Zazzali v. United States (In re DBSI, Inc.)

• Decision Date: 31 August 2017
• Docket Number: No. 16-35597,16-35597
• Citation: 869 F.3d 1004
• Parties: IN RE DBSI, INC., Debtor, James R. Zazzali, as Trustee for the DBSI Estate Litigation Trust, Plaintiff–Appellee, v. United States of America, Defendant–Appellant.
• Court: U.S. Court of Appeals — Ninth Circuit

869 F.3d 1004

IN RE DBSI, INC., Debtor,James R. Zazzali, as Trustee for the DBSI Estate Litigation Trust, Plaintiff–Appellee,

v.United States of America, Defendant–Appellant.

No. 16-35597

United States Court of Appeals, Ninth Circuit.

Argued and Submitted May 17, 2017, Seattle, Washington

Filed August 31, 2017

Ivan Clay Dale (argued), Thomas J. Clark, and Gilbert S. Rothenberg, Attorneys; Diana L. Erbsen, Deputy Assistant Attorney General; Caroline D. Ciraolo, Principal Deputy Assistant Attorney General; Tax Division, United States Department of Justice, Washington, D.C.; for Defendant–Appellant.

Jennifer A. Hradil (argued), Mark B. Conlan, Michael F. Quinn, and Brett S. Theisen, Gibbons P.C., Newark, New Jersey, for Plaintiff–Appellee.

Carolyn Wade, Senior Assistant Attorney General; Benjamin Gutman, Solicitor General; Ellen F. Rosenblum, Attorney General; Oregon Department of Justice, Salem, Oregon; Karen Cordry, Bankruptcy Counsel, National Association of Attorneys General, Washington, D.C.; for Amici Curiae States of Idaho, Illinois, Montana, Nebraska, New Mexico, New York, and Oregon.

Professor Stephen J. Lubben, Seton Hall University School of Law, Newark, New Jersey, for Amicus Curiae National Association of Bankruptcy Trustees.

Before: Michael Daly Hawkins, Ronald M. Gould, and Richard A. Paez, Circuit Judges.

OPINION

PAEZ, Circuit Judge:

We must decide whether a bankruptcy trustee can, through an adversary proceeding, avoid a debtor's federal tax payment, or whether the Internal Revenue Service's ("IRS" or "government") sovereign immunity prevents such relief. To resolve this question, we must consider the interplay between two Bankruptcy Code statutes: 11 U.S.C. §§ 106(a)(1) (" Section 106(a)(1)") and 544(b)(1) (" Section 544(b)(1)"). In Section 106(a)(1), Congress unambiguously abrogated sovereign immunity "with respect to" Section 544(b)(1). Under Section 544(b)(1), a trustee may avoid fraudulent transfers when the trustee can demonstrate that an actual unsecured creditor could avoid the same transfer under "applicable law" outside of bankruptcy. This is known as the "actual creditor" or "triggering creditor" requirement as it requires the existence of an actual creditor in whose shoes a trustee can stand. See 5 Collier on Bankruptcy ¶ 544.01 (Alan N. Resnick & Henry J. Sommer eds., 16th ed. 2017).

Here, James R. Zazzali ("Zazzali" or "Trustee") invoked Idaho's Uniform Fraudulent Transfer Act ("UFTA"), Idaho Code Ann. §§ 55–901 ¹ et seq ., as the "applicable law" to bring a Section 544(b)(1) adversary action to avoid $17 million in tax payments that the debtor, DBSI, Inc., fraudulently transferred to the IRS. An unsecured creditor who seeks to avoid such tax payments under Idaho law outside of bankruptcy would be precluded from doing so because of the government's sovereign immunity. The question, then, is whether, in the bankruptcy context, Congress's abrogation of sovereign immunity with respect to Section 544(b)(1) extends to the underlying state cause of action, or whether a trustee must also establish that Congress has waived sovereign immunity with respect to Idaho's UFTA.

Both the bankruptcy court and the district court ruled that Section 106(a)(1)'s abrogation of sovereign immunity "with respect to" Section 544(b)(1) extends to the derivative "applicable law"—here, Idaho's UFTA. In other words, an additional waiver of sovereign immunity was not necessary. As a result, the government could not rely on sovereign immunity to prevent the avoidance of the tax payments at issue. We agree, and affirm.²

I.

DBSI, Inc. and its affiliated entities, including FOR 1031, DDRS, and DBSI Investments (collectively, "DBSI"), engaged in the acquisition, development, management, and sale of commercial real estate properties throughout the United States. They did so, however, through an illegal Ponzi scheme—during their last two years in operation they purportedly lost $3 million per month and used new investor funds to meet existing obligations. This scheme eventually caught up with them, and in May 2013, the United States indicted several of the company insiders, who were later convicted of various fraud crimes. Their convictions were affirmed by our court.

