Should an innocent seller who gave full value be caught in the trap of a fraudulent transfer laid by someone who is defrauding the company he owns?
Siding with the Seventh Circuit and disagreeing with other courts of appeals, a split panel on the Ninth Circuit decided that Congress already made the policy decision and barred a seller from raising the good faith defense available to a subsequent transferee because the fraudster had kept the misappropriated money in a company account.
The owner of a business maintained a secret bank account in the company’s name but under his control. Over the years, he diverted $8 million of his company’s income into the account, which he used to pay personal and non-company expenses.
After the business went bankrupt, the trustee filed fraudulent transfer suits against 130 people or entities that received money from the secret account. In a test case, the bankruptcy judge dismissed a suit against a couple who sold real property to the owner in return for $220,000 from the secret account. The trustee alleged that the sellers received a constructively fraudulent transfer of $220,000 under Section 548(a)(1)(B) because the company, whose money paid the purchase price, received none of the consideration.
The bankruptcy court believed that the fraudster was the initial recipient of the fraudulent transfer, allowing the sellers to be subsequent transferees entitled to raise the defense of good faith under Section 550(b)(1) because they did not know there was fraud afoot.
The district court reversed in July 2015, ruling that the sellers were the initial transferees, making them ineligible for the good faith defense.
The majority on the court of appeals reached the same conclusion on Aug. 2 in an opinion authored by District Judge Algenon L. Marbley, sitting by designation from the Southern District of Ohio. Circuit Judge Jacqueline H. Nguyen dissented.
The majority opinion allocates the risk of fraud to the seemingly innocent sellers because they, as parties to the transfer, “generally stand in a better position to guard against corporate fraud than do unsuspecting creditors” not in a position to know that the money paying a personal expense came from a corporate account.
Section 550(b) is structured to give the good faith defense to subsequent transferees, but not to the initial transferee. On appeal, the sellers contended that they were subsequent transferees eligible for the defense because the fraudster should be viewed as the initial transferee. The decision in the circuit court therefore turned on the attributes of an initial transferee.
Judge Marbley said that the Ninth Circuit decided in 2006 to follow the Seventh Circuit by adopting the stricter “dominion test,” rather than the more lenient “control test” employed, for instance, in the Eleventh Circuit. The question is a matter of federal common law because the Bankruptcy Code does not define “initial transferee” as used in Section 550(a)(1).
According to Judge Marbley, the dominion test focuses on who has legal title. He said that the control test “involves a more gestalt analysis” focusing on “‘who truly had control of the money.’”
In the context of an insider, Judge Marbley said that the majority of courts hold that a principal who misappropriates company funds to pay a personal obligation is not an initial transferee. To become the initial transferee, the fraudster must first transfer the money to a personal account, which did not occur in the case at bar because the funds were always held in an account bearing the company’s name and tax identification number.
Making the fraudster the initial transferee “both misallocates the monitoring costs that Section 550 sought to impose and deprives the trustee” of potential recoveries, Judge Marbley said. In his view, the minority draw “largely on equitable principles and a concern that seemingly ‘innocent’ third parties will be held liable for fraudulent transfers.”
Judge Marbley declined to make a policy decision based on equitable principles “because Congress already performed that task.” He ended by saying that the majority’s decision would not let the fraudster off “scot-free” because he remains strictly liable under Section 550(a)(1) as the person “for whose benefit” the initial transfer was made.
Judge Nguyen began her dissent by saying, “There is nothing equitable about today’s decision.” She called on her circuit to sit en banc, repudiate the dominion test, and adopt the “control test used successfully in other circuits.”
Even employing the dominion test, Judge Nguyen disagreed. Characterizing the facts, she would have found that “the sham account never belonged” to the company because the fraudster “was acting adversely to [the company] in opening the sham account, [and] he did so in his personal capacity, not as an officer of the company.”
Don’t be surprised if there is a petition for rehearing en banc, and don’t be surprised if the petition is granted. But don’t hold your breath. It could be two years before there is an opinion en banc.