A recent decision by Delaware Bankruptcy Judge John Dorsey will limit the ability of trustees in bankruptcy to extend the lookback period to avoid pre-bankruptcy transfers beyond the four years provided by most state fraudulent transfer laws. In dismissing a trustee’s action to recover transfers made more than four years before the commencement of bankruptcy proceedings, Judge Dorsey dismissed the trustee’s effort pursuant to Section 544(b) of the Bankruptcy Code to apply the Internal Revenue Service’s ten-year look-back period to disputed transactions.
J&M Sales, a Delaware corporation, filed for bankruptcy in August 2018 under Chapter 7 of the Bankruptcy Code and a trustee was appointed to oversee its liquidation. The Bankruptcy Code provides trustees with the ability to avoid and recover pre-bankruptcy transfers that diminish estate assets to the detriment of creditors, including transfers made by an insolvent entity for which less than one ” reasonably equivalent value” was received in return. Article 548 of the Bankruptcy Code gives a trustee the direct right to avoid such transfers made within two years, and section 544(b) gives the trustee the right to piggyback on the rights of a creditor under the law of applicable state, which generally provides a four-year look-back period, so long as that creditor “holds[s] an unsecured debt that qualifies under section 502 [of the Bankruptcy Code].” Section 502(b) in turn provides that where a proof of claim is filed, the claim “shall be deemed granted, unless an interested party . . . objects.”
The trustee of J&M Sales sought to avoid a number of pre-bankruptcy transfers that took place before August 2014, but was limited by the four-year look-back period available to unsecured creditors under Delaware law. The trustee, however, argued that he could use the IRS as primary creditor under section 544(b) and assert the IRS’ right to avoid transfers for ten years.
Defendant assignees argued in opposition that the trustee could not use the IRS as primary creditor under section 544(b) because the IRS failed to file a proof of claim in the J&M case. Dirty. The trustee countered that it was not necessary for the IRS to have filed a proof of claim because section 544(b) refers to a claim that is “allowable” under section 502, rather than actually “allowed”. He argued that the fact that the debtor owed payroll taxes to the IRS at the outset of the case was sufficient for the trustee to step into the place of the IRS as primary creditor and use the retrospective of ten years. (Taxes were paid afterwards.)
Justice Dorsey disagreed. Although he acknowledged a 2014 Pennsylvania decision that supported the trustee’s argument, Judge Dorsey determined that the weight of judicial authority was contrary and ruled that “to be considered a valid claim for the purposes of section 544(b), there must be a proof of claim filed pursuant to section 502.” In a footnote, he observed that almost all corporate debtors owe payroll taxes at the time of filing. balance sheet, as these taxes are due but not to be paid.He said that as he made his decision based on the legal wording of Sections 502 and 544(b), he was “troubled” by the implications of the trustee’s argument “Under the trustee’s theory . . . every case of corporate bankruptcy would automatically have a ten-year cooling-off period for fraudulent transfers under section 544(b). This cannot not be what Congress had in mind when the enactment of Section 544(b). “
Judge Dorsey’s decision in J&M Sales will be frustrating for trustees in bankruptcy and other parties who may be authorized to act on behalf of a debtor’s bankruptcy, such as formal creditors’ committees in Chapter 11 cases. In many bankruptcy proceedings, avoiding pre-bankruptcy transfers, especially transfers made to insiders of a debtor, offers the only chance of providing a distribution to unsecured creditors. Given the importance of Delaware’s bankruptcy court, Judge Dorsey’s decision will likely limit efforts to use the IRS’ extensive lookback rights to lengthen the period to avoid pre-bankruptcy transfers.