statute of limitations
for enforcement actions. For example, the IRC provides that, with
certain exceptions, an action to collect a tax must be commenced by
the IRS no later than 10 years after the tax is assessed.
See 26 U.S.C. § 6502(a). The rationale behind a
longer federal statute of limitations is that public rights and
interests that the federal government is charged with defending
should not be forfeited due to public officials’ negligence.
Vaughan, 498 B.R. at 304.

On the basis of the plain meaning of section 544(b), nearly all
of the courts that have considered the issue have concluded that a
trustee or DIP bringing an avoidance action under that section may
step into the shoes of the IRS (if it is a creditor in the case) to
utilize the IRC’s 10-year statute of limitations. See,
e.g., Murphy v. ACAS, LLC (In re New Eng.
Confectionary Co.)
, 2019 Bankr. LEXIS 2281 (Bankr. D. Mass.
July 19, 2019); Viera v. Gaither (In re Gaither), 595 B.R.
201 (Bankr. D.S.C. 2018); Hillen v. City of Many Trees, LLC (In
re CVAH, Inc.)
, 570 B.R. 816 (Bankr. D. Idaho 2017);
Mukhamal v. Citibank, N.A. (In re Kipnis), 555 B.R. 877
(Bankr. S.D. Fla. 2016); Kaiser, 525 B.R. at 711-12.

Vaughan is apparently the only published decision to
the contrary with respect to the IRS and the IRC. The
Vaughan court reached its conclusion after considering
policy and legislative intent. It noted that the IRS is not bound
by state law statutes of limitations because it exercises sovereign
powers and is therefore protected by the doctrine of nullum
tempus occurrit regi
(“no time runs against the
king”). According to the court in Vaughan, Congress
did not intend for section 544(b) to vest sovereign power in a
bankruptcy trustee, and allowing a trustee to take advantage of the
IRC’s 10-year statute of limitations would be an overly broad
interpretation.

In MC Asset Recovery LLC v. Commerzbank A.G. (In re Mirant
Corp.)
, 675 F.3d 530, 535 (5th Cir. 2012), the U.S. Court of
Appeals for the Fifth Circuit rejected a line of cases holding that
the Federal Debt Collection Practices Act (“FDCPA”) can
be “applicable law” for purposes of section 544(b),
thereby affording the trustee use of the FDCPA statute of
limitations, because the FDCPA expressly provides that “[t]his
chapter shall not be construed to supersede or modify the operation
of … title 11.” Id. at 535 (quoting 28 U.S.C.
§ 3003(c)); accord MC Asset Recovery, LLC v. Southern
Co.
, 2008 WL 8832805 (N.D. Ga. July 7, 2008) (“[T]he
FDCPA cannot be the ‘applicable law’ within the meaning of
Section 544(b) of the Bankruptcy Code.”). However, the IRC
does not include comparable language.

The Vaughan minority approach has been rejected by
almost all other courts. For example, in Kipnis, the court
concluded that the meaning of section 544(b) is clear and does not
limit the type of creditor from which a trustee can choose to
derive rights. Moreover, because the court determined that its
interpretation of the statute was not “absurd,” the court
did not deem it necessary to expand its inquiry beyond the express
language of section 544(b) to consider legislative intent or policy
concerns. Kipnis, 555 B.R. at 882 (citing Lamie v.
United States Trustee
, 540 U.S. 526, 534 (2004) (“It is
well established that ‘when the statute’s language is
plain, the sole function of the courts-at least where the
disposition required by the text is not absurd-is to enforce it
according to its terms.'”)).

The court concluded that Vaughan‘s nullum
tempus
argument was misplaced. Because section 544(b) is a
derivative statute, the Kipnis court wrote, “the
focus is not on whether the trustee is performing a public or
private function, but rather, the focus is on whether the IRS, the
creditor from whom the trustee is deriving her rights, would have
been performing that public function if the IRS had pursued the
avoidance actions.”

However, the court agreed with Vaughan on one point-if
applied in other cases, the court’s ruling could result in a
10-year look-back period in many cases. According to the
Kipnis court, because the IRS is a creditor in a
significant number of cases, the paucity of decisions addressing
the issue can more likely be attributed to the fact that trustees
and DIPs have not realized that this “weapon is in their
arsenal.”

Triggering Creditor Must Have an “Allowable
Claim”

Avoidance under section 544(b) is permitted only if a transfer
could be avoided under applicable law by a creditor holding an
“allowable” unsecured claim. The term
“allowable” is not defined in the Bankruptcy Code.
However, section 502(a) provides that a claim for which the
creditor files a proof of claim is deemed “allowed”
unless a party in interest objects. Rule 3003(b) of the Federal
Rules of Bankruptcy Procedure provides that, in a chapter 9 or
chapter 11 case, a creditor need not file a proof of claim if the
claim is listed on the debtor’s schedules in the proper amount
and is not designated as disputed, contingent, or unliquidated.