DBSI was set up as an S corporation, and, while still in operation, made tax payments on behalf of its shareholders. Tax payments were handled in this manner because S corporations do not themselves pay taxes on corporate income, but rather the tax liability is passed through to the corporation's shareholders. I.R.C. §§ 1363, 1366. Between 2005 and 2008, DBSI paid the IRS a total of approximately $17 million in tax payments on behalf of its shareholders. The vast majority of these payments were made on behalf of Doug Swenson ("Swenson") and Thomas Var Reeve ("Reeve"), two of the largest shareholders. The IRS ultimately refunded approximately $3.6 million to Swenson and Reeve in claimed overpayments of their individual income tax liabilities.

In November 2008, DBSI filed for bankruptcy. A plan of liquidation was confirmed in October 2010, and, as part of that plan, Zazzali was appointed as trustee to administer the DBSI Estate Liquidation Trust. Shortly thereafter, Zazzali commenced an adversary proceeding in bankruptcy court to recover DBSI's allegedly fraudulent transfers to (1) company insiders, and (2) the IRS and taxing authorities of twenty-five states on behalf of company shareholders. This appeal concerns only those transfers that were made to the IRS.³

In bringing his claims against the IRS, Zazzali relied on two different sections of the Bankruptcy Code: 11 U.S.C. § 548 (" Section 548") and, as discussed above, Section 544(b)(1). Section 548 and Section 544(b)(1) both permit a trustee to avoid transfers, however they impose different statutes of limitations. Section 548 has a two-year statute of limitations, while Section 544(b)(1) incorporates the statute of limitations of the applicable law. Here, Idaho's UFTA has a four-year statute of limitations. Idaho Code Ann. § 55–918. Accordingly, pursuant to Section 548, Zazzali sought to recover transfers in the amount of approximately $56,000 that were made in the two years prior to the bankruptcy petition date. The government did not contest this claim. Under Section 544(b)(1), Zazzali sought to recover the remaining portion of the $17 million by avoiding transfers that were made within four years of the petition date.

The government moved to dismiss Zazzali's Section 544(b)(1) counts for failure to state a claim under Federal Rule of Civil Procedure 12(b)(6). See Fed. R. Bankr. P. 7012(b). The government argued that Congress had not abrogated sovereign immunity with respect to the Section 544(b)(1) underlying state law cause of action, and therefore, there was no unsecured creditor who could sue the government under Idaho's UFTA. The bankruptcy court rejected this argument and concluded that Section 106(a)(1)'s waiver of sovereign immunity permitted the Trustee's suit to proceed. The government appealed the bankruptcy court's ruling to the district court. While the government's appeal was pending, the Seventh Circuit decided In re Equipment Acquisition Resources, Inc. ("EAR "), 742 F.3d 743 (7th Cir. 2014), which analyzed the identical issue before the district court, and which is at issue in the current appeal. The Seventh Circuit came to the opposite conclusion as the bankruptcy court, and held that Section 106(a)(1)'s waiver of sovereign immunity does not extend to Section 544(b)(1)'s derivative state law claim. Nonetheless, the district court was unpersuaded by the Seventh Circuit's reasoning, and affirmed the bankruptcy court's ruling. Further, the district court declined to certify for interlocutory appeal its order affirming the denial of the government's motion to dismiss.

Because the adversary proceeding had been transferred to the district court pursuant to a motion by Swenson and his fellow defendants, proceedings continued in that court with respect to the merits of Zazzali's fraudulent transfer claims. The parties ultimately filed cross-motions for summary judgment. In its motion for summary judgment, the government conceded that the payments made to the IRS were fraudulent and that, pursuant to Section 548(a)(1)(A), Section 544(b)(1), and Idaho Code Ann. § 55–913(1)(a),⁴ Zazzali could avoid any transfer made within four years of filing his bankruptcy petition. However, relying on Idaho Code Ann. § 55–917(1),⁵ the government asserted an affirmative defense—that it received the payments or transfers in good faith and for value. The district court's resolution of the summary judgment motions turned on whether the government could prove the elements of its affirmative defense. The district court first concluded that the government did not receive the payments for value, stating that "[e]very legal theory offered by the [g]overnment to defend its right to retain this transfer seems to ignore the fact that the money at issue here is the proceeds of a widespread and devastating fraudulent scheme, stolen from scores of investors." The court likewise concluded that the government did not receive the transfers in good faith. In sum, the district court concluded that the government failed to establish its affirmative defense, and thus Zazzali, as a matter of law, was entitled to avoid the fraudulent transfers. The government does not challenge this ruling.

The court, however, still had to determine the extent to which Zazzali could recover the transfers. In its motion for summary judgment, the government argued that, even if the court were to reject its affirmative defense, Zazzali was not entitled to recover approximately $3.6 million of the fraudulent transfers because it already refunded that amount as tax overpayments to the shareholder-taxpayers. The district court agreed, concluding that the IRS was not an "initial transferee" within the meaning of 11 U.S.C. § 550(a)(1) ( " Section 550(a)(1)"), and...