Circuit Split Widens On Extent Of Abrogation Of Sovereign Immunity For Governmental Units In Bankruptcy Avoidance Litigation

• Jurisdiction: United States,Federal
• Law Firm: Jones Day
• Subject Matter: Litigation, Mediation & Arbitration, Insolvency/Bankruptcy/Re-structuring, Insolvency/Bankruptcy, Sovereign Immunity: Public Sector Government
• Author: Mr Dan Prieto and Mark Douglas
• Published date: 02 October 2023

Bankruptcy trustees and chapter 11 debtors-in-possession ("DIPs") frequently seek to avoid fraudulent transfers and obligations under section 544(b) of the Bankruptcy Code and state fraudulent transfer or other applicable nonbankruptcy laws because the statutory "look-back" period for avoidance under many nonbankruptcy laws exceeds the two-year period governing avoidance actions under section 548. Governmental units (defined below) sometimes argue that avoidance actions against them are precluded by the doctrine of sovereign immunity under the applicable nonbankruptcy law, even though section 106(a) of the Bankruptcy Code explicitly provides that sovereign immunity is abrogated "with respect to ... [section] 544."

The federal circuit courts of appeals (and many lower courts) are split regarding whether the abrogation of sovereign immunity by governmental units with respect to avoidance actions commenced under section 544(b) also extends to the causes of action arising under applicable nonbankruptcy law that a "triggering" or "predicate" creditor would be precluded from asserting outside of bankruptcy due to sovereign immunity. The U.S. Court of Appeals for the Tenth Circuit weighed in on this debate as a matter of first impression in U.S. v. Miller, 71 F.4th 1247 (10th Cir. 2023). Expanding what had been a 2-1 majority in the circuit courts on this issue, the Tenth Circuit ruled that the abrogation of sovereign immunity in section 106(a) permitted a chapter 7 trustee to sue the Internal Revenue Service to avoid and recover a fraudulent transfer under section 544(b)(1), even though an eligible existing creditor could not have sued the IRS outside of bankruptcy.

Waiver of Sovereign Immunity in the Bankruptcy Code

Pursuant to the federal system created by the U.S. Constitution, each state is a sovereign entity. In addition, both federal and state governmental bodies have sovereign immunity from suit unless that immunity has been abrogated by Congress, waived by the governmental body, or eliminated by a specific provision of the Constitution itself. See generally Collier on Bankruptcy ("Collier") ' 1.06.01 (6th ed. 2023).

Abrogation of sovereign immunity by Congress requires that: (i) Congress has "unequivocally expressed its intent to abrogate the immunity"; and (ii) lawmakers have acted "pursuant to a valid exercise of power." Id. (quoting Seminole Tribe v. Florida, 517 U.S. 44, 56 (1996); In re LTV Steel Co., Inc., 264 B.R. 455, 464 (Bankr. N.D. Ohio 2001)); accord LAC du Flambeau Bank of Lake Superior Chippewa Indians v. Coughlin, 143 S. Ct. 1689, 1695 (2023). The sovereign immunity of a litigant deprives a court of subject matter jurisdiction to adjudicate a dispute. See FDIC v. Meyer, 510 U.S. 471, 475 (1995) ("Sovereign immunity is jurisdictional in nature."). A waiver or abrogation of immunity must be strictly construed in favor of the sovereign, with any ambiguities to be resolved in favor of sovereign immunity. See Orff v. United States, 545 U.S. 596, 601-602 (2005).

The doctrine of sovereign immunity has been applied in bankruptcy cases to shield state and federal governments from claims asserted against them by bankruptcy trustees or DIPs. However, the Bankruptcy Code provides for a broad-ranging abrogation of such sovereign immunity. In particular, section 106(a) of the Bankruptcy Code provides that, "[n]otwithstanding an assertion of sovereign immunity, sovereign immunity is abrogated as to a governmental unit ... with respect to" nearly 60 provisions of the Bankruptcy Code specified in section 106(a)(1), including actions to enforce the automatic stay, preference and fraudulent transfer avoidance actions, and proceedings seeking to establish the dischargeability of a debt.

The abrogation in section 106(a) expressly includes litigation brought against a "governmental unit" under section 544 of the Bankruptcy Code. Section 544(b)(1) empowers a bankruptcy trustee to step into the...