The Restructuring Report

The Eighth Circuit recently ruled that avoidance causes of action are property of the bankruptcy estate under § 541 of the Bankruptcy Code and thus may be sold by the trustee or debtor in possession. Pitman Farms v. ARKK Food Company, LLC, et al., No. 22-2011 (8^th Cir. August 21, 2023). The ruling reinforces the notion that estate causes of action are assets that can be sold under § 363 of the Code, a practice which has been increasingly used in § 363 sales.

In the underlying case, the Chapter 7 trustee of the debtor, Simply Essentials, determined there were insufficient resources to pursue certain avoidance causes of action against the debtor’s parent, Pittman Farms, and instead sought bids to sell the causes of action to the highest bidder. Both Pittman Farms and ARKK made bids, and the trustee determined that the ARKK bid was superior. The trustee sought approval of a compromise with ARKK and the sale under § 363 of the causes of action to ARKK. The bankruptcy court approved both.

Pittman appealed to the Eighth Circuit. The only issue raised in the appeal was whether the avoidance actions are property of the estate, and therefore saleable under 363(a). The Court opinion, authored by former bankruptcy judge Michael Melloy, began its analysis by discussing whether § 541, which provides what constitutes property of the estate, includes avoidance causes of action. The court noted that two provisions of § 541 could be interpreted to include avoidance actions as property of the estate. First, under § 541(a)(1), property of the estate includes all legal or equitable interests of the debtor in property as of the commencement of the case. Further, § 541(a)(7) provides that property of the estate includes any interest in property the estate acquires after the commencement of the case. The opinion notes that it is well settled that property of the estate includes pre-petition causes of action of the debtor and that avoidance claims are a type of cause of action. The problem there, Pitman argued, is some types of avoidance claims do not exist unless or until a bankruptcy case is commenced. The court dealt with this issue by noting that the debtor has an inchoate or contingent interest in avoidance causes of action prior to the filing of the case, and that interest is sufficient to become property of the estate upon commencement of the case.

In addition, the court reasoned, the avoidance claims clearly constitute property of the estate as property acquired by the estate after the commencement of the case. The court explicitly rejected Pittman’s argument that avoidance action arises the moment the bankruptcy proceedings are commenced, but not after the case is commenced.

The court noted in its analysis that its conclusions were consistent with other court decisions around the country reaching the same conclusion. These cases include circuit level decisions in the Third and Fifth Circuits. See In re Wilton Armetale, Inc., 968 F.3^rd 273, 285 (3d Cir. 2020) and In re Moore, 608 F3d 253 (5^th Cir. 2010).

The Eighth Circuit’s conclusion and holdings bolsters recent practice of selling avoidance causes of action not only by trustees in Chapter 7 cases, but also by debtors in possession in Chapter 11 cases as part of a going concern sale of assets. Often, financial or strategic buyers want to acquire these claims as part of their bid. The reason is the buyers do not intend to pursue the avoidance claims but instead want to ensure that important creditors who supply goods or services to the business are not later sued for preferences or fraudulent transfers arising from the prior relationship with the debtor. Buyers perceive that they may have difficulty obtaining sources of supply on reasonable terms if those suppliers are being sued by the bankruptcy estate to recover on transfers.

Sometimes, unsecured creditors committees are supportive of such provisions because the value of the ongoing relationship post-closing is more important to their unsecured creditor constituencies than any incremental increase in recovery on their claims from sharing in proceeds of the avoidance recoveries. In addition, the sale of the claims may mean faster monetization of the avoidance claims to be paid out on creditor recoveries in the case.

Note that the decision of the debtor in possession to include avoidance claims as assets sold to a buyer will require some showing that the debtor took the value of the avoidance claims into account in deciding to accept a bid that includes a transfer of the avoidance claims. The reason is that the debtor or trustee will need to articulate to the court why the bid is the highest and best bid under the circumstances. Thus, the debtor will want an analysis of the value of the claims, which means taking into account not just the face amount of the claims but the risks and costs of recovering on the claims.

From the buyer’s perspective, the buyer will want to make sure derivative standing to pursue avoidance claims is granted and approved by the court, and that the buyer has the full ability to pursue and settle the claims without further estate fiduciary involvement. Evidentiary considerations such as obtaining access to attorney/client privileged communications should also be considered.

Finally, the Eighth Circuit opinion opens the door to another issue. The Court reasoned in part that avoidance causes of action are property of the estate because the debtor had a pre-petition inchoate interest in the avoidance causes of action. The question then is whether this interest is sufficient for the debtor to be able to grant a pre-petition security interest in those causes of action to its lender? If so, the lien issues may have a significant negative impact on the availability of the causes of action to fund payments to unsecured creditors in the case, potentially further eroding those recoveries in many cases.