Often and in various situations, bankruptcy professionals are called upon to hold funds in trust for their clients or other parties. Such situations typically arise in connection with the transfer of proceeds from sales, settlements and other transactions, but may result from other situations as well. When holding such funds, bankruptcy professionals act in a trustee capacity, possessing funds held in trust for another. In fact, even though legal title may have temporarily vested, it has done so only in trust for another.

Thus, as all bankruptcy professionals are aware, it is their duty to hold and protect such funds, the distribution of which directed by the terms of the trust relationship. When such distributions occur, the bankruptcy professional divests him/herself of legal title, and the trust relationship ends. And all are happy that the transaction ended in the desired result—at least, most of the time.

Other times, the original transferor may find itself insolvent and contemplating bankruptcy, or creditors of the transferor may assert that the transfer was fraudulent, whether because of the amount or the basis of the transaction itself. Nonetheless, both in and out of bankruptcy, statutes exist that address fraudulent transfers. In fact, most fraudulent transfer statutes allow the plaintiff to assert a cause of action against not only the final recipient of the funds, but also every entity that received such funds along the way. Thus, although multiple recoveries are not allowed, multiple defendants against whom recovery could be sought may exist. And bankruptcy professionals may find themselves caught in the middle, having been sued for a fraudulent transfer by virtue of receiving and subsequently transferring funds at the client's request.

The Avoidance of Fraudulent Transfers

Pursuant to the Bankruptcy Code, a trustee (or debtor-in-possession (DIP)) may avoid certain transfers including, but not limited to, preferential transfers under 11 U.S.C. §547 and fraudulent transfers under 11 U.S.C. §548. Meeting the factors set forth in §§547 and 548, however, are only half the inquiry. Assuming the appropriate factors are met, and a transfer is found preferential or fraudulent, the trustee may avoid the transfer and seek recovery of the property transferred from the initial transferee (the first entity that received the transfer) or any immediate or mediate transferee of the initial transferee (the second and/or subsequent person or entity that received the transfer). See 11 U.S.C. §550(a). As stated above, §550 entitles a trustee to a single satisfaction, regardless of the number of transferees. See 11 U.S.C. §550(d). Since the Bankruptcy Code fails to define "transferee," whether initial, mediate or immediate, courts have developed tests to determine what constitutes a transferee, including the "dominion and control test." See Bonded Financial Services Inc. v. European American Bank, 838 F.2d 890, 893 (7th Cir. 1988); In re Chase & Sanborn Corp., 848 F.2d 1196, 1199 (11th Cir. 1988); In re Columbia Data Products Inc., 892 F.2d 26, 29 (4th Cir. 1989); In re Bullion Reserve of North America, 922 F.2d 544, 549 (9th Cir. 1991); In re Baker & Getty Financial Services Inc., 974 F.2d 712, 722 (6th Cir. 1992). Dominion over funds means the right to put the money to one's own use. See Bonded, 838 F.2d at 893. Otherwise, the intermediary party is not an initial transferee because it holds the funds "only for the purpose of fulfilling an instruction to make the funds available to someone else." Id. And the simple fact that the intermediary could have violated its duties and spent the funds as it pleased does not change the analysis. See In re Baker & Getty Financial Services Inc., 974 F.2d 712, 722 (6th Cir. 1992).

Indeed, dominion and control refer to legal, as opposed to mere physical, possession of the property transferred. See In re Anton Noll Inc., 277 B.R. 875 (BAP 1st Cir. 2002); citing Bowers v. Atlanta Motor Speedway, 99 F.3d 151, 156 (4th Cir. 1996). Thus, under the dominion and control test, a party receiving a transfer directly from the debtor is not an initial transferee if that party does not gain actual dominion or control over the funds. In re Coutee, 984 F.2d 138, 140-41 (5th Cir. 1993). Using the dominion and control test, at least one court has examined a law firm's liability and status as an initial transferee under §550. See In re Fabric Buys of Jericho Inc., 33 B.R. 334 (Bankr. S.D.N.Y. 1983).

Jericho and Liability for Professionals When Acting as a Trustee

In Jericho, a plaintiff was represented by a law firm who filed suit against the debtor for breach of contract. The lawsuit was settled by the parties, resulting in a transfer by the debtor to the plaintiff's law firm. Upon depositing the transfer into its escrow account, the law firm then transferred the funds from the escrow account, for the amount of the settlement, to the plaintiff, who deposited such funds into his personal account. Subsequently, the debtor filed for bankruptcy, and sought to avoid the transfer of the settlement funds as a preferential transfer and recover the amount of the transfer from both the law firm and the plaintiff, asserting both were transferees under §550.

The U.S. Bankruptcy Court for the Southern District of New York applied the dominion and control test and determined that the law firm acted as a mere conduit of the transferred funds, as the business dealings giving rise to the settled lawsuit were strictly between the plaintiff and debtor. Jericho, 33 B.R. at 337. "That such amount was funneled through the escrow account does not make [the plaintiff's] lawyer an initial transferee." Id. The court further explained that the policy behind §550 was to avoid a transferees' ability to "hide" avoidable transfers by transferring them around to different entities to avoid their recovery. Id. Interestingly enough, the court further stated that "even if the [law] firm were deemed an initial transferee, the circumstances of this case, as stated above, would permit this court to exercise its equitable discretion and prevent the trustee from recovering a preference from the [law] firm." Id.

This decision by the Southern District of New York must be tempered with the rationale of the District Court for the Eastern District of Tennessee, which found that another law firm in a similar situation was an initial transferee due to its "bad faith." In re Southern Industrial Banking Corp., 126 B.R. 294 (E.D. Tenn. 1991). Specifically, the court held that the law firm did not accept the funds in good faith and held the law firm liable as an initial transferee. Id. at 300-01. Southern Industrial was decided prior to Baker & Getty Financial Services, and therefore its holding is now questionable.

Further, the reasoning of Southern Industrial is inapposite of Jericho, as it applied the safe-harbor provisions of §550(b). Jericho, on the other hand, did not examine the issue of good or bad faith, as §550(a) does not include a good-faith requirement. In fact, while §550(b) has a good-faith factor, §550(b) is meant to protect those transferees who receive a transfer for value in good faith and without knowledge of the avoidability of the transfer. This is a different determination from the dominion and control test, as the dominion and control test examines whether or not a defendant is an initial transferee in the first place.

Thus, Jericho did not examine good or bad faith, and correctly focused on whether the alleged initial transferee obtained dominion and control over the property transferred or was a mere conduit for the settlement transaction. Indeed, good faith is inconsequential, as the law firm was never a transferee as that term is used in §550. Jericho, 33 B.R. at 337.

Conclusion

Based on the dominion and control test, a bankruptcy professional, or other intermediary, should not be considered an "initial transferee" under §550(a) when it receives and holds funds in trust for another party. Otherwise, any bank, trust, escrow agent or other such entity could be held liable for receiving a transfer that it received only for a third party. And if that were the law, no party would agree to participate in such an arrangement, as every such arrangement would carry potential exposure under chapter 5 of the Bankruptcy Code. Stated otherwise, courts should not take "transferee" for all it could be worth rather than for what a sensible policy implies it is worth. See Bonded, 838 F.2d at 895.