As discussed in our articles on New Value Defense and Ordinary Course of Business Defense in bankruptcy, payments made to creditors within ninety days of filing bankruptcy (or longer if the creditor is an “insider”) can be retrieved by the Trustee in bankruptcy to be divided pro rata among the other creditors even if the payment was for legitimate debts due and owing. The reader should review those articles before reading further.
The payments sought to be retrieved are termed “preferential payments” and efforts to retrieve preferential payments are now common in bankruptcy.
These demands for return of such “preferential payments” can be substantial: our office has defended creditors facing a trustee seeking to obtain many millions of dollars paid for obligations the bankrupt incurred in the months before filing bankruptcy. Such actions are now common enough that the wise business will learn the various defenses that are available.
This article shall discuss the “mere conduit” defense to claims for return of preferential payments.
The Basic Theory:
Even if a payment would otherwise fall within the category of a preferential payment received, if one can demonstrate that the payment was not retained by the defendant but was immediately transferred to a third party who was the actual “creditor” paid, then the trustee will look to the ultimate recipient of the money rather than the entity that was just a “mere conduit” for payment to the actual creditor.
Section 550(a) of the Bankruptcy Code
TThe “mere conduit” defense is set forth under section 550(a) of the Bankruptcy Code. The pertinent part of section 550 pertinent part of section 550 provides as follows:
a. Except as otherwise provided in this section, to the extent a transfer is avoided under section 544, 545, 547, 548, 549, 553(b), or 724(a) of this title, the trustee may recover, for the benefit of the estate, the property transferred, or, if the court so orders, the value of such property, from –
- the initial transferee of such transfer or the entity for whose benefit such transfer was made; or
- any immediate or mediate transferee of such initial transferee.
11 U.S.C. § 550(a)
In order to support the “mere conduit” defense a party will have to show that it was merely a facilitator and did not assert sufficient control over the funds passing though its hands to create defacto ownership of the sums.
Initial Transferee Issue: Was the Payment Really Only “Mere Conduit?”
The initial transferee and the entity for whose benefit the transfer was made are held strictly liable to the trustee to repay sums received in the ninety days prior to filing bankruptcy. In re Bullion Reserve of N. Am., 922 F.2d 544, 547 (9th Cir. 1991).
For purposes of the mere conduit defense, since the trustee is able to recover property transferred from the debtor to the “initial transferee,” the determination of which entity was the actual “initial transferee” is important.
The Bankruptcy Code does not define the phrase “initial transferee.” The absence of a definition for “transferee” and the harsh result of an overly literal approach to Section 550 gave rise to the “conduit” defense to avoid preferential payment liability. In re Dominion Corp., 199 B.R. 410, 413 (9th Cir. 1996).
In the absence of a clear statutory definition, two standards to determine whether a party is an “initial transferee” have emerged: the “dominion test” and the “control test.” While the words “dominion” and “control” are synonyms when used in their lay sense, the “dominion test” and the “control test,” as originally stated, are not merely different names for the same inquiry. The two tests do differ, and the fact that the dominion test is sometimes stated as an inquiry into who had legal “control” over funds does not mean that the two standards are indistinguishable.” In re Incomnet, Inc., 463 F.3d 1064, 1069 (9th Cir. 2006).
The Ninth Circuit has applied the dominion test several times, but has declined to adopt the control test. See, e.g., Abele v. Modern Fin. Plans Servs., Inc. (In re Cohen), 300 F.3d 1097, 1102 n. 2 (9th Cir. 2002) (“Contrary to the BAP, the district court, and [appellee's] contentions, we have not explicitly adopted the ‘control test’ .... In this case we again rely exclusively upon the ‘dominion test’ ....”); In re Bullion Reserve of N. Am., 922 F.2d 544, 548-49 (9th Cir. 1991) (discussing both the dominion test and the control test, but ultimately selecting and relying exclusively on the “dominion test”). See also, In re Johnson, 357 B.R. 136 (Bkrtcy N.D. Cal 2006).
