Chapter 6 NON-STATUTORY DEFENSES

• Jurisdiction: United States

Chapter 6 NON-STATUTORY DEFENSES

In addition to the defenses set forth in § 547(c) of the Bankruptcy Code, a defendant may assert various defenses arising out of state law, developing bankruptcy law or express liability exemptions provided under federal non-bankruptcy statutes. The nature of these varied and less-than-uniform defenses is such that case law is not available in all circuits. Nonetheless, consideration of the following cases, combined with the absence of case law in the reader's jurisdiction, may provide the foundation for a creative defense.

A. Conduit vs. "Initial Transferee"

A bankruptcy trustee has broad powers under the Bankruptcy Code to avoid certain transfers of property made by the debtor prior to the filing of a bankruptcy petition. Under § 550(a) of the Bankruptcy Code, 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 the initial transferee of such transfer or the entity for whose benefit such transfer was made." The Bankruptcy Code does not define "initial transferee." Although several courts have held that the owner of the first set of hands to touch the property is the initial transferee, those courts then look to exercise their equitable powers to excuse innocent and casual "initial transferees" from responsibility under § 550(a).¹⁸⁷

The majority of the circuits appear to follow the analysis found in Bonded Financial Services Inc. v. European American Bank.¹⁸⁸ The Seventh Circuit explained that the "minimum requirement of status as a 'transferee' is dominion over the money or other asset, the right to put the money to one's own purposes. When A gives a check to B as agent for C, then C is the 'initial transferee' and the agent may be disregarded."¹⁸⁹ Many of the cases that follow are in the context of trustees attempting to avoid fraudulent transfers; however, the conduit defense may also be used to defend against a preference, as the "conduit" does not actually receive the transfer in the sense that it is not receiving the funds for its benefit under § 547(b).

Second Circuit

1. Christy v. Alexander & Alexander of New York Inc. (In re Finley, Kumble, Wagner, Heine Underberg, Manley, Myerson & Casey), 130 F.3d 52 (2d Cir. 1997).

The Second Circuit affirmed the district court in granting an insurance broker's motion for summary judgment that the payment received was received as a "mere conduit" and that the broker was not the "initial transferee." Summary judgment was appropriate because the insurance broker did not exercise dominion or control over the funds paid by the debtor law firm to the broker for the purchase of a discovery tale for its existing malpractice policy.

Fourth Circuit

1. Lowry v. Security Pacific Business Credit Inc. (In re Columbia Data Products Inc.), 892 F.2d 26 (4th Cir. 1989).

The Fourth Circuit affirmed the district court, which had affirmed the bankruptcy court's grant of summary judgment in favor of the secured creditors. Logan was a creditor of the debtor. Logan was also a party to a revolving credit note with Security Pacific. Under the note, Logan was required to deposit all of its receivables in a special depository account at United Jersey Bank. Once United Jersey received the funds, it was to transfer the funds by wire to Security Pacific. The debtor entered into a standby extension agreement with several of its creditors, including Logan, under which a committee received the payments from the debtor and redistributed the funds to the debtor's creditors. Several of those payments went to Logan through the account at United Jersey and subsequently were transferred to Security Pacific. The trustee sought to recover the transfers from Security Pacific. Security Pacific filed a motion for summary judgment, stating that it was not the initial transferee. The circuit court held that "a party cannot be an initial transferee if he is a mere conduit for the party who had a direct business relationship with the debtor."¹⁹⁰ In this case, the committee received funds from the debtor and transferred them to the various creditors of the debtor. The committee was a conduit. Although the trustee argued that Security Pacific was the initial transferee, the court followed Bonded Financial Services in that a "subsequent transferee cannot be the 'entity for whose benefit' the original transfer was made."¹⁹¹ Although Logan used the funds to pay its secured creditor, this was just an example of Logan exercising dominion over the funds. Thus, Pacific Security was not the initial transferee, and the trustee could not recover the transfer from it.

2. ZVI Guttman v. Construction Program Grp. (In re Railworks Corp.), 760 F.3d 398 (4th Cir. 2014).

The court of appeals reversed the district court, which had reversed the bankruptcy court, which had granted summary judgment in favor of Construction Program Group (CPG), thereby precluding the trustee from holding CPG liable for having received preference payments under §§ 547 and 550.

