A chapter 7 trustee sought to avoid a transfer by the debtor as a fraudulent conveyance and then to recover funds disbursed by the debtor to the seller of a shopping plaza. The trustee contended that the seller, and not the purchaser, was the “initial transferee” and consequently was absolutely liable. The bankruptcy court and district court agreed, and the seller appealed to the 9th Circuit.
The seller (Mano) had a contract to sell a six-acre shopping plaza to a buyer (Lindell) for $300,000 cash and a $1.9 million seller note. Under the contract, the buyer had a right to terminate the agreement during a 30-day due diligence, but was contractually obligated to buy once the period expired. An attorney was designated to receive the purchase money, distribute the money pursuant to the contract, record the deed and distribute closing and other documents as instructed by the parties.
In January 2009 the due diligence period expired, and a few days later the parties proceeded to close the sale. In connection with the closing the debtor (Mortgage Store) wired ~$311,000 to the attorney in satisfaction of the amount due from the buyer, and the attorney disbursed the money in accordance with the purchase contract.
In late 2010, Mortgage Store filed bankruptcy. The bankruptcy trustee argued that the debtor’s payment in connection with sale of the shopping plaza was a fraudulent transfer and sought to recover these funds from the seller. The bankruptcy court and district court held that the seller was an “initial transferee.”
Under Section 550 of the Bankruptcy Code, if a trustee avoids certain types of transfers, including fraudulent conveyances, it may recover the transferred property or the value of the property from (1) the “initial transferee” or “the entity for whose benefit such transfer was made,” or (2) an “immediate or mediate transferee of such initial transferee.” A subsequent transferee has potential defenses, including that it took the transferred property for value, in good faith, and without knowledge of the avoidability of the transfer, while the initial transferee is strictly liable.
The issue on appeal to the 9th Circuit was whether the seller was an initial transferee, or a subsequent transferee. The court announced that it applied the “dominion test.” Under this test, the question is whether the recipient has legal title and the ability to use the funds as it sees fit. In the words of the 7thCircuit, a person has dominion if it is “free to invest the whole [amount] in lottery tickets or uranium stock.” According to the 9th Circuit, the first person to establish dominion over funds after they have left the transferor is the initial transferee, with everyone else being considered subsequent transferees.
The seller argued that a party should be deemed to be the initial transferee if a third party receives and distributes the funds on its behalf. This was the analysis followed in a 1995 9th Circuit bankruptcy appellate panel decision. At that time the 9th Circuit employed what it called a “hybrid ‘dominion and control’ test.” In addition to considering who has dominion, the court considered the transaction as a whole to make sure that its conclusions were logical and equitable. This was viewed as a “very flexible, pragmatic” test.
However, the 9th Circuit rejected this approach in a 2006 decision, moving instead to a pure dominion test so that “the touchstones in this circuit for initial transferee status are legal title and the ability of the transferee to freely appropriate the transferred funds.”
In this case by the time that the debtor transferred the funds, the buyer was required to close. In the court’s view it had no right to prevent distribution of funds to the seller, much less to invest them in lottery tickets or uranium stocks. The fact that the closing attorney was disbursing funds on behalf of and for the benefit of the buyer was not relevant to the question of whether the buyer had the ability to use the funds as he saw fit.
The court acknowledged that this result seemed harsh in light of the fact that the seller was not involved in any way in the impropriety of the debtor: (The debtor had been operating a Ponzi scheme.) In contrast, the buyer had a longstanding relationship with the debtor, serving as its president and sole shareholder from 1996 to 2008. Although he transferred ownership and management to his daughter in 2009, he retained control over the debtor’s finances.
However, in the context of bankruptcy it is almost always the case that an innocent third party will be adversely affected. From a policy standpoint, the court concluded that any exercise of its discretion “must be to allocate risk such that the parties tending to have the lowest monitoring costs must bear the costs of the debtor’s failings.” In theory the initial transferee is the best monitor. Once a party is determined to be the initial transferee, it has strict liability.
In a footnote the court appeared to take pains to justify its decision. It noted that the seller entered into a contract that “allowed [the buyer] to satisfy his obligations under the contract through a third party. In so doing, [the seller] accepted the risk that [the buyer’s] obligation would be satisfied through an avoidable conveyance.” It further noted that the buyer did not have the proper incentives to monitor the debtor for fraud due to his long term relationship.
Thus the seller was liable as an initial transferee.
This is not the first time a recipient of funds got burned based on the underlying source of the funds – just one more issue to consider when trying to assess the structure of a transaction.