Do Preference Actions Survive a Pledge or Assignment

Do Preference Actions Survive a Pledge or Assignment

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In a recent case, a debtor-in-possession (DIP) lender requested preference and avoidance actions as part of its collateral package. The debtor's counsel declined, saying that granting such a lien could actually create something that the DIP would never want—releasing the very rights that the liens sought to encumber. Was he right by being overly conservative, or was he completely off of his rocker? Should unsecured creditors object to the request if it is presented as part of the DIP financing package? Would the reaction be different if the creditor thought it had received a large preference?

Possible Release of Avoidance Actions

There is a growing body of case law where preference actions by assignees are defeated based simply on who is prosecuting the actions. Sometimes the actions are brought by lenders who foreclosed on the actions, and other times the actions are dismissed because the "causes of action" were "sold" to third parties. Since either action ends the suit, the defendant (creditor) can walk away with no liability to the estate or its creditors.

This recently occurred in In re Metal Brokers International Inc., 225 B.R 920 (Bankr. E.D. Wis. 1998). The chapter 7 trustee sold the rights to three preference claims for $15,000. The assignee then filed a preference action against one of the targets who filed a motion to dismiss based on the assignee's lack of standing. Understandably, the assignee responded that the transfer had been authorized by the court where the preference suit was then pending.

The court dismissed the preference adversary proceeding on the grounds that the assignee lacked standing to pursue it, relying on In re Xonics Photochemical Inc., 841 F.2d 198, 202 (7th Cir. 1988) and In re Vitreous Steel Products Co., 911 F.2d 1223, 1230-31 (7th Cir. 1990).1

Responding to the argument that the court had already effectively ruled that the assignment could be made (and implicitly that it would be effective), the court distinguished its ruling allowing the transfer of the cause of action. It ruled that the preference target's due process rights to challenge standing could not be waived by the bankruptcy court. While the court could allow the chapter 7 trustee to sell (by a type of quit claim) the ligation rights, it could not simultaneously prevent the preference target from raising the assignee's lack of standing as part of its defense—particularly where the target never received notice of the proposed assignment.

Other cases where avoidance actions by assignees were dismissed or otherwise disposed of include In re North Atlantic Millwork Corp., 155 B.R. 271, (Bankr. D. Mass. 1993), In re AK Services Inc., 159 B.R. 76, (Bankr. D. Mass. 1993) and In re S&D Foods Inc., 110 B.R. 34 (Bankr. D. Colo. 1990). Contrary cases allowing an assignee to pursue avoidance actions include In re Professional Investment Properties of America, 955 F.2d 623 (9th Cir. 1992), cert. denied, 506 U.S. 818, 113 S.Ct. 63, 121 L.Ed.2d 31 (1992).

Recovery Solely for Lender's Benefit

A case with a peculiar twist2 had the secured lender (Congress Financial Corp.) asserting a claim to the proceeds of the trustee's preference claims. When the chapter 7 trustee did not respond to the adversary proceeding, judgment in Congress' favor was entered. The trustee then filed a preference suit against AJC International and others that was met by a motion to dismiss.

The court, relying on 11 U.S.C. §550, analyzed the case on the issue of whether the preference recovery would benefit the estate. Following authorities on the question of whether a recovery will benefit the estate was evaluated on a case-by-case basis,3 and the court outlined a three-prong analysis of (1) whether it was a chapter 7 or 11 trustee, (2) whether secured creditors had a claim to the recovery, and (3) whether the unsecured creditors would benefit from the recovery.

The type of bankruptcy was significant because it had been held that a chapter 7 trustee was to safeguard unsecured creditors' rights and not work solely for the secured creditors. It had already been adjudicated that Congress had a lien on the recovery. The trustee and Congress agreed that the recovery would go to Congress and would not benefit the unsecured creditors.

In dismissing the adversary proceeding with prejudice, the court distinguished between the avoidability of the preference and the ability to recover the property. Since the property could only be recovered under 11 U.S.C. §550 and there was no benefit to the estate from avoiding the transfer, the adversary proceeding was dismissed.

Not All Assignments Are Prohibited

The distinction drawn between chapter 7 and 11 cases is critical. Chapter 11 includes a provision in 11 U.S.C. §1123 that allows a plan of reorganization to include a provision for retaining and enforcing causes of action by the reorganized debtor, a trustee or "a representative of the estate appointed for such purpose."4 This provision has been relied upon in cases where a liquidating trustee was appointed to liquidate the estate pursuant to a plan of reorganization.5

Reacting to Proposed Pledge or Sale of Preference Actions

The effect of a sale or pledge of preference causes of action remains in flux. Consequently, the debtor's attorney described above was correct to raise the issue. Having been raised, the real question is how creditors should respond to a proposal that includes selling or pledging avoidance powers.

As with most things in life, reacting to a proposed pledge or sale of preference action depends upon the facts of the specific case. If your unsecured creditor clients received substantial preferential payments during the 90 days before bankruptcy, they might be eager to have preference claims end up somewhere other than in the hands of the DIP or trustee. Such a transfer could give them a defense they would not otherwise have. In fact, some creditors might encourage a sale of the causes of action to give them the best of both worlds—cash for the estate (from the buyer) and a new defense to the preference suit.

On the other hand, if your clients did not receive payments during the 90 days before the bankruptcy and are relying on preference recoveries for a distribution, they would probably oppose the pledge or sale since it could actually reduce the estate through releasing causes of action. Either way, creditors should consider the pleadings coming across their desks in these cases to learn the effects of each.


1 Where a creditor receives standing to prosecute avoidance and other action for the benefit of the estate, courts have upheld that delegation of the trustee's powers. See In re Natchez Corp., 953 F.2d 184 (5th Cir. 1992), In re The Gibson Group Inc., 66 F.3d 1436 (6th Cir. 1995) and In re Vogel Van & Storage, 210 B.R. 27 (N.D.N.Y. 1997). Return to article

2 Congress Credit Corp. v. AJC Intl., 186 B.R. 555 (D. P.R. 1995). Return to article

3 See In re Pearson Industries Inc., 178 B.R. 753 (Bankr. C.D. Ill. 1995). Return to article

4 11 U.S.C. §1123(b)(3). Return to article

5 See In re Texas General Petroleum Corp., 52 F.3d 1330 (5th Cir. 1995); In re Mako Inc., 985 F.2d 1052 (10th Cir. 1993); In re Sweetwater, 994 F. 2d 1323 (10th Cir. 1989); and In re Chase & Sanborn Corp., 813 F2d 1177 (11th Cir. 1987). Return to article

Journal Date: 
Thursday, April 1, 1999