Pursuant to Section 550(a) of the Bankruptcy Code, once a trustee has successfully avoided a fraudulent transfer, he may recover the fraudulently transferred assets from either the initial transferee or “any immediate or mediate transferee” of the initial transferee. As discussed below, this distinction by the Bankruptcy Code between initial and subsequent transferees is critical to assessing potential avoidable transfer liability. Trustees have an absolute right of recovery against the initial transferee and any entity for whose benefit such transfer was made. While trustees can recover from subsequent transferees as well, subsequent transferees who accepted the property “for value, in good faith, and without knowledge” of the voidability of the transfer may avail themselves of the “ ‘good faith’ defense of Section 550(b) of the Bankruptcy Code.
Courts have taken two approaches when applying § 550 to fraudulent transfers involving the misappropriation of corporate funds by company directors, officers, or other insiders. Under the so-called “two-step transaction” approach, the debtor company is deemed to have made the initial transfer to the corporate principal, thus making him or her strictly liable as the initial transferee In re Orange County Sanitation, Inc., 221 B.R. 323 (Bankr.S.D.N.Y.1997) followed this approach and stands for the proposition that when an officer of a corporate debtor receives a check drawn on the debtor’s account and uses it to pay his/her personal debts, the officer and not the check’s payee is the initial transferee of corporate funds for transfer avoidance purposes. This has been described as the “minority approach.”
The alternative analysis is the “one-step transaction” approach, pursuant to which courts hold that a principal of a debtor corporation who misappropriates company funds to satisfy personal obligations is not an initial transferee. These courts reason that the mere power of a principal to direct the allocation of corporate resources does not amount to legal dominion and control, which is required for initial-transferee status. This has been described as the majority approach. In re Circuit Alliance, Inc., 228 B.R. 225 (Bankr.D.Minn.1998), followed this two-step approach and criticized Orange County, noting that it never addressed the conundrum of how a party outside the formal chain of title and possession can be deemed the recipient of a transfer, given the requirements of 11 U.S.C. §101(54) that, “property or … an interest in property” pass to the transferee. The court noted that Orange County also ignored what Circuit Alliance describes as the well-reasoned decisions holding that the concept of ‘entity for whose benefit’, and ‘transferee’ are mutually exclusive, finding that the corporate officer, rather than the initial transferee, is simply an entity for whose benefit the transfer was made.
For the reasons just cited, and for the failure to articulate a rationale on the plain language of the statute, these decisions are not good authority. Whether he was an “entity for whose benefit” or not, Casey was never a recipient or repository of the funds. Thus, he was never the transferee, and certainly was not an initial one.
Circuit Alliance, 228 B.R. 234-35.
In In re Anton Noll, Inc., 277 B.R. 875 (1st Cir.BAP 2002), the debtor’s president, who also served as CEO and was the 100% stockholder, caused the debtor corporation to issue a check in the amount of $260,892.54 payable to the order of “cash” and drawn from the debtor’s account. The memo portion of the check contained the writing “IRS $260,892.54.” The officer then personally endorsed the check and presented it to the bank, purchasing a bank check made payable to the IRS for the same amount. At the time of the withdrawal of its funds, the debtor was not indebted to the IRS nor did it receive any value on account thereof.
The court determined that the officer was the initial transferee, not the IRS. The court applied the test adopted in Bonded Financial Service, Inc. v. Eur. Am. Bank, 838 F.2d 890 (7th Cir.1988). In this decision, the Seventh Circuit ruled that “a mere conduit” could not be deemed the transferee. Merely having the ability to control funds “as principals of companies often do” does not automatically render the possessor a transferee. Bonded ruled that under §550(a)(1) the transferee must be in “dominion and control” of the funds and that “dominion and control” refers to legal, as opposed to mere physical possession of the property transferred. Thus, to be held to the standard of an initial transferee, a transferee must have the legal right to use the funds to whatever purpose he or she wishes, be it to invest in “lottery tickets or uranium stocks.” 838 F.2d at 894.
