Ten Years Gone – Delaware Bankruptcy Judge Rejects Effort to Extend Lookback Period for Avoidance of Pre-Bankruptcy Transfers

Kelley Drye Client Advisory

recent decision by Delaware Bankruptcy Judge John Dorsey will limit the ability of bankruptcy trustees to expand the lookback period for avoiding pre-bankruptcy transfers beyond the four years provided under most state law fraudulent conveyance statutes.  In dismissing a trustee’s action to recover transfers made more than four years prior to the commencement of the bankruptcy case, Judge Dorsey rejected the trustee’s effort pursuant to section 544(b) of the Bankruptcy Code to apply the Internal Revenue Service’s ten year lookback period to the 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 conveyances made by an insolvent entity for which less than reasonably equivalent value” was received in return.  Section 548 of the Bankruptcy Code gives a trustee the direct right to avoid such transfers made within a two year lookback period, and section 544(b) gives the trustee the right to piggy-back on the rights of a creditor under applicable state law, which typically provide a four year lookback, so long as such creditor hold[s] an unsecured claim that is allowable under section 502 [of the Bankruptcy Code].”  Section 502(b) in turn provides that when a proof of claim is filed, the claim is deemed allowed, unless a party in interest . . . objects.”

The J&M Sales trustee sought to avoid a number of pre-bankruptcy transfers which took place earlier than August 2014, but was limited by the four year lookback period available to unsecured creditors under Delaware law.  The trustee contended, however, that he could utilize the IRS as the predicate creditor under section 544(b) and assert the IRS’s right to avoid transfers as far back as ten years

The defendant transferees argued in opposition that the trustee could not use the IRS as a predicate creditor under section 544(b) because the IRS had not filed a proof of claim in the J&M Sales case.  The trustee countered that it was not necessary for the IRS to have filed a proof of claim, as section 544(b) references a claim that is allowable” under section 502, rather than actually allowed.”  He argued that the fact that the debtor had owed payroll taxes to the IRS at the start of the case was sufficient for the trustee to be able to step into the IRS’s shoes as predicate creditor and utilize the ten year lookback.  (The taxes were subsequently paid.)

Judge Dorsey disagreed.  Although he acknowledged a 2014 Pennsylvania decision that supported the trustee’s argument, Judge Dorsey determined that the weight of caselaw authority was contrary, and held that in order to be considered an allowable claim for purposes of Section 544(b) there must be a proof of claim filed as required by Section 502.”  In a footnote, he observed that nearly every business debtor owes payroll taxes at the time of bankruptcy filing because such taxes are accrued but not actually due to be paid.  He stated that while he was reaching his decision based on the statutory language of sections 502 and 544(b), he was troubled” by the implications of the trustee’s argument.  Under the Trustee’s theory . . .  every business bankruptcy case would automatically have a ten-year lookback period for fraudulent transfers under Section 544(b). That cannot be what Congress had in mind when enacting Section 544(b).”

Judge Dorsey’s decision in J&M Sales will be frustrating for bankruptcy trustees and other parties which may be authorized to act on behalf of a debtor’s bankruptcy estate, such as official creditor committees in chapter 11 cases.  In many bankruptcy proceedings, the avoidance of pre-bankruptcy transfers, especially transfers made to a debtor’s insiders, offers the only chance of providing any distribution to unsecured creditors.  Given the prominence of the Delaware bankruptcy court, Judge Dorsey’s ruling will likely limit efforts to use the IRS’s expansive lookback rights to lengthen the period for avoiding pre-bankruptcy transfers.