Freddie Fraudster wholly owns and operates Loser LLC, an operating business with significant cash flow. Unbeknownst to anyone, over the span of several years Freddie diverts more than $8 million in funds from Loser LLC’s business operations into a “secret” bank account he maintains at a separate Bank in the name of Loser LLC, but over which Freddie at all times holds exclusive discretion and control. Freddie uses the secret account as his personal piggy-bank, paying on going personal expenses such as: regular monthly mortgage payments to his Bank on his personal residence, utility and homeowner association payments regarding that same residence, funding a personal horseracing hobby, and hiring Sally Trueblood, a salt of the earth interior designer to whom Freddie paid approximately $230,000 over time—using checks from the “secret” Loser LLC account–as payment for legitimate interior design services provided by Sally in remodeling a building owned by Freddie personally. It was stipulated that Sally was referred to Freddie by another of her clients and did not know Freddie previously, that she had provided her design services to Freddie based a truly arms’ length transaction, that the value of the services she provided were consistent with the amounts paid, and that she had otherwise acted at all times in good faith with respect to Freddie and the services she provided to him without knowing anything about Freddie’s unrelated fraudulent activities.
As one might expect, Loser LLC suffered significant losses and filed for Chapter 7 Bankruptcy protection. Freddie went into hiding somewhere outside the country. A Chapter 7 Trustee was appointed to recover and liquidate Loser LLC’s assets for the benefit of its creditors, and Freddie’s scheme of diverting Loser LLC’s funds into the secret bank account for Freddie’s personal benefit, was uncovered. The Trustee then “sued the checkbook” for the secret account, filing more than 100 fraudulent transfer suits against virtually every recipient of any payment out of the “secret” account under Bankruptcy Code section 548(a)(1)(B), alleging that each recipient was strictly liable for the return of all payments from the secret account because they were the initial recipient of a constructive voidable transfer for which Loser LLC received no benefit or consideration.
Because Ms. Trueblood was obviously an “innocent” recipient of payments made via checks written on Freddie’s “secret” Loser LLC checking account, the parties chose to use the Trustee’s lawsuit against Ms. Trueblood as a “test case” to obtain a ruling on an affirmative defense that would be asserted by virtually each of the 100 “checkbook” defendants sued by the Trustee. Section 550(b) of the Bankruptcy Code provides that an otherwise avoidable fraudulent transfer may only be recovered from an “initial” transferee or the recipient of the benefits of the transfer, and cannot be recovered from a “mediate or subsequent” transferee if the subsequent transferee “takes for value, . . . in good faith, and without knowledge of the avoidability of the transfer avoided.
The Bankruptcy Court initially ruled in Ms. Trueblood’ s favor, holding that Freddie’s diversion of Loser LLC funds into the “secret” bank account over which he held “exclusive control,” was sufficient to render Freddie as the “initial” transferee of the diverted funds referenced in Section 550(b), thereby rendering Ms. Trueblood an innocent “subsequent” transferee entitled to avail herself of Section 550(b)’s good faith defense. On appeal, the US District Court initially, and the US Ninth Circuit Court of Appeals ultimately, disagreed, and ruled that the appropriate inquiry was to focus on who, at the time of the challenged transfer, had “dominion” over the funds being transferred, and defined such “dominion” as (essentially), “whether the recipient of funds has legal title to them.”
Following this logic, the Ninth Circuit reasoned that notwithstanding that Freddie’s “diversion” of Loser LLC’s operating revenues into a secret account over which he exercised exclusive control, because the “secret” account was at all times maintained in the name of Loser LLC (and not Freddie or another unrelated entity), Loser LLC all times retained “dominion” over the funds at issue, and Loser LLC could not, under any circumstances, be considered the “initial transferee” of its own funds for the purposes of Section 550(b). This led the Court to the inevitable conclusion that Ms. Trueblood (and virtually all of the other100+ “checkbook” defendants), was therefore (i) ineligible to assert the Section 550(b) good faith defense, and (ii) was strictly liable to the Chapter 7 Trustee for the return of all the payments she received from the secret account because the services she provided did not benefit Loser LLC.
The bottom-line lesson from this case is that form over substance matters in the Ninth Circuit. Because Freddie diverted Loser LLC’s operating funds into a “secret account” that remained in the name of Loser LLC, everyone who received a check written on the secret account for Freddie’s personal expenses was strictly liable for, and had no defense to, an avoidable transfer claim by Loser LLC’s Chapter 7 Trustee. Had Ms. Trueblood (or any of the other recipients) insisted on having Freddie pay her with a personal check or in cash—even if the initial origins of the funds used to cover any such payment was the very same “secret” Loser LLC account–Ms. Trueblood and those in her position would then have been deemed a “subsequent transferee” of the diverted funds entitled to the good faith defense of Section 550(b).
After issuing its ruling, the Ninth Circuit remanded the Trueblood case back to the Bankruptcy Court after striking Ms. Trueblood’s Section 550(b) good faith defense. The Bankruptcy Court then applied the Ninth Circuit’s logic in each of the other 100(+) avoidable transfer actions filed against every recipient of a payment from the secret account. Recoveries on this theory included recovery of payments made out of the secret account to, among other things, Las Vegas Casinos for Freddie’s personal gambling debts, monthly mortgage payments made on Freddie’s home loan, monthly utility payments and homeowner association dues paid regarding Freddie’s residence, payments made to the seller of real property to Freddie through an escrow agent, and other similar payments made by Freddie directly from the “secret” Loser LLC account for personal expenses. In each instance, had the recipient of any such payment insisted that Freddie make the payment with a personal check or cash, they would have been entitled to assert the Section 550(b) good faith defense, resulting in a limitation on the Chapter 7 Trustee’s recourse on those transactions solely to Freddie or to those who were involved in (or at least aware of) his diversion of funds.
- If a Borrower or customer is permitted to set up automatic monthly mortgage (or other) payments electronically, the Banker/Creditor should verify and make sure that the automatic payments are actually being made by the Borrower or Customer who owes the payment.
- To the extent possible, particularly when working with a small business owner, real estate developer or other entrepreneur who regularly conducts business through the use multiple entities and/or multiple bank accounts, make an effort to “match” the source of payments received, or to be received, to bank accounts or other funding sources to a party obligated for the loan. It should particularly be viewed as a red flag if checks are received from an unknown or seemingly unrelated small business entity who is not an obligor or guarantor of the obligation being repaid.
- Whenever a loan pay off, or property purchase resulting in a loan payoff, is taking place through a third-party escrow, endeavor to include instructions to escrow in the payoff demand that escrow is to determine, verify and advise you prior to closing as to the source of the funds being used to pay off the loan and/or purchase the property through said escrow. To the extent that the source of funding cannot be sufficiently tied to the beneficiary of the transaction, consult with legal counsel to determine whether there are unnecessary “form over substance” avoidable transfer risks in the transaction that can be minimized prior to escrow’s close.
 This article is drawn from the US Ninth Circuit Court of Appeals decision rendered on October 2, 2017 in: Henry v. Official Comm. Of Unsecured Creditors of Walldesign, Inc. (In re Walldesign, Inc.), 872 F.3d 954 (9th Cir. 2017). The names have been changed to protect the (not so) innocent.