Mere Conduit.

AuthorCarlson, David Gray


"Mere conduit" is a legal fiction employed in fraudulent transfer and avoidance theory law. Its use is often misleading, unnecessary, and in fact may be rendered obsolete by the Supreme Court's recent decision in Merit Management Group v. FTI Consulting, Inc., 138 S. Ct. 883 (2018). Furthermore, a large majority of leading cases in this area muddle fraudulent transfer law with the law on corporate theft, depriving financial intermediaries of the defense accorded to bona fide transferees for value. Finally, courts often mistake banks as initial transferees of fraudulent transfers (absolutely liable in spite of good faith and value given to a third party) when they are really transferees of the initial transferee and, therefore, entitled to the good-faith-transferee-for-value defense. Courts attempt to correct this error on an ad hoc basis by announcing that ban\s are mere conduits. Stern criticism is reserved for Bonded Financial Services v. European American Bank, 838 F.2d 890 (7th Cir. 1988), the leading case on "mere conduit," which will be revealed as contradictory. Bonded has led directly to the astonishing declaration in a recent Sixth Circuit case that bad-faith ban\s, servicing Ponzi schemes, are innocent of liability for fraudulent transfers because they are "mere conduits." The principal goal of this article, however, is to retire "mere conduit" fiction from the lexicon forever.

Table of Contents I. Introduction II. Fraudulent Transfers A. State Law B. Stolen Funds Contrasted C. Federal Bankruptcy Law 1. Benefited Entities 2. Transferees of Transferees 3. Stolen Funds III. Mere Conduit Analysis A. All or Nothing 498 B. Legal and Equitable Title C. Bailments D. Consignments E. No Transfer at All F. Unrelated Transfers G. Secured Creditors as MereConduits H. Banks as More than MereConduits 1. Triangular Cases 2. AntLTriangular Cases I. Conduits, Setoffs, and Security Interests in Deposit Accounts: Bonded's FundamentalContradiction J. Banks Acting in Bad Faith K. Giving It Back L. Safe Harbor IV. Conclusion I. Introduction

Fraudulent transfer law vastly empowers unsecured creditors against their strong enemies, their debtors. (1) Insolvent debtors embody the Christian dictum that in weakness there is strength. (2) Such debtors, psychoanalysis would say, are ""between the two deaths." They are symbolically dead but physically alive. From this position they are immune from the incentives imposed by the law of debt collection. (3) Debtors are strong because they can transfer assets fraudulently in an instant to some friend, relative, or corporate insider. The only sure strategy to protect against fraudulent transfers is for a creditor to take a mortgage or security interest on hard assets in advance. But then our creditor would be a powerful secured creditor, not a weak unsecured creditor.

The shadow world of the fraudulent transfer entails insolvent debtors and third-party transferees who themselves may be insolvent or otherwise judgment-proof. How convenient it would be for bankruptcy trustees, who represent unsecured creditors, if the bank that mediated the fraudulent transfer could be held responsible for it. In cases where the ultimate transferee is judgment-proof, this is just the ticket. (4) Banks are solvent, even if dodgy fraudsters and their donees are not.

The Bankruptcy Code tempts a trustee to target banks and other financial intermediaries. Although the trustee is empowered to recover fraudulent transfers under both [section] 548(a) (5) and 544(b)(1), (6) these provisions are semi-mediated by [section] 550(a), which provides:

to the extent that a transfer is avoided under section ... 544 [or] 548 ... the trustee may recover, for the benefit of the estate, the property transferred, or, if the court so orders, the value of such property, from--

(1)the initial transferee of such transfer or the entity for whose benefit such transfer was made; or

(2) any immediate or mediate transferee of such initial transferee. (7)

In effect, these provisions increase the set of possible defendants when a debtor bestows a fraudulent transfer upon a third party. The trustee can recover from the initial transferee, a third party as "the entity for whose benefit such transfer was made," or a "transferee of a transferee."

The favored target is a bank as the "initial transferee" of someone else's fraudulent transfer. (8) If the bank were a second-order transferee--a transferee of a transferee--the bank could bask in the defense of [section] 550(b):

The trustee may not recover under section (a)(2) of this section from-- (1) a transferee that takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer avoided ... (9) The reference to [section] 550(a)(2) in [section] 550(b) indicates that an initial transferee may not assert this defense. (10) Accordingly, good-faith banks may be dunned when they are deemed initial transferees of someone else's fraudulent transfer, as they are not permitted to assert their status as a good-faith transferee. (11)

Courts have intuited that, when a bank mediates between the debtor and the third-party donee who is the one actually enriched, innocent banks (or even bad-faith banks) (12) should be held harmless. The usual rhetorical strategy for absolving the bank is to proclaim that the bank is a "mere conduit." (13) The word "mere" does vital work here.

