December 29, 2022
Section 548(a) of the Bankruptcy Code empowers a trustee or a chapter 11 debtor-in-possession to set aside “transfers” occurring within two years before bankruptcy that are deemed to be “fraudulent.” In general, transfers are “fraudulent conveyances” under section 548(a) if the debtor makes the transfer with the actual intent to hinder, delay or defraud its creditors or if the debtor makes the transfer while insolvent and without receiving a reasonably equivalent value in exchange. Historically, section 548(a) has been applied to set aside a wide variety of pre-bankruptcy transactions, ranging from something-for-nothing conveyances among family members to landlords’ lawful terminations of debtor-tenants’ below-market leases. But section 548(a)’s reach has limits. A recent non-precedential opinion by the Court of Appeals for the Third Circuit illustrates one of those limits. The Third Circuit ruled that a third party’s pre-bankruptcy termination of a debtor’s real estate purchase option was not a “transfer” capable of being set aside as a fraudulent conveyance.
The facts of the case are somewhat convoluted, but boil down to this: The owner of a building and real estate in New Jersey leased the premises to a restaurant tenant. The owner-debtor filed bankruptcy. Under the debtor’s court-approved chapter 11 plan, its property was sold to a secured creditor. In connection with that plan, the tenant signed a new lease and the (former) owner was granted the option to repurchase the property from the secured creditor. The plan specified the timing for the repurchase option to be exercised. Several years later, the secured creditor issued notices required by the confirmed plan to the former owner and to the tenant in order to terminate the lease and to trigger the period within which the former owner could exercise the repurchase option, failing which the option would lapse. Despite repeated notices, the former owner and tenant were “radio silent” and did not exercise the repurchase option. The secured creditor filed a discharge of the option and sold the property.
After the property sold, the former owner and tenant each filed chapter 11 petitions and listed both the lease and option to repurchase the property as assets in their bankruptcies. Litigation ensued regarding whether the secured creditor’s terminations of the lease and repurchase option were valid and whether the debtors could avoid the terminations under section 548(a) as “fraudulent conveyances.” The bankruptcy court ruled in favor of the secured creditor, upholding the validity of the terminations. The court also found the terminations of the lease and repurchase option were not “transfers” under section 548(a)(1)(B) of the Bankruptcy Code and therefore could not be recovered as fraudulent conveyances. The debtors appealed that decision to the district court. It affirmed. They appealed to the Circuit and lost again.
Applying New Jersey law, the Third Circuit concluded that, pre-bankruptcy, the secured creditor had validly terminated the lease for abandonment and had validly terminated the repurchase option. Under New Jersey law, termination of lease also terminated the tenancy.
Next, the Circuit assessed the bankruptcy court’s decision that termination of the repurchase option was not a “transfer” that can be set aside as a “fraudulent conveyance” under section 548(a). Notably, the Circuit began by “leaving aside the issue of fraud,” thus side-stepping whether under other circumstances any actual or constructive fraud can taint the termination of a lease or repurchase option. Instead, it focused solely on whether a “transfer” occurred. Section 101(54) of the Bankruptcy Code defines a “transfer” to include “each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with . . . property; or . . . an interest in property.”
First, the Circuit determined what “interest in property” was at issue. Interests in property typically are defined by reference to non-bankruptcy state or federal law. The Circuit adopted the district court’s conclusion that, under New Jersey law, the option to repurchase the property was a “future contingent interest” that the Bankruptcy Code protects. Second, the Circuit opined that no “transfer” of that interest had occurred when the secured creditor terminated the repurchase option. The Circuit agreed with the district court that the debtors’ failure to convert their “contingent interest” into actual ownership (by failing to exercise the repurchase option) did not amount to “dispos[ing] of or part[ing] with” their protected interest in the property. According to the Circuit, the debtors did not “transfer” their option rights to the secured creditor, “but rather ‘failed to pursue a business opportunity’ by allowing their interest in potential ownership to lapse.” In so ruling, the Circuit was mindful of the U.S. Supreme Court’s observations regarding “avoidance powers” such as section 548(a) in Mission Product Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652 (2019) – namely, that the Bankruptcy Code imposes “stringent” limits on allowing debtors to use section 548(a) “to unwind pre-bankruptcy transfers” and “everything the Code does to keep avoidances cabined – so they do not threaten the rule that the estate can take only what the debtor possessed before filing.” Because the debtors made no prepetition attempts to exercise their option rights, any interest they had in the property no longer existed when they filed for bankruptcy. The Circuit therefore agreed with the lower courts that termination of the option did not constitute a “transfer” under section 548(a).
The decision is Speedwell Ventures LLC v. Berley Assocs. Ltd. (In re Pazzo Pazzo Inc.), No. 21-2344, 2022 U.S. App. LEXIS 34619, 2022 WL 17690158 (3d Cir. Dec. 15, 2022).
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