When a person “pays” a debt with a fictitious check, someone other than the bad guy usually ends up losing. The Sixth Circuit Court of Appeals recently addressed such a situation in White Family Cos., Inc., v. Slone (In re Dayton Title Agency, Inc.), Case Nos. 12-3265;3359, July 31, 2013. In Dayton Title, the accused bad guy was Krishan Chari. Chari operated a real estate business in which he bought and sold commercial properties.

Those purchases were often accomplished through the use of short-term bridge loans. In September of 1999, Chari received two such loans totaling approximately $4.8 million which were intended to enable him to complete the purchase and sale of a specific property. The loans came due on Oct. 3, 1999, and Chari gave checks to repay the two creditors. Unfortunately, the checks were dishonored for insufficient funds. Chari then wrote a new check that was payable to Dayton Title Agency (DTA). DTA deposited the check in its account that was supposed to include trust funds. It then, in violation of its own procedures, issued two checks to Chari’s lenders.

Presumably, this form of transaction was intended to provide added assurances to the two lenders by “running the money” through DTA. One of the lenders exchanged his check from DTA with an official bank check, and the second lender deposited his check at another bank and that check cleared through the normal banking check collection process.  

Of course, Chari’s check, having been drawn on an entirely fictitious account, bounced, and the bank where DTA originally deposited that check exercised its right of charge back on that check and debited the more than $4.8 million back against DTA. DTA responded by filing for bankruptcy relief, and it brought this action (now being pursued by its bankruptcy trustee) to recover the payments made to Chari’s two creditors. The trustee’s action was brought under the Ohio fraudulent transfer law, with the trustee alleging that the payments received by the Chari’s creditors were made from DTA’s assets, while DTA was insolvent, and for which DTA received no value in return.

In 2002, the bankruptcy court initially found in favor of DTA, but that decision was reversed by the district court. On remand, the bankruptcy court again found for DTA in 2003, and the case was again appealed to the district court. The district court once more found for the creditors, and that decision was appealed to the Sixth Circuit which issued its decision on July 31. The Court of Appeals reversed the district court and held that the payments made to the lenders by DTA constituted a transfer of DTA’s property that could be recovered by the bankruptcy trustee.

The focus of the dispute was on whether the payments by DTA actually were transfers of DTA’s property given that they were made from a “trust” account. The account was DTA’s IOTA (Interest on Trust Accounts) account. That account held approximately $725,000 of deposits by purchasers of real estate in transactions unrelated to Chari, $21,000 of fees and expenses owed to DTA, and a provisional credit of over $4 million from the check wrote to DTA. The provisional credit had been granted by DTA’s bank. Chari’s lenders argued that because these funds were included in a trust account, they were not DTA’s property. Rather, DTA held those funds solely as a trustee and had only legal title. Their argument was that because this was not a transfer of DTA’s property, no fraudulent transfer could have occurred and that the proceeding should be dismissed.

The $21,000 in the account clearly belonged to DTA, and so that amount was unquestionably an asset that DTA transferred to Chari’s lenders for no valuable consideration given that DTA received nothing in return from the lenders. To the contrary, there was no dispute that the $725,000 provided to DTA by its regular customers was not property of DTA. It served only as a trustee of those funds for the purpose of other real estate transaction, and any transfer of those funds would not constitute a transfer of the assets of DTA. The disputed category was the portion of the funds that were derived from the provisional credit given to DTA by its bank when Chari’s fraudulent check was deposited in that bank.

Chari’s lenders argued that the provisional credit funds were held by DTA in trust for the benefit of those lenders. Essentially, they asserted that Chari’s deposit with DTA created a trust for the benefit of the lenders with DTA serving as the trustee. In that event, any subsequent transfer of those funds would be a transfer of trust funds to the beneficiaries rather than a transfer of DTA’s assets.

The Sixth Circuit rejected this position for several reasons. First, the court held that no trust existed because Chari did not actually transfer anything to DTA by his fraudulent check. With no specific trust property, there could be no trust. Second, even though the bank in which the Chari check was deposited gave property to DTA (the provisional credit) there was no explicit declaration of a trust by the bank. Under applicable Ohio law, there must be an explicit declaration of trust for a trust to be recognized, so no trust could result from the bank’s provisional credit to DTA. Without a trust, the funds in the DTA account attributable to the provisional credit were assets of DTA that could be fraudulently transferred.

The Chari lenders also claimed that a previous Sixth Circuit case, Stevenson v. J.C. Bradford & Co., 277 F.3d 838 (6th Cir. 2002) (In re Cannon II), governed this case and should result in a judgment in their favor. The Court of Appeals disagreed. Instead, the court held that Cannon II was distinguishable from the facts in this case. Here, the wrongdoer was Chari and not DTA, while in Cannon II, the wrongdoer was the debtor whose account included both trust and non-trust deposits. Therefore, the analysis of the contents of the debtor’s bank account in Cannon II was not applicable to the evaluation of the contents of DTA’s bank account.

The Chari lenders argued further that provisions of the UCC limited DTA’s interest in the funds that were transferred to the lenders. Specifically, they claimed that under UCC § 4-210 (codified in Ohio as Ohio Rev. Code § 1304.20), the bank that issued the provisional credit to DTA had a security interest in the item that was being collected as well as any proceeds of that item. The lenders asserted that the provisional credit was proceeds of the check, but the Court of Appeals again disagreed. It noted that the definition of “proceeds” under UCC § 9-102(a)(64) (Ohio Rev. Code §1309.102(a)(64)) would not include a provisional credit issued by a collecting bank. Moreover, at the time that DTA transferred the funds to Chari’s lenders, the collecting bank had only its ability to charge back the account by revoking the provisional credit.

The Sixth Circuit reversed the district court and affirmed the decision of the bankruptcy court. Thus, Chari’s lenders were liable to return approximately $4.1 million to the bankruptcy trustee. The bankruptcy court held that the trustee could not recover the portion of the payment made to Chari’s lenders that was derived from trust funds held by DTA on behalf of third parties who were engaged in real estate transactions unrelated to Chari or his lenders. Those amounts were not assets of DTA, so no fraudulent transfer of those funds occurred.

As Circuit Judge Merritt noted in his concurring opinion, the result in the case conforms to a sense of fairness in that the lenders dealt directly with Chari, the ultimate wrongdoer in the case. He stated that had their dealing been solely with Chari, they would have suffered the full loss from Chari’s fraud.