Wednesday, February 18, 2009

Debtor's State Law Disclaimer, Relinquishing Her Rights to Trust Property, Is Not a Voidable Fraudulent Conveyance

By Andrew Toth-Fejel, Bankruptcy Litigation Support for Attorneys,

Gaughan v. Costas (In re Costas)
Ninth Circuit Court of Appeals Case No. 06-16520
February 6, 2009

The Issue and the Holding
If a debtor relinquishes her rights as a beneficiary of a trust or a will through a state law providing for such "disclaimer" (sometimes called "renunciation"), is the act of doing so a "transfer . . . of an interest of the debtor in property" under § 548(a)(1) of the Bankruptcy Code and thus avoidable by the bankruptcy trustee? No, a disclaimer is not an avoidable transfer, under state statutes which provide that the disclaimer relates back "for all purposes" to the date of death of the trust grantor or the testator. This relation-back effectively negates the transfer to the disclaimant altogether.

The Issue In the Context of the Case Law

In the context of the prior case law, the question is whether a previous Ninth Circuit BAP (Bankruptcy Appellate Panel) opinion, Wood v. Bright (In re Bright), 241 B.R. 664 (9th Cir. BAP 1999), had been indirectly overturned by the Supreme Court opinion of Drye v. United States, 528 U.S. 49 (1999).

This BAP opinion dealt squarely with the same issue as present here, interpreting a Washington State disclaimer very similar to the Idaho one applicable here, and held that a debtor's disclaimer does not constitute a transfer under § 548(a)(1). Its primary rationale was that because the state statute provided that a properly executed disclaimer relates back to the death of the testator "for all purposes," the disclaiming beneficiary was deemed to never have had an interest in property under the will.

The Supreme Court opinion in Drye dealt instead with whether a taxpayer could effectively disclaim an interest in an inheritance to avoid the attachment of federal tax liens on that interest, the tax liens having been filed before the taxpayer exercised the disclaimer. Even though state law here, as in Bright above, provided for the relating back of the disclaimer to the death of the testator, the Supreme Court held that the taxpayer's disclaimer right was a property right under the Internal Revenue Code, and that the tax lien attached to the property disclaimed even though other creditors could not reach that property because of the state law's relating back provision.

So the question is whether Drye's holding is limited to federal tax liens, or whether it extends to other federal statutes, making disclaimers avoidable transfers under § 548.

The Oregon Connection
This Ninth Circuit Costas opinion is the first circuit court of appeals to address Drye's impact on § 548 avoidance, after lower courts had split on it. Of local interest in Oregon, the Ninth Circuit is finally catching up with this very same issue which was decided by Judge Trish Brown eight years ago in In re Nistler, 259 B.R. 723 (Bankr. D. Or. 2001). In that Chapter 7 case, the trustee, Michael Grassmueck, represented by David Mills, of Eugene, Oregon, filed an adversary proceeding seeking a declaration that debtor's disclaimer was ineffective as a fraudulent conveyance under § 548. One of the debtors was the beneficiary of two trusts which held property of significant value, and was also a beneficiary under the will of the trusts' grantor. This trust grantor died in May 1999, the debtor executed a disclaimer of his right to receive any interest in the trust and estate properties in June 1999, and the following month filed a Chapter 7 case with his wife, seeking to discharge unsecured debts in excess of $700,000. Judge Brown phrased the issue as follows:
The primary question presented by this case is whether the US Supreme Court’s decision in Rohn F. Drye, Jr. et al v. United States, 528 U.S. 49, 120 S.Ct. 474, (1999) indirectly overrules the Ninth Circuit Bankruptcy Appellate Panel’s decision in In re Bright, 241 B.R. 664 (9th Cir. BAP 1999) which held that a debtor’s disclaimer of inheritance under a will was not a transfer of any “interest of the debtor in property” within the meaning of the fraudulent transfer provisions of the Bankruptcy Code.
The judge distinguished the case at issue from the Supreme Court's Drye opinion, stating that although Drye also involved a disclaimer, the Supreme Court in that case relied specifically on provisions of the Internal Revenue Code and that thus its opinion did not extend to the fraudulent transfer context in bankruptcy. In so doing Judge Brown "respectfully" directly rejected the recently published opposite conclusion of another bankruptcy judge.

Thus, upon a motion for summary judgment by debtors' counsel, Richard Parker of Portland, Judge Brown ruled that the disclaimer of inheritance was not a transfer of any "interest of the debtor in property" under § 548, and entered summary judgment in favor of debtor and against the trustee. On appeal to the U.S. District Court in Portland, in a short unpublished opinion Judge Anna Brown affirmed the bankruptcy court's ruling "in all respects".

The Ninth Circuit's Rationale
The Court of Appeals here in Costas largely followed Judge Trish Brown's rationale of eight years earlier in Nisler. After determining that under state law, Arizona's here, the debtor "had no property interest in the disclaimed property," the "remaining question . . . is how to translate this state law back into the bankruptcy context. The Court looked closely at the Supreme Court's opinion in Drye and concluded, as had Judge Brown, that Drye is distinguishable from the fraudulent conveyance context in bankruptcy, for the following reasons:

Timing: In Drye, since "the tax lien was already in place prior to the execution of the disclaimer,"[a]pplication of the state law fiction would have stripped the government of this [pre-existing] interest." "In contrast, the disclaimer here occurred pre-petition, meaning that the retroactive divestment of property interests occurred prior to the bankruptcy estate gaining any interests in the right to disclaim."

Legal Context: Drye involved tax liens, the Supreme Court's "language repeatedly stressed this limitation" and the extraordinary priority given federal tax liens given their tax collection purpose. This "contrasts sharply with the policy of bankruptcy law, which largely respects substantive state law rights, neither granting a creditor new rights in the debtor’s property nor taking any away."

Reliance on Butner: Somewhat in contrast to Judge Trish Brown's 2001 opinion (which relied more heavily on the BAP's Bright opinion), the Court of Appeals repeated referred to an older Supreme Court opinion, Butner v. United States, 440 U.S. 48, (1979), for the proposition that "Congress has generally left the determination of property rights in the assets of a bankrupt’s estate to state law,” "[u]nless some federal interest requires a different result." The Court thus focuse on whether there was any such compelling "federal interest" in the § 548 context.

"Bankruptcy Estate Augmentation": The Court held that increasing the size of bankruptcy estates is not a sufficient federal interest and "would . . . interfere with Butner’s three goals of avoiding uncertainty, forum shopping, and windfall recoveries."

"Federal Rules of Avoidance": Although the bankruptcy avoidance rules for fraudulent cconveyances are clearly a "federal interest," but Congress' use of the generic word "property" in § 548 shows an intent to follow not trump state law.

"Applying Butner’s deferential approach to state law, rather than the rule of Drye, we hold that a disclaimer, properly executed under Arizona law, does not qualify as the “transfer . . . of an interest of the debtor in property” for purposes of § 548."

by Andrew Toth-Fejel
Bankruptcy Litigation Support for Attorneys
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