Fraudulent Conveyance in Bankruptcy

Disavowing an Inheritance

In re Costas, --- F.3d ----, (C.A.9th,2009)

The Bankruptcy Code's federal fraudulent conveyance provision allows a trustee to avoid “any transfer ... of an interest of the debtor in property” within a two year reach back period where the transfer was actually or constructively fraudulent. 11 U.S.C. § 548(a)(1). Debtor was left an inheritance which he relinquished under Arizona law. He then filed bankruptcy under Chapter 7. The Chapter 7 trustee, sought to avoid Costas' disclaimer of the Trust property under 11 U.S.C. § 548.

Bankruptcy courts have ruled in favor of the debtor in this situation but that ruling was thrown into doubt by Drye v. United States, 528 U.S. 49 (1999). In Drye, a tax debtor inherited his mother's estate after the IRS had obtained a tax lien on all his “property and rights to property.” Relying on Arkansas' relation-back disclaimer rule, Drye disclaimed his inheritance and argued that he had no property to which the IRS lien could attach. The Supreme Court, however, rejected Drye's theory and held that the tax lien attached to disclaimed property despite state law relation-back rules. After discussing the breadth of federal tax lien law, the Court described its analysis: “We look initially to state law to determine what rights the taxpayer has in the property the Government seeks to reach, then to federal law to determine whether the taxpayer's state-delineated rights qualify as ‘property’ or ‘rights to property’ within the compass of the federal tax lien legislation.” Although Drye asserted that he had nothing but the right to reject a gift, the Supreme Court disagreed, reasoning that a rejected gift returns to the donor, whereas a disclaimer channels the property to another person. Finding this power to channel a sufficient state law interest to constitute “property” under the federal tax lien provisions, the Court held that the lien attached despite Drye's refusal to take the property.

In this case, the Ninth Circuit was the first circuit court to address Drye's impact on § 548 avoidance. Lower courts had split on the issue. The Ninth Circuit distinguished Drye on timing issues. In Drye, the tax lien was already in place prior to the execution of the disclaimer. Thus, before the taxpayer attempted to execute his disclaimer, the federal government already had an interest in the subject property. Application of the state law fiction would have stripped the government of this 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. Therefore, the state law did not operate to defeat any pre-existing interests. Rather, the situation in Drye is more analogous to a post-petition disclaimer, where a debtor invokes the disclaimer protections of state law only after the creation of the bankruptcy estate. In cases of post-petition disclaimers, courts have generally included disclaimed property in the estate, reasoning that the right to disclaim itself belongs to the estate as of the time of filing.

The Ninth Circuit also distinguished Drye based on its legal context. Drye is a tax lien case. The purpose of tax liens is to allow the government to reach property not available to other creditors. In contrast bankruptcy law largely respects substantive state law rights, neither granting a creditor new rights in the debtor's property nor taking any away.