Fraudulent Transfers and Trust Accounts What Are You Holding When the Music Stops

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Mar 2003

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Often and in various situations, bankruptcy professionals are called
upon to hold funds in trust for their clients or other parties. Such situations
typically arise in connection with the transfer of proceeds from sales,
settlements and other transactions, but may result from other situations as
well. When holding such funds, bankruptcy professionals act in a trustee
capacity, possessing funds held in trust for another. In fact, even though legal
title may have temporarily vested, it has done so only in trust for another.

Thus,
as all bankruptcy professionals are aware, it is their duty to hold and protect
such funds, the distribution of which directed by the terms of the trust
relationship. When such distributions occur, the bankruptcy professional
divests him/herself of legal title, and the trust relationship ends. And all
are happy that the transaction ended in the desired result—at least, most
of the time.

Other
times, the original transferor may find itself insolvent and contemplating
bankruptcy, or creditors of the transferor may assert that the transfer was
fraudulent, whether because of the amount or the basis of the transaction
itself. Nonetheless, both in and out of bankruptcy, statutes exist that address
fraudulent transfers. In fact, most fraudulent transfer statutes allow the
plaintiff to assert a cause of action against not only the final recipient of
the funds, but also every entity that received such funds along the way. Thus,
although multiple recoveries are not allowed, multiple defendants against whom
recovery could be sought may exist. And bankruptcy professionals may find
themselves caught in the middle, having been sued for a fraudulent transfer by
virtue of receiving and subsequently transferring funds at the client's
request.

<h3>The Avoidance of Fraudulent Transfers</h3>

Pursuant
to the Bankruptcy Code, a trustee (or debtor-in-possession (DIP)) may avoid
certain transfers including, but not limited to, preferential transfers under <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
U.S.C. §547</a> and fraudulent transfers under <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
U.S.C. §548</a>. Meeting the factors set forth in
§§547 and 548, however, are only half the inquiry. Assuming the
appropriate factors are met, and a transfer is found preferential or fraudulent,
the trustee may avoid the transfer and seek recovery of the property
transferred from the initial transferee (the first entity that received the
transfer) or any immediate or mediate transferee of the initial transferee (the
second and/or subsequent person or entity that received the transfer). See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
U.S.C. §550(a)</a>. As stated above, §550
entitles a trustee to a single satisfaction, regardless of the number of
transferees. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
U.S.C. §550(d)</a>. Since the Bankruptcy Code
fails to define "transferee," whether initial, mediate or
immediate, courts have developed tests to determine what constitutes a
transferee, including the "dominion and control test." See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…
Financial Services Inc. v. European American Bank,

838 F.2d 890, 893 (7th Cir. 1988)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…
re Chase & Sanborn Corp., 848 F.2d 1196,
1199 (11th Cir. 1988)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…
re Columbia Data Products Inc., 892 F.2d 26, 29
(4th Cir. 1989)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
re Bullion Reserve of North America, 922 F.2d
544, 549 (9th Cir. 1991)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
re Baker & Getty Financial Services Inc.,

974 F.2d 712, 722 (6th Cir. 1992)</a>.
Dominion over funds means the right to put the money to one's own use. See
<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…; 838 F.2d at 893</a>. Otherwise, the intermediary party is not an initial transferee
because it holds the funds "only for the purpose of fulfilling an
instruction to make the funds available to someone else." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…; And the simple fact that the intermediary could have violated its
duties and spent the funds as it pleased does not change the analysis. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
re Baker & Getty Financial Services Inc.,

974 F.2d 712, 722 (6th Cir. 1992)</a>.

Indeed,
dominion and control refer to legal, as opposed to mere physical, possession of
the property transferred. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Anton Noll Inc., 277 B.R. 875 (BAP 1st Cir.
2002)</a>; citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
v. Atlanta Motor Speedway, 99 F.3d 151, 156
(4th Cir. 1996)</a>. Thus, under the
dominion and control test, a party receiving a transfer directly from the
debtor is not an initial transferee if that party does not gain actual dominion
or control over the funds. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
re Coutee, 984 F.2d 138, 140-41 (5th Cir. 1993)</a>. Using the dominion and control test, at least one court has
examined a law firm's liability and status as an initial transferee under
§550. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…
re Fabric Buys of Jericho Inc., 33 B.R. 334
(Bankr. S.D.N.Y. 1983)</a>.