CPG was the general underwriter for TIG Insurance Co. (TIG). CPG was to collect, receive and account for premiums on issued insurance policies. CPG was liable to TIG for all net premiums, regardless of whether or not CPG had been able to collect those premiums from the insureds. Further, the premiums actually collected by CPG became the property of TIG, held by CPG in trust for TIG in a fiduciary capacity. CPG was required to segregate the premiums from its other funds.

The chapter 11 litigation trustee sued CPG to avoid and recover insurance payments that the debtor had made to it during the preference period.

Relying on its own precedent, the court of appeals noted that for CPG to be liable as an initial transferee under § 550, (1) CPG needed to have legal dominion and control over the property — the right to use the property for its own purposes — and (2) it needed to exercise this legal dominion and control. It then noted that a party cannot be an initial transferee if the party is a mere conduit for the party with a direct business relationship with the debtor.

Further, in order for CPG to have been liable as the entity for whose benefit the transfer was made, it must have been a guarantor or debtor: someone who receives the benefit but not the money.

He argument that the trustee made, and that the district court accepted, was that CPG had the status of both (1) a mere conduit and (2) the entity for whose benefit the transfer was made. He court of appeals disagreed, ruling that a party who is a mere conduit can never be the entity for whose benefit a transfer is made, much as a party who is a mere conduit can never be the initial transferee of a transfer.

CPG was a mere conduit because CPG held insurance premiums (including those paid by the debtor) in trust for TIG. CPG, while having physical dominion over the premiums, had no right (as against TIG) to put the premiums to its own use.

He trustee pointed to the part of the agreement between CPG and TIG making CPG liable to TIG for premiums even if CPG did not collect those premiums from the insureds. He trustee argued that this made CPG a contingent creditor of the debtor: If the debtor did not pay its premiums, CPG would have to pay TIG and then would have a claim back over against the debtor for the premiums that CPG had paid to TIG. Hus, when the debtor actually paid the premiums to CPG during the preference period, and when CPG then remitted those funds to TIG, CPG was benefitting from the debtor's transfer because CPG's liability to TIG was being extinguished by CPG's remittance to TIG of the funds transferred to it by the debtor.

The court of appeals rejected this reasoning, noting that every conduit has, by definition, an obligation to pass the funds received by the conduit onto some third party; the conduit is always contingently liable to the third party if it fails to pass on the funds (because there is an obligation to pass on the funds and not put them to the conduit's own use). If the district court's reasoning were adopted, a mere conduit could never be a mere conduit, because it would always be liable under § 550 as the entity for whose benefit the transfer was made. The court declined to eviscerate the mere-conduit defense under § 550. Simply put, according to the court, if one is demon-strably a mere conduit, one cannot be, as a matter of law, the entity for whose benefit the transfer was made.

Fifth Circuit

1. Cullen Center Bank & Trust v. Hensley (In re Criswell), 102 F.3d 1411 (5th Cir. 1997).

The Fifth Circuit reversed the district court and remanded the case with instructions. The chapter 7 trustee brought a preference action against a creditor who had recorded a judicial lien against the debtor during the 90 days prior to the petition date. The appellate court concluded that the recording of a judicial lien constituted a preference in this case, but the creditor asserted that even if the judicial lien were a preference, the creditor was a subsequent and good-faith transferee for value. The creditor argued this position because, subsequent to the recording of the judicial lien, the chapter 7 trustee resolved litigation with the debtor whereby the debtor's prior transfer of oil and gas properties to a trust was returned to the debtor's bankruptcy estate. In other words, at the time the judicial lien was recorded, it did not attach to these mineral rights until the trustee brought the mineral rights back into the bankruptcy estate.

He trustee argued that the creditor was an initial transferee by virtue of its judicial lien that attached to an interest of the debtor's property. He lien constituted a transfer from the debtor whose interest became subject to the creditor's lien rights. He encumbering of the lien rights was, therefore, inescapably an initial transfer, and the creditor was an initial transferee. He court agreed with this argument, finding that the debtor retained an...