Banks, insurance brokers, and other agents can breathe a sigh of relief as the Fourth Circuit enabled the “mere conduit” defense to survive another day. The Fourth Circuit has long recognized the proposition that an avoidable transfer cannot be recovered, pursuant to section 550(a)(1) of the Bankruptcy Code, from a transferee who acted as a “mere conduit” for another party having the direct business relationship with the debtor. In Guttman v. Construction Program Group (In re Railworks Corporation), this recovery defense was put to the test.

The Alleged Preferential Transfers

Railworks Corporation, a national provider of rail systems services, filed a voluntary chapter 11 petition in 2001. Prepetition, Railworks maintained insurance coverage through TIG Insurance Company. Rather than paying premiums to TIG directly, Railworks paid Construction Program Group — the managing general underwriter for TIG — which then forwarded the payments, less commissions, to TIG.

CPG and TIG were parties to a General Agency Agreement, pursuant to which CPG was obligated to collect, receive, and account for the premiums related to the Railworks insurance policies. The agreement consisted of, among other provisions, the following terms: (i) CPG was liable to TIG for payment of the premiums attributable to the policies, regardless of whether the premiums had been collected; (ii) premiums collected by CPG were property of TIG and to be held in trust for TIG; and (iii) TIG was obligated to pay to CPG commissions, which CPG could deduct from the collected premiums.

Within the 90 days leading up to the filing of Railworks’ chapter 11 petition, Railworks transferred four premium payments totaling approximately $2 million to CPG. CPG forwarded the premiums, less commissions, to TIG.

The Chapter 11 Litigation Trustee, appointed pursuant to Railworks’ confirmed plan of reorganization, sought to avoid Railworks’ payments to CPG as preferential transfers pursuant to section 547 of the Bankruptcy Code and collect the payments from CPG under section 550(a)(1). Section 550(a)(1) permits recovery of an avoided transfer from either the initial transferee or the entity for whose benefit the transfer was made.

Decisions of the Lower Courts

The United States Bankruptcy Court for the District of Maryland rejected the Litigation Trustee’s argument that the payments could be recovered from CPG under section 550(a)(1). The bankruptcy court determined that CPG was not an initial transferee because CPG never had “legal dominion and control” over the transfers. In other words, CPG was a “mere conduit” that never had an “unrestricted right to use the transferred property” for its own purposes. For this reason and several others, the bankruptcy court granted CPG’s motion for summary judgment.

The Litigation Trustee appealed to the United States District Court for the District of Maryland. The district court agreed with the Litigation Trustee, holding that, for purposes of recovery under section 550, CPG occupied a “dual status” as both a “mere conduit” and as one for whose benefit the transfers occurred. The district court explained that CPG benefitted from the transfers because CPG’s contingent liability — the obligations to pay premiums to TIG regardless of whether they were collected from Railworks — was extinguished when CPG received the payments and remitted them to TIG. The district court vacated the bankruptcy court’s decision and remanded for further proceedings.

The Fourth Circuit’s Opinion

CPG appealed to the Fourth Circuit. On appeal, the parties agreed that CPG was a “mere conduit” and thus not an “initial transferee” under the first prong of section 550(a)(1). As such, the dispute before the Fourth Circuit focused on whether, notwithstanding CPG’s status as a “mere conduit,” CPG also could be considered an entity for whose benefit the transfers were made, in accordance with the second prong of section 550(a)(1).

The Fourth Circuit disagreed with the “dual status” proposition that the Litigation Trustee had proposed and that the district court had applied. The Fourth Circuit concluded that, just as a mere conduit cannot be an initial transferee for the purposes of avoidance recovery, so too a mere conduit cannot be “one for whose benefit the transfer was made.”

According to the Fourth Circuit, CPG was indisputably a “mere conduit” that did not have a legal right to use the payments as it pleased. If, as the Fourth Circuit explained, the court were to adopt the Litigation Trustee’s reasoning — that a contingent liability was extinguished upon Railworks’ payment to CPG — a conduit would always be contingently liable to the principal or beneficiary, and thus a conduit would always be an entity for whose benefit a transfer was made. “This is so,” according to the Fourth Circuit, “because a conduit, by definition, has an obligation to pass the funds on to a third party, and, if he fails to pass the funds to the third party, he is liable for those funds.” Simply put, the Fourth Circuit was “unwilling” to “eviscerate the conduit defense.”

Because CPG was a “mere conduit” for the premium payments from Railworks to TIG, and, according to the Fourth Circuit, a party cannot be both a mere conduit and an entity for whose benefit a transfer was made, the Litigation Trustee was unable to recover the payments from CPG under section 550(a)(1).

Conclusion

It appears that the Litigation Trustee’s argument, i.e., a conduit benefitted through extinguishment of a contingent liability, did not sit well with the Fourth Circuit. Interestingly, the Fourth Circuit perceived the “mere conduit” defense as a given and never questioned its continued validity in light of the Litigation Trustee’s contingent liability argument.

Perhaps the Litigation Trustee should not have conceded on appeal that CPG was a “mere conduit.” Pursuant to its agreement with TIG, CPG arguably had taken on the credit risk of collecting the receivables from Railworks and, therefore, was the party with the true economic interest in the payments. Such a position may have offered the Fourth Circuit an option to rule in favor of the Litigation Trustee without putting the “mere conduit” defense at risk of “evisceration.” In any event, thanks to the principle of stare decisis, the “mere conduit” defense lives to see another day.