Thus, if an unsecured creditor has not filed a proof of claim
and if, in a chapter 9 or chapter 11 case, its claim either is not
scheduled in any amount or is scheduled as disputed, contingent, or
unliquidated, a handful of courts have concluded that the claim is
not “allowable” and the trustee or DIP may not step into
the creditor’s shoes to bring an avoidance action under section
544(b). See In re Republic Windows & Doors,
2011 WL 5975256, *11 (Bankr. N.D. Ill. Oct. 17, 2011) (a chapter 7
trustee could not take advantage of the IRC’s 10-year statute
of limitations because the IRS had not filed a proof of claim in
the case); Campbell v. Wellman (In re Wellman), 1998 WL
2016787, *3 (Bankr. D.S.C. June 2, 1998) (“[A]s Robert
McKittrick was the only creditor of these three [creditors] to file
a proof of claim, he is the only one with an allowable claim into
whose shoes the [chapter 7] Trustee may step pursuant to §
544(b).”).

However, the majority approach is otherwise. Most courts have
held that the allowability of a claim for purposes of section
544(b) should be determined as of the petition date and, therefore,
that the failure to file a proof of claim does not disqualify a
creditor from being the triggering creditor. See,
e.g., In re Tabor, 2016 WL 3462100, at *2 (Bankr.
S.D. Fla. June 17, 2016); Whittaker v. Groves Venture, LLC (In
re Bolon)
, 538 B.R. 391, 408 n.8 (Bankr. S.D. Ohio 2015);
Finkel v. Polichuk (In re Polichuk), 506 B.R. 405, 432
(Bankr. E.D. Pa. 2014); In re Kopp, 374 B.R. 842, 846
(Bankr. D. Kan. 2007).

In Zagaroli, the bankruptcy court considered whether a
chapter 7 trustee could step into the shoes of the IRS for purposes
of section 544(b).

Zagaroli

In 2018, Peter Zagaroli (“debtor”) filed a chapter 7
case in North Carolina. The IRS filed a proof of claim in the case
in the unsecured amount of approximately $4,000. In 2020, the
chapter 7 trustee sued the debtor’s parents, seeking to avoid
2010 and 2011 transfers of real property by the debtor to his
parents as fraudulent transfers under the North Carolina UVTA,
which has a four-year look-back period. See N.C. Gen.
Stat. § 39-23.9. The defendants moved to dismiss, arguing that
the challenged transfers occurred more than four years prior to the
petition date. The trustee countered that he could utilize the
IRC’s 10-year look-back period because the IRS was a triggering
creditor.

The bankruptcy court denied the motion to dismiss.

The defendants argued that, instead of focusing on the plain
language of section 544(b), the court should consider the
legislative history, the purpose of the provision, related
provisions of the Bankruptcy Code, and other relevant statutes,
such as the IRC, which requires specific authorization to bring any
action thereunder. See 26 U.S.C. § 7401. According to
the defendants, limiting consideration solely to the language of
section 544(b) would lead to “absurd results or conflict with
other statutory provisions.”

The bankruptcy court rejected those arguments. When the language
of a statute is unambiguous, the court explained, “‘the
court’s task is simple: apply the plain language'”
(citation omitted). Moreover, the court wrote, “the
Defendants’ position would result in leaving both the Trustee
and the IRS without the right to avoid offending transfers”
that occurred outside the look-back period under state law. The
court concluded that “the applicable law that the Trustee
seeks to invoke is the [North Carolina UVTA] and the IRC, both of
which the IRS could have used to seek to avoid the transfers
outside of bankruptcy.”

Outlook

Zagaroli does not break new ground on the power of a
bankruptcy trustee or DIP to bring avoidance actions under section
544(b) of the Bankruptcy Code. Nevertheless, the court’s
endorsement of the majority approach on the availability of a
longer look-back period in cases in which the IRS is a creditor is
notable. Widespread adoption of this approach could significantly
augment estate avoidance action recoveries.

Furthermore, the IRS is not the only potential triggering
creditor under section 544(b) with a longer look-back period. Other
federal and state governmental entities may also provide that
additional tool to a trustee or DIP. See, e.g.,
In re 160 Royal Palm, LLC, 2020 WL 4805478 (Bankr. S.D.
Fla. July 1, 2020) (permitting a debtor under section 544(b) to
take advantage of the Securities and Exchange Commission’s
six-year statute of limitations for fraudulent transfer claims
under 28 U.S.C. §§ 2415(a) and 2416); Alberts v. HCA
Inc. (In re Greater Southeast Cmty. Hosp. Corp. I)
, 365 B.R.
293, 304 (Bankr. D.D.C. 2006) (the trustee of a liquidating trust
created by a chapter 11 plan could step into the shoes of the IRS
as well as the U.S. Department of Health and Human Services
(six-year statute of limitations for actions to collect Medicare
overpayments under 28 U.S.C. § 2415) for the purpose of
bringing an avoidance action under section 544(b) and the Illinois
UFTA); G-I Holdings, Inc., 313 B.R. at 636 (the asbestos
claimants’ committee in a chapter 11 case could step into the
shoes of the New Jersey Department of Environmental Protection
(10-year statute of limitations for enforcement action) for
purposes of section 544(b)). In addition, despite the Fifth
Circuit’s rejection of the FDCPA as “applicable law”
for purposes of § 544(b), other courts have ruled to the
contrary. See, e.g., Gaither, 595 B.R. at 214; In re
Alpha Protective Servs., Inc.
, 531 B.R. 889, 905 (Bankr. M.D.
Ga. 2015) (citing cases). Thus, understanding the approach adopted
in a particular jurisdiction is paramount for this purpose.

Originally published February 2021.

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