The Bonded court distinguished between two scenarios wherein a principal misappropriates funds from his corporation for the principal’s personal use. In the first, characterized as a “one-step transaction,” the principal causes the company to issue a check payable directly to the principal’s creditor. As an example, if the note accompanying the check states: “use this check to reduce the principal’s loan” instead of deposit this check into the principal’s account, §550(a)(1) would provide a ready answer. The bank would be the initial transferee and the principal would be the entity for whose benefit the transfer was made.” Id. at 892. In the second scenario, a two-step transaction occurs. The principal first acquires legal title to the funds and, therefore, full dominion and control, and second, forwards the funds to a third-party. Accordingly, the principal must be deemed the initial transferee. Id. at 893-94.
In Anton Noll, the court followed the Bonded analysis. In doing so, the court stated as follows:
Under Rhode Island law, a check payable to “cash” is an instrument payable to the bearer. Section 6A-3-111(c). A bearer is “the person in possession of the instrument.” Section 6A-1-201(5). Rhode Island law defines a negotiation as “the transfer of an instrument in such form that the transferee becomes a holder.´ Section 6A-3-202(1). If an instrument is negotiable to bearer, it is negotiated by delivery. In turn, “the holder of an instrument whether or not he or she is the owner may transfer or negotiate it and . . . on payment or satisfaction, discharge it or enforce payment in his or her own name.” Section 6-3-301(2000).
Anton Noll, 277 B.R. at 880.
Anton Noll noted that its facts involved a two-step transaction. Because the check was payable to “cash” it was negotiable upon delivery to the bearer, the corporate officer. Thus, under state law, the corporate officer obtained legal ownership and possession of the debtor’s funds upon receipt of the check. At that point, the corporate officer obtained the legal right to use the money as he pleased. Be it to buy “lottery tickets or invest in uranium stocks.” Here, the corporate officer chose to purchase the treasurer’s check to satisfy his tax liabilities with the IRS. The corporate officer, therefore, exercised sufficient dominion and control over the funds for the court to determine that he was the initial transferee under §550(a) and that the IRS was the subsequent transferee. Id. at 881.
A similar conclusion was reached in In re Abatement Environmental Resources, Inc., 301 B.R. 824 (Bankr.D.Md.2002). Here, an officer and stockholder of the debtor caused the debtor to issue checks payable to the IRS for application to the officers individual income tax liability. The IRS asserted that it was not the “initial transferee.” The court disagreed. It noted that any discussion of “dominion and control” refers to dominion and control over the funds after the disputed transfer, not dominion and control over the transferor for the transfer. Id. (quoting Rupp v. Markgraf, 95 F.3d 936, 940 (10th Cir. 1996)). Based on this analysis, the court noted that it was clear that the funds in issue went from the debtor to the IRS and that after the checks were issued and sent, the officer had no dominion and control over the funds. Id. at 828-29.
In In re Antex, Inc., 397 B.R. 168 (1st Cir.BAP 2008), an officer of Antex, Inc. had the corporate debtor issue multiple checks totaling $68,684.25 to the officer’s ex-wife covering the officers duty to support his ex-wife and minor children. The trustee filed an adversary complaint against the ex-wife seeking to recover the payments as fraudulent conveyances. The ex-wife denied that she was the initial transferee. The court started its analysis by noting that “it is widely accepted that a transferee is one who at least has ‘dominion over the money or other assets, the right to put the money to one’ own purposes.” Id. (citing Anton Noll, 277 B.R. at 879). The court ruled that the fact that her former husband controlled the debtor, directing it to issue the checks to the defendant, was not outcome determinative as to whether she was the initial transferee. The court stated that a principal who directs a debtor corporation to issue a check to pay for a personal debt is not an initial transferee. Id. at 173. In other words, “the mere power of a principal to direct the allocation of corporate resources does not amount to legal dominion and control.” Id. (citing Bowers v. Atlanta Motor Speedway, Inc. (In re Southeast Hotel Props., L.P.), 99 F.3d 151, 155 (4th Cir. 1996)).
The undisputed facts show that Mr. Robichaud never had legal dominion and control over the funds. Although Mr. Robichaud controlled the Debtor’s operations and arranged for the checks to be issued to the Appellant, the checks were direct transfers from the Debtor’s accounts to the Appellant. Once the checks were issued, Mr. Robichaud did not have the right to use the money for any other purpose than to hand the checks over to the Appellant. The Appellant would have us focus on the “economic realities” of the transaction rather than their form. However, in our view, Mr. Robichaud’s lack of legal dominion and control is a point of substance and an important element of the “economic realities.” Id.
