In re The Mortgage Store, Inc.
In re The Mortgage Store, Inc., ___F.3d___, 2014 Westlaw 6844630 (9th Cir. 2014). In a fraudulent transfer appeal, in a Chapter 7 bankruptcy case adversary proceeding, the Ninth Circuit Court of Appeals has held that an "initial transferee" of a fraudulent transfer made by an insolvent corporation was strictly liable under the "pure dominion" rule, even though the debtor corporation’s insider was the party who exercised indirect control over the funds and even though the recipient of the money was unaware of its source.
Following is detail of the case, which appeared in the California State Bar’s Insolvency Committee e-bulletin of 1/13/15:
Facts: The owner of a shopping center entered into a $3 million sales agreement with an individual purchaser, under which the purchaser would provide the owner with $300,000 in "earnest money" and would execute a promissory note for the balance, secured by a mortgage in favor of the vendor. The "earnest money" was to be funneled through an attorney, acting on behalf of both the vendor and purchaser. Unbeknownst to the vendor, the purchaser himself did not provide the "earnest money." Instead, the money came from a separate corporation controlled by the purchaser; the corporation was experiencing financial trouble at the time.
Less than two years later, that corporation filed a Chapter 7 petition. Its trustee brought a fraudulent transfer action against the vendor, claiming that the corporation received no value in exchange for the payment and that the vendor was the "initial transferee" of the earnest money payment. Under 11 U.S.C.A. §550(a)(1), an "initial transferee" is strictly liable for the receipt of a fraudulent transfer and cannot interpose a "good faith" defense under §550(b). The trustee moved for summary judgment. The bankruptcy court ruled in favor of the trustee, as did the District Court.
Reasoning: The Ninth Circuit affirmed. The vendor argued that the individual purchaser himself should be the viewed as the "initial transferee," citing In re Presidential Corp., 180 B.R. 233 (9th Cir. BAP 1995), for the proposition that a party should be deemed the initial transferee when another party receives and distributes funds on the first party’s behalf. The court disapproved of the holding in Presidential because it relied on the flexible "dominion and control" test; the court held that In re Incomnet, 463 F.3d 1064 (9th Cir. 2006) had articulated a new test, the "pure dominion" test: "[T]he touchstones in this circuit for initial transferee status are legal title and the ability of the transferee to freely appropriate the transferred funds."
The vendor argued that since the purchaser had the ability to direct his corporation to pay money on his behalf, he was the person with dominion over that money and therefore he was the initial transferee, rather than the vendor. But the court disagreed, holding that the purchaser never had legal title to the funds in question. Furthermore, he had lost control over that money at the time the money was paid from the attorney (acting as an escrow agent) to the vendor: "Because the conditions precedent for the contract’s consummation had been satisfied by the time [the insolvent corporation] transferred the funds to [the attorney], [the purchaser] had no right to control their distribution."
The vendor then protested that imposing strict liability on a completely innocent party was a very harsh result. The court responded with a long explanation of the policies justifying the imposition of liability on an initial transferee:
In virtually every case involving a bankrupt entity, a third party will be injured because the debtor’s obligations to creditors, by definition, outstrip its assets. In the case of a debtor’s fraudulent conveyance, injury must fall on either the transferee of the conveyance or the debtor’s creditors . . . . The aim of §550 . . . must be to allocate risk such that the parties tending to have the lowest monitoring costs must bear the costs of a debtor’s failings…
Unlike subsequent transferees, who "usually do not know where the assets came from and would be ineffectual monitors if they did," initial transferees tend to have relationships and influence with the debtor . . . . By placing the risk on initial transferees rather than creditors, Congress ensured that creditors "need not monitor debtors so closely," the idea being that "savings in monitoring costs make businesses more productive."
The court then explained that the vendor in this case was not helpless to protect itself against the risk of fraudulent transfer liability:
Although [the vendor] asserts it did not have direct contact with the debtor [corporation] until well after the transfer, [the vendor] was represented by counsel in the transaction and entered a contract that allowed [the purchaser] to satisfy his obligations under the contract through a third party. In so doing, [the vendor] accepted the risk that [the purchaser] obligation would be satisfied through an avoidable conveyance.
Professor Schector’s Comment: It is telling that the court’s policy defense of the strict "initial transferee" rule goes on for so many paragraphs; to quote Shakespeare, "The lady doth protest too much, methinks." (Hamlet, Act III, Scene II.) The court implicitly recognizes that this is a very harsh rule and that there is really no practical way for the vendor (or any other payee) to protect itself.
At one point, the court quotes Scholes v. Lehmann, 56 F.3d 750, 761 (7th Cir.1995), for the dubious proposition that "conveyance recipients could hold cash reserves or obtain liability insurance to hedge against the possibility of a fraudulent conveyance." But since the payee rarely knows that he or she is a "conveyance recipient" of a fraudulent transfer, this must mean that every payee of every check must always obtain some sort of insurance to hedge against the possibility of unforeseen fraudulent transfer liability. That is patently unworkable: the occasional catastrophic loss is apparently just a risk of doing business.
I am disappointed that the court did not discuss the ambiguous role of the attorney in this case. Recall that he acted as an escrow agent, apparently on behalf of both parties. One could argue that his receipt of the money from the insolvent corporation was on behalf of the purchaser, the corporate insider who set up the whole deal. Therefore, since the attorney was the agent of the purchaser, the purchaser would be viewed as the initial transferee. Alternatively, the attorney could be characterized as nothing more than a conduit acting on behalf of the insolvent corporation, thus transmuting the vendor into the initial transferee.
In hindsight, I suppose that the vendor could have insisted that the funds in question come directly from the purchaser’s personal bank account, so as to eliminate the possibility that the purchaser was obtaining the funds from an unknown insolvent corporation; in that case, the purchaser would have been the initial transferee, and the vendor would have qualified as a "subsequent transferee." The vendor would have had to be simultaneously paranoid and prescient to insist on such an arrangement. Worse yet, one can easily envision that a bankruptcy court could seize on this awkward arrangement as evidence that the vendor, as a subsequent transferee, must have been on notice of the tainted source of the money, thus fatally impeaching its putative "good faith transferee" defense.
Note that as a result of the rejection of Presidential, the trustee in analogous cases has now gained another strictly liable defendant: if the corporate officer who directs the transaction but never receives the money is not a "transferee," he must the "entity for whose benefit" the transfer was made, under §550(a)(1). The trustee may obtain a judgment against both the controlling officer and against the hapless initial transferee.
For a detailed discussion of Incomnet, see 2006 Comm. Fin. News. 71, Preference Recipient Has "Dominion" over Funds, Even If Recipient Is under Statutory Duty to Transmit the Funds to a Third Party.