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March 31, 2022

A Growing Circuit Split: Does the IRS Have Sovereign Immunity from Fraudulent Transfer Claims under 11 U.S.C. § 544(b)(1)?

By John T. Baxter

In a March 8, 2022 decision, the United States Court of Appeals for the Fourth Circuit issued an opinion holding, in part, that the Internal Revenue Service (the “IRS”) does not have sovereign immunity for claims arising under section 544(b)(1) of Title 11 of the United States Code (the “Bankruptcy Code”) (a 544(b)(1) claim is described below). This decision falls in line with a similar holding in the Ninth Circuit from 2017 but stands in stark contrast to a 2014 decision from the Seventh Circuit. The result is a widening circuit split on an interesting question of statutory interpretation.

In In re Yahweh Center Inc., Case No. 20-1685 (4th Cir. March 8, 2022), the Fourth Circuit made short work of the question regarding the IRS’s immunity. In the eyes of the Fourth Circuit, section 106(a) answers the question rather simply. On its face, this appears straightforward, as section 106(a) expressly states that “sovereign immunity is abrogated” with respect to various Bankruptcy Code provisions, including section 544. In addition, the Fourth Circuit held that the IRS had waived any sovereign immunity defense under section 106(b) when it filed a proof of claim in the case.

While the Fourth Circuit’s decision appears to be a straightforward interpretation of the interplay between sections 106 and 544(b)(1), there’s more to the story than meets the eye, as one would expect from any issue on which the circuits are split.

To understand the differing opinions on the issue, an understanding of section 544(b)(1) is necessary. Under this section of the Bankruptcy Code, the trustee is empowered to “avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim.” This section is often utilized, as it was in all three discussed cases, to assert state-law fraudulent transfer claims against a transferee. This is distinct from a section 548 claim for fraudulent transfer under federal law. Section 544 claims require that the fraudulent transfer cause of action be available to an unsecured creditor “under applicable [i.e. State] law.” Section 548 does not have that requirement and is, thus, a direct cause of action, where section 544(b)(1) claims are derivative of an unsecured creditor’s claim. This distinction is critical in parsing out the circuit split.

The Seventh Circuit, in In re Equipment Acquisition Resources, Inc., 742 F.3d 743 (7th Cir. 2014), was the first to address this issue and is, thus far, the only circuit court to side with the IRS. In analyzing the issue, the Seventh Circuit looked to Supreme Court guidance on how to interpret sovereign immunity waivers, noting that such analysis involves “two analytically distinct inquiries”: (1) whether there has been a waiver of sovereign immunity (which there has no doubt been under section 106(a)); and (2) whether the source of substantive law upon which the claimant relies provides an avenue for relief. It is on this second point where the Seventh Circuit made its case.

The Seventh Circuit reasoned that under state law, the IRS would be immune from any fraudulent transfer action that an unsecured creditor could allege, and it was only because of the waiver of immunity afforded by section 106(a) that a trustee could, in theory, bring the claim. But because the trustee must effectively stand in the shoes of the unsecured creditor and bring the derivative claim, substantive state law barred the claim and, thus, the sovereign immunity waiver was ineffective with regard to section 544(b)(1) claims. The trustee understandably argued that this interpretation would render section 106(a) ineffective, but the Seventh Circuit shot that argument down, noting that the sovereign immunity waiver also applied to state and municipal governmental entities and not just the federal government. It also noted that section 544(a) claims could still be affected by the sovereign immunity waiver; it was only the derivative 544(b)(1) claims for which the immunity was not waived.

In contrast, the Ninth Circuit, in In re DBSI, Inc., 869 F.3d 1004 (9th Cir. 2017), held that the 106(a) waiver did apply to sovereign immunity in derivative 544(b)(1) claims and, thus, the IRS was not immune from fraudulent transfer claims under this provision. Rejecting the same arguments made by the IRS in Equipment Acquisition Resources, the Ninth Circuit held that, despite the fact that a creditor could not bring a claim under state law, “Section 106(a)(1)'s abrogation of sovereign immunity is absolute with respect to Section 544(b)(1) and thus necessarily includes the derivative state law claim on which a Section 544(b)(1) claim is based.” The Ninth Circuit based its interpretation, in part, on the fact that the sovereign immunity waiver in section 106(a) was enacted after the enactment of section 544(b)(1) and, thus, Congress could have withheld that particular subsection from the waiver had it elected to do so. Finally, the Ninth Circuit held that allowing for sovereign immunity to apply in this situation would render section 106(a) a nullity.

While the Fourth Circuit did not go into as great of an analysis as its sister courts, it noted that it sided with the Ninth Circuit’s interpretation as the better approach. As a result, there is now a 2-1 split in the circuits. Of note, the IRS was still successful in having the fraudulent transfer claim dismissed in Yahweh, it just did not win on the sovereign immunity argument.

Because the circuit split is growing, this appears to be an issue ripe for determination by the United States Supreme Court. We will keep an eye out for any further developments in this increasing circuit split.

Nelson Mullins attorneys are experienced in handling bankruptcy matters of all sizes and are well equipped to advise debtors, trustees, purchasers, and other stakeholders on both the legal and practical aspects of any number of issues that arise in a bankruptcy case, including fraudulent transfer and preference claims.