The defendant also argued that her ex-husband was the initial transferee because the debtor’s financial records identified the payments to the defendant as advances to a stockholder (the ex-husband) or as a distribution of capital (again to the ex-husband). However, notwithstanding these entries, the court noted that there was nothing in the record to support a finding that the ex-husband had legal dominion over the funds after they were disbursed by the debtor. Quite simply, “characterizing the payments as ‘advances to a stockholder’ or as ‘distributions of capital’ in the company ledger does not establish that Mr. Robichaud ever exercised independent control over the funds.” Id.
Matter of Walldesign, Inc., 872 F.3d 954 (9th Cir.2017) similarly followed this “majority approach.” In this case, the unsecured creditors committee brought an adversary proceedings to recover payments that the transferor, an individual who was the Chapter 11 debtor’s sole shareholder, director, and president, made from a secret bank account that he had created to fraudulently siphon money away from the debtor and use for his personal expenses. The committee sought $220,350.00 from the sellers of real property used by transferor for a tasting room for his vineyard and $232,948.16 from an interior design firm whose services were provided for property owned by transferor. This secret bank account was in the name of the corporate debtor.
The court stated that under the “one-step transaction” approach, courts hold that a principal of a debtor corporation who misappropriates company funds to satisfy personal obligations is not an initial transferee. Id. at 964. The mere power of a principal to direct the allocation of corporate resources does not amount to legal dominion and control,” which is required for initial-transferee status. Id. The court explained:
As the Tenth Circuit has explained, “[m]any principals presumably exercise de facto control over the funds of the corporations they manage” and “can choose to cause their corporations to use those funds appropriately or inappropriately.” Id. (quoting Rupp v. Markgraf, 95 F.3d 936, 941 (10th Cir.1996)). But “[this] distinction is only relevant to the question whether the principal’s conduct amounted to a breach of duty to the corporation.” Id. (quotation omitted). The distinction is not relevant to whether the principal qualifies as an initial transferee. Id. Thus, a principal’s control over the business operations of a corporation “does not, in itself, compel a finding that [the principal] had dominion … over the funds transferred from [the corporation] to [a third party].” Id. at 1200.
Id. at 964. Walldesign stated that there are three reasons to follow the majority approach. Again, quoting Rupp, the court noted that first, the text of §550(a)(1) compels this result.
Determining the initial transferee of a transaction is necessarily a temporal inquiry; there must be a transfer before there can be a transferee. The extent to which a principal has de facto control over the debtor before the funds are transferred from the debtor, and the extent to which the principal uses this control for his or her own benefit in causing the debtor to make a transfer, are not relevant considerations in determining the initial transferee under §550.
Id. (quoting Rupp, 95 F.3d at 941). In other words, according to the court, the “flow of funds” matters, and receipt of the transferred property is a necessary element for that entity to be a transferee under §550. But “[s]imply directing a transfer, i.e., such as directing a debtor to transfer funds, is not enough.” Id. Therefore, the principal is not a transferee at all but, rather, is the party for whose benefit the transfer was made.
This leads to the second reason. The court stated that the structure of §550(a)(1) indicates that a principal does not become an initial transferee simply by using his or her control over corporate assets to effect a fraudulent transfer. Rather, section 550 imposes strict liability on both initial transferees and any beneficiaries of the fraudulent transfers. The court stated that this distinction between the beneficiaries of a transfer and initial transferees strongly indicates that, as a general rule, beneficiaries and initial transferees are separate parties to a fraudulent transfer. Id. at 965.
Finally, third, the policy concerns underlying §550 counsel in favor of treating beneficiaries, initial transferees, and subsequent transferees separately and requiring “legal control” over the funds as opposed to mere “de facto” control for initial-transferee status. A corporate principal (whether a shareholder, director, officer, or other insider) who effects a transfer of company funds in his or her representative capacity does not have dominion over those funds in his or her personal capacity. Therefore, such a principal does not qualify as an initial transferee under §550(a)(1). Id.
Matthew T. Gensburg
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