Basically, this absolving term says, "Look, we know the bank is the initial transferee of someone else's fraudulent transfer. But we choose to pretend that a mere conduit is not a transferee and proceed accordingly." (14) Thus are banks and other financial intermediaries absolved from being the initial transferee of a fraudulent transfer when they are "mere conduits."

"Mere conduit" is a legal fiction (15)--a theoretical prevarication uttered in the course of instituting the result that intuition demands. Finding the notion of "transferee" to be inconvenient, the fiction permits courts to ignore the literal terms of the statute to get the result that natural law requires. (16)

The Supreme Court has recently demonstrated that one can live well without the "mere conduit" fiction. In Merit Management Group v. FTI Consulting, Inc., (17) a buyer of stock (Valley View) allegedly paid too much in a sweetheart deal. Valley View borrowed the purchase price from its bank (Credit Suisse). Valley View instructed Credit Suisse to wire the borrowed funds to an escrow agent (Citizen's Bank). Citizen's Bank was to release the funds to the selling shareholders (including Merit Management) when the shareholders tendered the shares. The shareholders did so. Citizens Bank released the funds to the shareholders and the stock to Valley View. In Valley View's subsequent bankruptcy proceeding, the transaction was alleged to be a constructive fraudulent transfer--a transfer for less than reasonably equivalent value. (18)

The district court (19) had ruled that, since Valley View had channeled the money through a "financial institution," (20) [section] 546(e) applied. According to [section] 546(e):

Notwithstanding sections 544 ... 548(a)(1)(B) and 548(b) ..., the trustee may not avoid a transfer ... made by or to a financial institution ... in connection with a securities con' tract that is made before the commencement of the case, except under section 548(a)(1)(A) of this title. (21) The theory was that Valley View transferred funds to Citizens Bank, and Citizens Bank transferred funds to the shareholder. Since the Citizens transfer was a transfer "by ... a ... financial institution," the transaction was sheltered by the [section] 546(c) safe harbor and the shareholders were entitled to pocket the loot.

The Seventh Circuit reversed. (22) Bucking a plurality of launder-friendly appellate courts, (23) it proclaimed that the financial institutions (Credit Suisse and Citizens Bank) were "conduits." (24) That is, they were not transferees. Therefore, the shareholders were ineligible for the safe harbor of [section] 546(c).

In affirming the Seventh Circuit, Justice Sotomayor, writing for a unanimous Supreme Court, obliterated the safe harbor, but without using the legal fiction "mere conduit." According to Justice Sotomayor, Citizens Bank did not make a conveyance directly to the shareholders. Rather, Valley View did. Citizens accepted money from Valley View and was a transferee. As a result of the deposit, Citizens Bank owed a duty to Valley View to pay the shareholders. Citizens Bank's duty was to pay with Valley View property. Valley View directed Citizens Bank to pay the shareholders. This was the fraudulent transfer. The shareholders were the initial transferees of Valley View's property. To be sure, there was a transfer to Citizens Bank but never a fraudulent transfer (25) Nor did Citizens make a fraudulent transfer to the shareholders. Citizens was simply not part of the fraudulent transfer chain. The fraudulent transfer (Citizens Bank's duty to pay) traveled from Valley View directly to the shareholders. Therefore, [section] 546(e) did not apply.

The Supreme Court showed that property analysis is not so feeble as the "mere conduit" courts fear. We need not abandon the usual common sense definition of "transfer," if we think clearly about it. We need not cower beneath the false cloak of an unbelievable fiction that bank deposits are not transfers of funds to the bank. We can validate the intuition that a mediating bank is not part of the fraudulent transfer chain without resort to legal abracadabra.

The purpose of this article is to vindicate Justice Sotomayor's avoidance of the "mere conduit" fiction. Following the lead of the Supreme Court, "mere conduit" should be expelled from legal discourse. Instead, through the ancient tools of property analysis, we can vindicate intuition in a forthright manner. If this article is successful, courts...

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