In a recent decision, In re Philadelphia Entertainment and Development Partners, L.P., No. 14-000255-mdc (Bankr. E.D. Pa. Dec. 31, 2019), the Bankruptcy Court for the Eastern District of Pennsylvania held that state sovereign immunity does not prevent bankruptcy courts from hearing fraudulent transfer claims against states. The Court also found, however, that the debtor’s state-issued slot machine operating license did not constitute a property interest for fraudulent transfer purposes. Practitioners should beware that while fraudulent transfer claims might fall under the in rem jurisdiction of bankruptcy courts, those claims must properly involve the res of the estate, which is often determined by state law.

Background

Before the bankruptcy, Philadelphia Entertainment and Development Partners, L.P. (the “Debtor”) planned to operate a casino. It paid $50 million to the State of Pennsylvania to obtain a slot machine license. The state’s Gaming Control Board later revoked this license following a proceeding in which it determined that the Debtor failed to meet its licensing requirements. The Commonwealth Court of Pennsylvania affirmed the revocation after the Debtor appealed. In 2014, the Debtor filed for chapter 11 protection and initiated an adversary proceeding against the State and its Department of Revenue, claiming they committed a fraudulent transfer by revoking the Debtor’s slot machine license without refunding the $50 million fee.

The bankruptcy court had previously dismissed the Debtor’s fraudulent transfer claims on grounds that the claims violated the Rooker-Feldman Doctrine, which holds that federal jurisdiction does not extend to claims that function as appeals of state court judgments. The Third Circuit Court of Appeals reversed and remanded to determine (i) whether claim or issue preclusion barred judicial review; (ii) whether the Debtor stated fraudulent transfer claims, and (iii) whether sovereign immunity barred judicial review of those claims.

The Court’s Reasoning

On remand, the bankruptcy court defined the operative “fraudulent transfer” as the revocation of the license, rather than the payment of the fee or the state’s failure to refund the fee to the Debtor, an issue that the Debtor apparently conceded. The Court then held that claim and issue preclusion did not bar the Debtor’s claims under section 544 of the Bankruptcy Code, which allows debtors to avoid transfers that are avoidable pursuant to applicable law – here the Pennsylvania Uniform Fraudulent Transfer Act (PUFTA) – and the fraudulent transfer provisions of Code section 548. Both claims were bankruptcy-specific, and the Debtor did not and could not bring them in the earlier state proceedings, which considered the basis for revoking the license pursuant to state law.

On the sovereign immunity issue, the Court discussed the application of the Supreme Court’s decision in Central Virginia Community College v. Katz, 546 U.S. 356 (2006), which held that sovereign immunity did not prevent bankruptcy courts from hearing avoidance and preference claims against a state entity arising from sections 547 and 550 of the Code. Katz did not explicitly extend to fraudulent transfers, but the bankruptcy court followed Katz’s reasoning in finding that fraudulent transfer actions aided in the uniform treatment of state and private creditors, and that legislative history indicated that states waived sovereign immunity for fraudulent transfers upon ratifying the Bankruptcy Clause of the Constitution. Key to this reasoning was the waiver of state sovereign immunity for in rem causes of action or actions ancillary to that in rem jurisdiction. The court noted that the authority to recover estate property has been core to the administration of debtors’ estates since the 18th century, and recovery of fraudulently-transferred estate property has historically played a key role in that authority.

While fraudulent transfers of debtors’ property interests are not subject to state sovereign immunity defenses, the court held that in this case, the Debtor was not seeking recovery of a property interest, as required under the fraudulent transfer provisions of section 548 of the Code and PUFTA. Under either statute, state law would determine whether a property interest existed, in this case the Pennsylvania Gaming Act, which created the license program. That statute explicitly disclaims any entitlement to the licenses and categorizes them as “privileges.” The court rejected the debtor’s argument that the Court must look to PUFTA, which defines licenses generally as “property” for fraudulent transfer purposes, holding that PUFTA did not defeat the Gaming Act’s more specific and more recent language determining the slot machine licenses were not property interests. On those grounds, the Court determined that the Debtor did not state fraudulent transfer claims for which relief could be granted. The Court dismissed the Debtor’s complaint with prejudice.

Conclusion and Take-Away

This decision adds fraudulent transfer claims to the universe of actions debtors can bring against a state entity in front of a bankruptcy court following the decision in Katz, at least in the Eastern District of Pennsylvania. However, those claims must involve property interests. A slot machine license is only one example of a right or interest that according to state law does not constitute a property interest. Other types of licenses, permits, franchises, or contracts might similarly invoke state law to determine their statuses as property interests. Practitioners should review the state law that grants and defines their clients’ rights to analyze the likelihood of success of any fraudulent transfer claims.