In this case, the sole shareholder, director and president of a company (all the same Individual) transferred about $8,000,000 into a secret bank account which he then used to pay personal debts. The question before the Court was whether the transfers to the bank account made the Individual, in his personal capacity, an initial transferee within the meaning of § 550.
The surprising answer (although not stated in this way) is that it depends on whether the secret bank account was opened in the name of the company or individual. In this case, the secret account was completely under the dominion and control of the Individual; the Individual’s wife was a signatory on the account and the only purpose it served was to pay personal expenses. None of that mattered. The account was opened under the company’s name. The District Court held that the Individual was not an initial transferee since the account was a company account.
This is a big deal because it meant that 3rd parties who were paid from that account could not raise certain defenses, discussed below.
Under § 550(a) of the Bankruptcy Code, a trustee of the debtor may recover a fraudulent transfer of estate property from either “(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.”
The distinction between an “initial transferee” and a subsequent transferee is critical because the trustee’s right to recover from an initial transferee is absolute. A subsequent transferee, on the other hand, has a defense. A trustee may not recover from a subsequent transferee if “the subsequent transferee accepted the transfer for value, in good faith, and without knowledge of the transfer’s voidability.” 11 U.S.C. § 550(b)(1).
Since initial transferee is not defined by the code, Courts have created their own definitions. The major tests are the “dominion” test and the “control test.” According to the district court, the 9th Circuit has explicitly adopted the dominion test to the exclusion of the control test.
Under the dominion test, a transferee is one who has dominion over the money or other asset, i.e. the right to put the money to one’s own purposes. The test focuses on whether someone had legal authority over the money and the right to use the money however desired. The control test, on the other hand, takes a more gestalt view of the entire transaction to determine who, in reality, controlled the funds in question.
According to the district court, the control test shifts the risk too far towards creditors of the debtor because an unscrupulous insider could make an “initial transfer” to himself insolating any subsequent transfers. After analysis of 9th Circuit law, the court concluded: “As these cases demonstrate, a corporation’s principal who effects a transfer from the corporation in his representative capacity does not have dominion over those funds in his personal capacity, and therefore does not constitute an initial transferee of those funds under the Bankruptcy Code.”
Author’s comments: The analysis should turn on whether the transfer is to an intermediary/conduit to facilitate the transfer. Conduit / intermediary transfers should not be designated as “initial transferees” thereby shielding a subsequent transfer to the actual “initial transferee.” That is a fair reading of the code.
I do not think the analysis should be limited to either the “dominion” test, the “control test” or as some courts have applied it, the “dominion and control” test because if we assume clawback actions are fair, then why hinge the entire analysis on how title to the bank account was held? If the president of the company had transferred the funds from the initial, secret, company account to his own personal account and paid the defendant from that personal account, then the defendant here would have been shielded. That is too trivial of a distinction for me to be happy with.
Query: Should you advise your client, who is about to sell something to a wholly owned company, to have the company first transfer its funds into the company’s owner’s account before paying your client? The committee notes seem to indicate that this type of “washing” is not prohibited by the good faith requirement.
You can find the district court opinion here.