A Michigan bankruptcy court recently held that the doctrine of sovereign immunity is abrogated by 11 U.S.C. § 106(a)(1) with respect to a bankruptcy trustee’s action to avoid fraudulent transfers against a branch of the state under 11 U.S.C. § 544(b)(1). The court found that the requirement that an “actual creditor” be able to assert a fraudulent transfer action under applicable bankruptcy law did not make the doctrine of sovereign immunity applicable notwithstanding the express language of section 106(a)(1). Kohut v. Wayne Cnty. Treasurer (In re Lewiston), 528 B.R. 387 (Bankr. E.D. Mich. 2015).
The chapter 7 trustee filed a complaint against the county to avoid and recover $307,602.83 in fraudulent transfers pursuant to 11 U.S.C. §§ 544(b)(1) and 550. The individual debtor was a real estate developer. During the six years prior to his bankruptcy filing, the debtor personally made transfers to the county to pay taxes and fees owed by his real estate projects. The debtor had no legal obligation to personally pay the taxes; the debtor’s projects were insolvent when he made the transfers to the county; and the debtor received no benefit in exchange for his payments to the county. The county moved to dismiss the complaint based primarily on the doctrine of sovereign immunity.
The trustee brought the complaint under 11 U.S.C. § 544(b)(1) which allows a trustee to avoid transfers that an unsecured creditor of the debtor could avoid pursuant to applicable nonbankruptcy law. Pursuant to section 544(b)(1), the trustee brought the complaint under the Michigan Uniform Fraudulent Transfer Act (“MUFTA”). The court noted two significant differences between a cause of action brought under 11 U.S.C. § 548 (the Bankruptcy Code’s fraudulent transfer statute) and one brought under MUFTA pursuant to section 544(b)(1): (1) MUFTA allows the avoidance of fraudulent transfers made within six years before the filing of the complaint while section 548 has a shorter two year reach back period; and (2) section 544(b)(1) requires that an actual unsecured creditor could have brought the fraudulent transfer claim under applicable nonbankruptcy law.
In its motion to dismiss, the county contended that an actual unsecured creditor could not bring the MUFTA cause of action under applicable nonbankruptcy law because the doctrine of sovereign immunity bars causes of action against the county. The county argued that it is a political subdivision of the state and thus is immune from suit unless it consents under the 11th Amendment of the United States Constitution and Michigan state law. See Pohutski v. City of Allen Park, 641 N.W.2d 219 (Mich. 2002). The trustee generally did not dispute these claims, but argued that the county’s sovereign immunity was expressly waived under 11 U.S.C. § 106(a)(1), which provides that “[n]otwithstanding an assertion of sovereign immunity, sovereign immunity is abrogated as to a governmental unit to the extent set forth in this section with respect to” section 544, among various other specifically enumerated Bankruptcy Code sections.
The county conceded that section 106(a)(1) abrogates sovereign immunity with respect to section 544 and did not attempt to challenge the holding of the United States Supreme Court in Central Virginia Community College v. Katz, 546 U.S. 356 (2006), which upholds the power of Congress to abrogate states’ sovereign immunity in enacting bankruptcy laws pursuant to the Bankruptcy Clause (Art. I, § 8, cl. 4). Rather, the county’s argument was that since an “actual” creditor under nonbankruptcy law could not bring the cause of action because of sovereign immunity, neither could the trustee by virtue of section 544(b)(1).
The case law on this issue is split. The Seventh Circuit, the only circuit court to address the issue, found in In re Equipment Acquisition Resources, Inc. 742 F.3d 743 (7th Cir. 2014) that an action could not be brought against the I.R.S. under section 544(b)(1) because an actual creditor could not sue the Internal Revenue Service (“I.R.S.”) under the Illinois Uniform Fraudulent Transfer Act under the doctrine of sovereign immunity. Accord Dillworth v. Ginn (In re Ginn-La St. Lucie Ltd.), No. 10-2976-PGH, 2010 WL 8756757 (Bankr. S.D. Fla. Dec. 10, 2010); Pyfer v. Katzman (In re National Pool Construction, Inc.), no. 09-34394, 2015 WL 394507 (Bankr. D.N.J. Jan. 29, 2015).
On the other side, there are cases such as Zazzali v. Swenson (In re DBSI, Inc.), 463 B.R. 709 (Bankr. D. Del. 2012) which concluded, based on a textual analysis of section 106(a)(1), that the express abrogation of sovereign immunity with respect to section 544 was not consistent with the application of sovereign immunity under certain circumstances. Quoting another case, the court rhetorically inquired:
Why would Congress explicitly waive sovereign immunity for all other avoidance actions under the Bankruptcy Code, and include a waiver of sovereign immunity for actions under section 544 knowing that section 544 encompasses state law theories, but then require a separate waiver of sovereign immunity for the necessary state law component in actions under section 544? The argument offered by the United States defies logic.
In re DBSI, 463 B.R. at 717 (quoting Furr v. I.R.S. (In re Pharmacy Distributor Services, Inc., 455 B.R. 817, 821 (Bankr. S.D. Fla. 2011)). Accord VMI Liquidating Trust v. United States (In re Valley Mortgage Inc.), no. 12-01277-SBB, 2013 WL 5314369 (Bankr. D. Colo. Sept. 18, 2013).
Recognizing the split in the statutory interpretation, the Michigan bankruptcy court here concluded in favor of abrogation of sovereign immunity. The court reasoned:
The statute is susceptible to only one interpretation: it simply eliminates sovereign immunity however and whenever it applies “with respect to” the 59 sections of the Bankruptcy Code listed in § 106(a)(1). Section 544 is one of those sections. In this case, the Complaint is brought under § 544. That ends the inquiry. Wayne County cannot raise sovereign immunity as a defense to the Complaint under § 544 because sovereign immunity with respect to § 544 is unequivocally and unambiguously abrogated by § 106(a)(1).
The argument that the “actual creditor” requirement of section 544 cannot be met outside of bankruptcy because of sovereign immunity, the court concluded, did not pass logical muster. Indeed, an actual creditor could prevail, notwithstanding sovereign immunity, because section 106(a)(1) expressly abrogates sovereign immunity with respect to an action brought under section 544. Accordingly, the court denied the county’s motion to dismiss.
The Insolvency Law Committee recently published an e-Bulletin regarding the above cited case of Pyfer v. Katzman (In re National Pool Construction, Inc.), no. 09-34394, 2015 WL 394507 (Bankr. D.N.J. Jan. 29, 2015), which came to the opposite result. As noted in the earlier e-Bulletin, the court in National Pool Construction did not provide a full discussion of case law coming out on the side of abrogation of sovereign immunity. Here, however, the court considered both sides of the argument and came out in favor of abrogation. What we are left with is a significant divide in the statutory interpretation, with one faction interpreting the “actual creditor” requirement in section 544 to come ahead of section 106(a)(1), and the other finding that the abrogation of sovereign immunity set forth in section 106(a)(1) as it applies to section 544 must be understood to apply to the underlying state law.
These materials were prepared by Zev Shechtman (email@example.com) of Danning Gill Diamond & Kollitz LLP, Los Angeles, California. Editorial contributions were provided by ILC member Doris A. Kaelin, of Gordon & Rees LLP and Peter J. Gurfein (firstname.lastname@example.org) ILC e-Bulletin co-editor-in-chief.