Under the dominion test, “a transferee is one who ... has ‘dominion over the money or other asset, the right to put the money to one’s own purposes.’ ” In re Incomnet, Inc., 463 F.3d at 1070 (citing to In re Cohen, 300 F.3d at 1102, citing Bonded Fin. Servs. Inc. v. European Am. Bank, 838 F.2d 890, 893 (7th Cir. 1988)); see also In re Video Depot, Ltd., 127 F.3d 1195, 1198 (9th Cir. 1997); In re Bullion Reserve, 922 F.2d at 548. The inquiry focuses on whether an entity had legal authority over the money and the right to use the money however it wished. See In re Cohen, 300 F.3d at 1102; Bonded Fin. Servs., 838 F.2d at 893-94.
In practical terms, the dominion test requires that a transferee “be free to invest the whole [amount] in lottery tickets or uranium stocks ... Dominion is therefore akin to legal control (e.g., the right to invest the funds as one chooses), not mere possession.” In re Cohen, 300 F.3d at 1102 (brackets and parentheses in original; internal quotes omitted).
Section 550(b) of the Bankruptcy Code
The main issue then is whether a party was the “initial transferee” of the transfers from the bankrupt. If the defendant is not considered to be the initial transferee, Section 550(b) of the Bankruptcy Code provides an exception to a debtor’s ability to recover preferential transfers. Section 550(b) provides as follows:
b. The trustee may not recover under section (a)(2) of this section –i.e., other than from an initial transferee - from
- a transferee that takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer avoided; or
- any immediate or mediate good faith transferee of such transferee.
The critical distinction between the liability of an initial transferee and a subsequent transferee is that the estate may not recover from a subsequent transferee who takes:
- for value (including the satisfaction or securing of an antecedent debt);
- in good faith; and
- without knowledge of the transfer's avoidability.
11 USC §550(b)(1).
The good faith defense operates only in favor of subsequent transferees. See In re Video Depot, Ltd., 127 F.3d at 1197–1198. Similarly, the good faith defense is not available to an entity for whose benefit the initial transfer was made. California Practice Guide: Bankruptcy Chapter 21. Avoidance And Turnover Actions L. Recovering Avoided Transfers And Liens (11 USC § 550).
The subsequent transferee bears the burden of establishing all the elements of the good faith defense—value, good faith and without knowledge of avoidability. In re Laguna Beach Motors, Inc., 159 B.R. 562, 566 (Bkrtcy . C.D. Cal. 1993).
The three requirements are in the disjunctive. Even if a transferee acted in good faith, for example, it cannot claim § 550(b) protection if it did not give value. California Practice Guide: Bankruptcy Chapter 21. Avoidance And Turnover Actions L. Recovering Avoided Transfers And Liens (11 USC § 550).
“Value” for purposes of § 550(b)(1) means reasonably equivalent value. Full market value is not required. In re Laguna Beach Motors, Inc., 159 B.R. at 568. Moreover, the “value” need not have been given directly to the debtor: “The statute does not say ‘value to the debtor’; it says ‘value.’ A natural reading looks to what the transferee gave up rather than what the debtor received.” California Practice Guide: Bankruptcy Chapter 21. Avoidance And Turnover Actions L. Recovering Avoided Transfers And Liens (11 U.S.C. §550).
“Knowledge” generally means actual, not constructive, notice; but knowledge of sufficient facts to put the transferee on inquiry may constitute knowledge of voidability:
“ ‘Knowledge of voidability’ requires that the transferee have knowledge of sufficient facts that (i) puts the transferee on notice that the transfer might be avoidable or (ii) requires further inquiry into the situation and such inquiry is likely to lead to the conclusion that the transfer might be avoidable.” In re Richmond Produce Co., Inc., 195 B.R. 455, 464 (N.D. Cal 1996).
Once a subsequent transferee has qualified for the § 550(b)(1) good faith defense, a transferee of that transferee need only establish that it received the transfer in good faith.
It is readily apparent that the mere conduit defense is fact intensive: it requires demonstration of financial and business relationships and quite often documentation and even testimony in a formal hearing in the Bankruptcy Court. It also exposes another party…the final recipient of the sums…to the potential liability for the preferential payment. It is, in effect, pointing the finger at a third party and can lead to rather strained relationships between two potential creditors since one is claiming that the demand should rightfully be addressed to the other creditor.
Nevertheless, it is a vital defense and can avoid a creditor who promptly paid out the sums received having to return sums no longer in its possession to a trustee. And, for any creditor who is receiving payments from an insolvent party who plans to promptly pay them out to another creditor party, some legal advice and good record keeping is certainly appropriate given the risks involved.