Restructuring

The Eleventh Circuit has found that an attorney who allegedly was the “mastermind” of his client’s fraudulent transfer of settlement funds through the attorney’s trust account could be held liable as an “initial transferee” upon a showing of the attorney’s lack of good faith. In re Harwell, No. 09-14997, 2010 WL 5374340 (11th Cir. Dec. 29, 2010).  The case raises interesting questions about the necessary elements of the “mere conduit” defense to fraudulent transfer liability.
At the outset, it’s worth noting that the appeal before the Eleventh Circuit arose from the attorney’s motion for summary judgment in the underlying bankruptcy case, and, therefore, for purposes of its summary judgment ruling, the bankruptcy court viewed the facts and drew inferences in a light most favorable to the non-moving party, the chapter 7 trustee in the bankruptcy case.
In the underlying case, a creditor had obtained a $1.4 million judgment against the client/debtor.  Around that time, the attorney represented the client/debtor in negotiating a settlement of an unrelated business dispute. The settlement proceeds of just over $500,000 were deposited into the attorney’s client trust account.  Pursuant to the client’s instructions, the attorney disbursed the money to the client, some of the client’s family members, and selected creditors.  None of the settlement proceeds were paid to the judgment creditor.
The client filed a chapter 11 case that was subsequently converted to a chapter 7 proceeding.  The trustee in the chapter 7 case initiated a fraudulent transfer action against the attorney to recover the settlement proceeds, and asserted that the attorney himself was liable as the “initial transferee” under section 550(a)(1) of the Bankruptcy Code, which allows recovery of avoided transfers from an initial transferee, a subsequent transferee, or the entity for whose benefit such transfer was made.  The attorney did not dispute that he was the initial recipient of the funds but asserted as a defense that he was a “mere conduit” who did not have dominion and control over the funds, and, thus, could not be considered an initial transferee of the settlement funds for purposes of the fraudulent transfer action.
The bankruptcy court granted summary judgment in favor of the attorney, despite assuming, for purposes of summary judgment, that the attorney was the “mastermind” of the fraudulent transfer of hundreds of thousands of dollars that would otherwise be available for creditors.  The bankruptcy court held that the attorney was not an initial transferee because he never had dominion and control over the settlement proceeds, which he kept in his trust account for the client/debtor.  The district court affirmed, finding that the attorney acted in his fiduciary capacity and was obligated to disburse the funds according to his client’s instructions; therefore, the attorney exercised no control over the funds, as required for initial transferee liability.  The Eleventh Circuit, however, reversed and remanded for further proceedings, finding that disputed issues of material fact relating to the attorney’s alleged lack of good faith precluded summary judgment.
Noting that there was no clear definition of the term “initial transferee” under the Bankruptcy Code, the Eleventh Circuit surveyed its relevant decisions that have addressed the term “initial transferee” in various contexts in order to clarify the applicable standard.  The court acknowledged that, under a strict reading of section 550(a)(1), the first recipient of the debtor’s funds (here, the attorney) would be liable for the fraudulent transfer as an initial transferee.  The court then noted that there is an “equitable exception” to the literal statutory language for an initial recipient who was a “mere conduit” because the recipient lacked control over the funds.  Central to the “mere conduit” or control exception is the recipient’s good faith:

[G]ood faith is a requirement under this Circuit’s mere conduit or control test.  Accordingly, initial recipients of the debtor’s fraudulently-transferred funds who seek to take advantage of equitable exceptions to § 550(a)(1)’s statutory language must establish (1) that they did not have control over the assets received, i.e., that they merely served as a conduit for the assets that were under the actual control of the debtor-transferor and (2) that they acted in good faith and as an innocent participant in the fraudulent transfer.

The Eleventh Circuit panel dismissed any suggestion that the good faith principle was mere dicta in the court’s prior precedent, holding explicitly that good faith is required under the Circuit’s mere conduit or control exception to initial transferee liability.  The court concluded that, to take advantage of this equitable exception, a defendant in a fraudulent transfer action must have acted in good faith and have been an innocent participant in the transfer.
The Court of Appeals then reasoned that, because the bankruptcy court assumed for purposes of summary judgment that the attorney was the mastermind of the debtor’s scheme to fraudulently funnel the debtor-client’s money into and out of the attorney’s trust account, there were triable issues of fact precluding summary judgment on the attorney’s assertion of the “mere conduit” or control defense.  Accordingly, the Eleventh Circuit remanded the case to the bankruptcy court for further findings on whether the attorney acted in good faith.
In a previous post, we discussed another recent case, Paloian v. LaSalle Bank N.A., where the Seventh Circuit grappled with initial transferee liability in the context of a trustee of a securitized investment pool.  Similar to the Eleventh Circuit in Harwell, the Seventh Circuit in Paloian noted that the Bankruptcy Code does not define “initial transferee” but that courts have looked to the entity with control over the funds as the real recipient of a fraudulent transfer.  In Paloian the Seventh Circuit held that LaSalle, as trustee, was the legal owner of the securitization trust’s assets, and the proper subject of an avoidance action to recover certain loan payments made to the trust, even though LaSalle argued it lacked the requisite control over disbursement of the funds.  That is, just because LaSalle was contractually obligated to disburse the funds to the certificate holders of the trust did not conclusively establish LaSalle’s “mere conduit” status.  The Eleventh Circuit in Harwell also was not persuaded by the attorney’s arguments that he was merely acting in his capacity as a fiduciary who had no discretion regarding how the debtor’s funds in his client trust account were disbursed (and was not the legal owner of the funds), given that there were allegations that the attorney was not an innocent participant in the fraudulent transfer scheme.  However, the Eleventh Circuit might have simply said that even though the attorney was obligated to transfer the funds to third parties in accordance with the client’s instructions, he still retained meaningful control over the disbursement of the funds because he allegedly engineered the fraudulent transfer scheme, and therefore exercised some power over how the funds would be disbursed.  Instead, the Eleventh Circuit focused on the attorney’s good faith, which would seem to add an additional evidentiary hurdle for agents, banks, insurance brokers, and similar parties who are duty-bound to take only limited actions with respect to funds owned by their clients and seek to avoid initial transferee liability under the mere conduit exception.
As the Eleventh Circuit noted, a literal interpretation of the term “initial transferee” in section 550(a) of the Bankruptcy Code would lead to the first recipient of the debtor’s fraudulently transferred funds, and that, under a rigid interpretation of section 550(a)(1), such a first recipient would be strictly liable for an avoided transfer.  Notwithstanding that courts have carved out an equitable exception to the literal statutory language for entities with no control over the fraudulently transferred funds, there is no mention of “good faith” in section 550(a)(1).  In contrast, Congress chose to add a “good faith” exception to a subsequent transferee’s liability in section 550(b) of the Bankruptcy Code.
Although both the Eleventh and Seventh Circuits declined to find the “mere conduit” exception applicable in the Harwell and Paloian cases, there appears to be a developing split in the circuits on whether the exception requires proof of good faith by the defendant.  We’ll keep monitoring this issue as the “mere conduit” case law continues to develop; it could end up before the Supreme Court someday.