‘Mere Conduit’ Defense to a Fraudulent Transfer Isn’t Limited to Banks

Courts are continually dealing with the seeming unfairness of pinning liability on the initial recipient of a fraudulent transfer who had no inkling there was fraud was afoot.

As Bankruptcy Judge Roberta A. Colton of Jacksonville, Fla., said in a Nov. 1 opinion, “Section 550(a)(1) can be read to impose strict liability on [an] initial transferee of an avoided fraudulent transfer,” because the statute does not give the initial transferee a good faith defense. On the other hand, a subsequent transferee does have a good faith defense under Section 550(b)(1).

The case at bar arose from the liquidation of Taylor Bean & Whitaker Mortgage Corp., which had been the country’s largest independent mortgage lender. The business came to an abrupt halt following a raid by the FBI in 2009 because the company had been “engaged in a scheme to defraud” beginning in 2002, Judge Colton said.

Ultimately, the bankruptcy court confirmed a chapter 11 plan creating a trust to pursue claims on behalf of creditors. The plan trustee set about filing fraudulent transfer suits, because a transfer with “actual intent” to defraud is based on the debtor’s fraudulent intent under Section 548(a)(1)(A), not the knowledge or intent of the transferee. At least theoretically, anyone who received a payment from the debtor could therefore be seen as the recipient of a fraudulent transfer because the funds were stolen from other creditors.

The plan trustee filed a $34 million suit against the debtor’s payroll service provider, contending that it was the initial transferee who should be liable, even though it had no knowledge it was receiving stolen funds.

“To mitigate against such a harsh and inequitable result,” Judge Colton described how the Eleventh Circuit created the concept of “the ‘mere conduit’ exception to initial transferee liability.” The defense, she said “is designed to protect those who simply and innocently facilitate the transfer, but do not actually end up with the transferred property.”

To qualify as a “mere conduit,” Judge Colton said the transferee must show that (1) it did not have control over the asset it received, and (2) it “acted in good faith and as an innocent participant in the fraudulent transfer.”

To classify the defendant as a “mere conduit,” Judge Colton meticulously described how the payroll service provider conducted business. Among the important features of the business were the following: The debtor wire-transferred money to cover payroll into a segregated although commingled account only containing payroll for the debtor and other customers. At the appropriate time, the service provider paid the workers or garnishors and turned over withholding taxes to the government. The debtor paid the service provider’s fees separately. The debtor had the right at any time to withdraw money from the segregated payroll account.

The service provider argued that it was the functional equivalent of a bank that is entitled to “mere conduit” status, even though banks may use customers’ deposits to make loans.

Judge Colton agreed. She said that “‘mere conduit’ status is not limited to a bank.”

The obligations of the payroll service provider, she said, “are analogous to a bank’s obligations when it accepts money into a deposit account.” The debtor “always directed and maintained control of its payroll.”

Because the payroll company did not control the transfers into or out of the account, Judge Colton said it was “neither logical nor equitable [for the service provider to] be held liable for the funds that passed through . . . to employees, taxing authorities and garnishors.”

Having found that the payroll service provider did not exercise control over the transfers, Judge Colton next analyzed whether the defendant had “actual knowledge” of the fraud or “had knowledge of facts or circumstances that would have put [it] on inquiry notice.”

The record had no facts to suggest that the payroll service provider had actual knowledge of fraud. Likewise, Judge Colton said there was no “inquiry notice” because the service provider “has no legal or contractual obligation to review, evaluate, or audit its clients’ transactions, nor should it.”

Even if the service provider had suspicions, Judge Colton asked, what could it do? The debtor’s outside auditors had been duped, and the debtor’s board was controlled by the fraudster-in-chief.

Although good faith “is not usually an issue ripe for summary judgment,” Judge Colton dismissed the suit because “the material facts are not in dispute and even favorable inferences do not help the Trustee.” It is a “tough case,” she said, “to argue that the company handling the automated payroll should have acted where the [debtor’s board] and auditors failed to do so.”