Iowa District Court Upholds Bankruptcy Court’s Ruling Rejecting Creditor’s Argument That Prepetition Liens Can Encumber Avoidance Actions Under 8th Circuit’s Simply Essentials Decision

U.S. District Judge Leonard T. Strand of the Northern District of Iowa issued an opinion on July 17 affirming, on de novo review, the lower bankruptcy court’s September 2024 BDC Group decision that held that a secured creditor’s prepetition liens on general intangibles of the debtor do not attach to avoidance actions. The bankruptcy court decision, penned by Chief Bankruptcy Judge Thad J. Collins, rejected the creditor’s argument that avoidance actions – as inchoate property of the debtor – could be encumbered by prepetition liens.

Broadly, the district court opinion clarifies the effect of the Eighth Circuit’s 2023 Simply Essentials decision, which held that avoidance actions could be sold under Bankruptcy Code section 363(b). In reaching that conclusion, the circuit court – like the Fifth Circuit in its 2024 South Coast Supply decision – construed that avoidance actions are property of the estate, including under Bankruptcy Code section 541(a)(1), as “inchoate or contingent interests held by the debtor prior to the filing of bankruptcy.”

In alluding to “inchoate” property, the Eighth Circuit’s decision arguably opened the door to creditors to assert prepetition liens against avoidance actions because such avoidance rights can exist before the bankruptcy and therefore be subject to prepetition encumbrances. In largely adopting the bankruptcy court’s rationale, Judge Strand shuts down this line of argumentation.

In his opinion, Judge Strand details that secured creditor Keystone Savings Bank, or KSB, asserted a lien on avoidance actions of the debtor based on “the Eighth Circuit’s statement in Simply Essentials that ‘the debtor has an inchoate interest in the avoidance actions prior to the commencement of the bankruptcy proceedings.’” According to KSB, this meant that secured creditors can receive a debtor’s interest in avoidance actions as collateral because Simply Essentials overturned prior bankruptcy case law holding that avoidance actions are after-acquired property that cannot be encumbered by prepetition liens.

The portion of Simply Essentials relied on by KSB is below.

Like the bankruptcy court, Judge Strand rejects KSB’s argument. The district court judge notes that the bankruptcy court both found that “‘KSB reads far too much into the Eighth Circuit’s comments about ‘an inchoate interest’ of the debtor” and explained that the circuit court “narrowly defined” a debtor’s inchoate interest to “not allow for post-petition recovery on pre-petition liens on the debtor’s inchoate interest in avoidance actions.”

The judge writes that although the Simply Essentials decision recognized the debtor’s inchoate interest in avoidance actions prior to the commencement of the bankruptcy case, the reasoning was applied to the sole issue on appeal – whether avoidance actions can be sold as property of the estate.

According to Judge Strand, the circuit court reasoned that avoidance actions are brought for the benefit of the estate and therefore belong to the estate, such that the sale of avoidance actions is consistent with congressional intent behind including a fiduciary duty to maximize the value of the estate. KSB’s argument that the debtor’s inchoate interest in avoidance actions can be encumbered with prepetition liens would turn Simply Essentials’ reasoning “on its head” by allowing a single creditor to diminish the estate at the expense of all other creditors, Judge Strand says.

The judge also rejects KSB’s argument that it may assert a lien on the debtor’s inchoate interest in postpetition proceeds of avoidance actions. Judge Strand points out that the bankruptcy court noted that such arguments have been almost uniformly rejected by case law that KSB did not even acknowledge, and the bankruptcy court found that “proceeds” only covers property that is directly attributable to prepetition collateral without addition of estate resources.

Judge Strand writes that “[t]he inchoate right in avoidance actions that a debtor possesses matures into the debtor’s right to file for bankruptcy,” after which “avoidance actions ‘arise as a brand-new thing’ which are ‘created postpetition in the trustee or a DIP, solely for one of them to pursue, and solely for the benefit of the estate,’” quoting the bankruptcy court. The bankruptcy court correctly held that avoidance actions “‘are the quintessential things that require the addition of estate resources to succeed and produce a recovery’ and thus cannot be proceeds [of prepetition collateral],” the judge says.

The judge also dispenses with KSB’s argument that the bankruptcy court erred in analogizing a debtor’s inchoate interest in avoidance actions to a spouse’s inchoate dower interest. According to Judge Strand, KSB misconstrued the bankruptcy court’s argument. The bankruptcy court did not argue “that the presence of a spouse’s unassignable inchoate dower interest stands for the proposition that an inchoate right can never be assigned” but rather that inchoate dower interests are “merely an example of how inchoate interests are not necessarily assignable.”

In fact, KSB’s own argument that dower interests are not transferable because of “‘unique public policy undergirding dower interests’ actually supports the non-assignability of avoidance actions,” Judge Strand finds. The policy of maximizing value of the estate “supports, rather than undermines, a finding that an inchoate interest in avoidance actions cannot be encumbered for the post-petition benefit of a single creditor,” the judge concludes.