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Ninth Circuit Allows Trustee’s Fraudulent Conveyance Suit against IRS

The Ninth Circuit Court of Appeals recently split with the Seventh by holding that sovereign immunity does not prevent a bankruptcy trustee from avoiding a debtor’s federal tax payments to the Internal Revenue Service. In Zazzali v. United States (In re DBSI, Inc.), No. 16-35597, 2017 U.S. App. LEXIS 16817 (9th Cir. May 17, 2017), DBSI, Inc. and its affiliated entities operated an illegal Ponzi scheme that engaged in the acquisition, development, management, and sale of commercial real estate properties throughout the United States. While operating the scheme, DBSI paid the IRS a total of approximately $17 million on behalf its shareholders. DBSI subsequently filed for bankruptcy, after which DBSI’s liquidating trustee sought to avoid and recover the tax payments as fraudulent transfers under 11 U.S.C. 544(b)(1) and Idaho’s Uniform Fraudulent Transfer Act. In defense, the IRS claimed that its sovereign immunity prohibited the trustee from recovering the payments. Section 544(b)(1) provides that a trustee may 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. The effect of this section is “to clothe the trustee with no new or additional right in the premises over that possessed by a creditor, but simply puts him in the shoes of the latter.” “If the actual creditor could not succeed for any reason-whether due to the statute of limitations, estoppel, res judicata, waiver, or any other defense-then the trustee is similarly barred and cannot avoid the transfer.” The effect of Section 544(b)(1) is that a trustee is normally subject to a government’s sovereign immunity defense. However, Congress expressly abrogated sovereign immunity “with respect to” Section 544(b)(1) under 11 U.S.C. 106(a)(1). Given this express abrogation, and using well-settled canons of statutory interpretation, the Ninth Circuit found Congress’s waiver of sovereign immunity unequivocal, resulting in a split with the Seventh Circuit, which held otherwise.

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