<h3>Jericho and Liability for Professionals When Acting as a Trustee</h3>

In
Jericho, a plaintiff was represented by a law
firm who filed suit against the debtor for breach of contract. The lawsuit was
settled by the parties, resulting in a transfer by the debtor to the
plaintiff's law firm. Upon depositing the transfer into its escrow
account, the law firm then transferred the funds from the escrow account, for
the amount of the settlement, to the plaintiff, who deposited such funds into
his personal account. Subsequently, the debtor filed for bankruptcy, and sought
to avoid the transfer of the settlement funds as a preferential transfer and
recover the amount of the transfer from both the law firm and the plaintiff,
asserting both were transferees under §550.

The
U.S. Bankruptcy Court for the Southern District of New York applied the
dominion and control test and determined that the law firm acted as a mere
conduit of the transferred funds, as the business dealings giving rise to the
settled lawsuit were strictly between the plaintiff and debtor. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…; 33 B.R. at 337</a>. "That such amount was funneled through the escrow account
does not make [the plaintiff's] lawyer an initial transferee." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…; The court further explained that the policy behind §550 was to
avoid a transferees' ability to "hide" avoidable transfers by
transferring them around to different entities to avoid their recovery. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…; Interestingly enough, the court further stated that "even if
the [law] firm were deemed an initial transferee, the circumstances of this
case, as stated above, would permit this court to exercise its equitable discretion
and prevent the trustee from recovering a preference from the [law]
firm." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…;

This
decision by the Southern District of New York must be tempered with the
rationale of the District Court for the Eastern District of Tennessee, which
found that another law firm in a similar situation was an initial transferee
due to its "bad faith." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Southern Industrial Banking Corp., 126 B.R.
294 (E.D. Tenn. 1991)</a>. Specifically, the
court held that the law firm did not accept the funds in good faith and held
the law firm liable as an initial transferee. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; at 300-01</a>. Southern
Industrial was decided prior to Baker &
Getty Financial Services, and therefore its holding
is now questionable.

Further,
the reasoning of Southern Industrial is
inapposite of Jericho, as it applied the
safe-harbor provisions of §550(b). Jericho,
on the other hand, did not examine the issue of good or bad faith, as
§550(a) does not include a good-faith requirement. In fact, while
§550(b) has a good-faith factor, §550(b) is meant to protect those
transferees who receive a transfer for value in good faith and without knowledge
of the avoidability of the transfer. This is a different determination from the
dominion and control test, as the dominion and control test examines whether or
not a defendant is an initial transferee in the first place.

Thus,
Jericho did not examine good or bad faith, and
correctly focused on whether the alleged initial transferee obtained dominion
and control over the property transferred or was a mere conduit for the
settlement transaction. Indeed, good faith is inconsequential, as the law firm
was never a transferee as that term is used in §550. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…; 33 B.R. at 337</a>.

<h3>Conclusion</h3>

Based
on the dominion and control test, a bankruptcy professional, or other
intermediary, should not be considered an "initial transferee"
under §550(a) when it receives and holds funds in trust for another party.
Otherwise, any bank, trust, escrow agent or other such entity could be held liable
for receiving a transfer that it received only for a third party. And if that
were the law, no party would agree to participate in such an arrangement, as
every such arrangement would carry potential exposure under chapter 5 of the
Bankruptcy Code. Stated otherwise, courts should not take
"transferee" for all it could be worth rather than for what a
sensible policy implies it is worth. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…; 838 F.2d at 895</a>.

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Saturday, March 1, 2003 - 12:00

Bankruptcy Rule

2003