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Ninth Circuit – Crucial to Cogitate Relevant State Law While Determining Legal or Equitable Interests of a Debtor in Property

November 20, 2017, California Defendant Innovation Ventures, LLC and International IP Holdings, LLC is a company engaged in the business of making an energy drink. Debtors’ were also engaged in manufacturing a similar drink. The Defendant brought a federal anti-counterfeiting lawsuit and obtained orders freezing the Debtors’ bank accounts.

The Debtors concurrently agreed to deposit all of the funds in their bank accounts into an account owned by their attorney, pending final resolution of the lawsuit or the parties’ further agreement. Six days prepetition, the Debtors and the Defendant settled the lawsuit, and the Defendant received the money from the Debtors.

The Chapter 7 Trustee brought a preference action against the Defendants to recover these funds. The Trustee contended that the alleged transfer of funds divested the Debtors of their interest in funds and hence was preferential under Sec. 547. The Defendants argued that the agreement (and accompanying order) placed the alleged funds either in custodia legis or in escrow and hence they were beyond the reach of the Trustee’s Sec. 547 avoidance powers.

The bankruptcy court found that in custodia legis did not apply and declined to enter summary judgment on the escrow theory. However, in the final event, the bankruptcy court granted the judgment in favor of the Defendant based on the federal law. The Debtors appealed.

The Ninth Circuit agreed and found that the funds were not in the custody of the district court (i.e., in custodia legis) because they could be released by agreement of the parties. Further, there was a genuine dispute of material fact on escrow theory for both parties because the intent issue remained unresolved and the summary judgment record did not support either a constructive or express trust theory. Thus, neither party was entitled to summary judgment.

However, the Ninth Circuit stated that although the bankruptcy court was correct in denying summary judgment on various theories, it erroneously granted summary judgment in the Defendant’s favor when it declined to apply relevant state law to determine the estate’s interest in the settlement funds.

The Ninth Circuit held that the bankruptcy court wrongly concluded that the only law left to apply was federal bankruptcy law and that state law was immaterial. Although the operative legal question, i.e., whether the funds were the property of the estate is a federal question to be decided by federal law, the Ninth Circuit stated that the contours of the estate’s and debtor’s interest in property are determined by reference to non-bankruptcy, usually state law and the bankruptcy courts must look to state law to determine whether and to what extent the debtor has any legal or equitable interests in property as of the commencement of the case.

Whitmore v. Innovation Ventures, LLC (In re Roman), Nos. CC-17-1112-TaLS, CC-17-1133-TaLS, 2017 Bankr. LEXIS 3987 (B.A.P. 9th Cir. Nov. 20, 2017)