Posts

The Diaz case (In re Diaz, 547 B.R. 329, 9th Cir. BAP), has not received enough love but I find it to be too fascinating not to write about because of its potential for so much advantage!

There were essentially two holdings in the case:

  1. The California homestead exemption contains a “residence” requirement which includes an “intent” component; and
  2. The burden is on the Debtor to prove intent.

The intent component of the residence requirement requires that debtors have a bona fide intention to make the premises their home or residence.

Read more

9th Circuit Applies California Law to Contract Where Parties Agreed to Apply Georgian Law

The basic facts of the case are an individual entered into an agreement with a bank located in Georgia to borrow money to purchase her home. It is not clear whether the individual even signed the contract or where the contract was signed but it ends up not mattering because the bank sued in California District Court under diversity jurisdiction. Note: in California, if a contract contains an attorney fees clause provision, both sides of the dispute get to use it. That’s not the law in Georgia. The Bank wanted to be able to enforce its attorney fee clause against litigants but to not allow other litigants to use that clause against the bank!

California law was applied to this contract in two instances.

First, the choice of law clause had to be interpreted. It would be circular logic to apply the choice of law clause in determining which states’ laws applied to the choice of law clause. The Court held that in diversity jurisdiction cases, such as this one, it would “apply the substantive law of the forum in which the court is located, including the forum’s choice of law rules.” Since the lawsuit was in California, California’s choice of law clause applied to the case.

California follows restatement second of Conflict of Laws § 187 to determine the law that applies to a contract with a choice-of-law clause. Under § 187, a California court begins its analysis by determining “whether the chosen state has a substantial relationship to the parties or their transaction, or … whether there is any other reasonable basis for the parties’ choice of law. If so, the court then determines whether California would “be the state of the applicable law in the absence of an effective choice of law by the parties.” If the chosen forum has a substantial relationship to the parties or their transaction but California law would apply in the absence of a choice-of-law provision, the court then determines whether the relevant portion of the chosen state’s law is contrary to a fundamental policy in California law.

If there is such a conflict, the court finally determines whether California has a materially greater interest than the chosen state in the determination of the particular issue.

Since California’s Supreme Court has yet to rule on the matter, the 9th Circuit had to predict whether California’s reciprocity law, § 1717, embodies a fundamental policy of the state. The 9th Circuit decided it did and thereby affirmed the lower court’s decision to award attorney fees to the individual.

The case can be found here.

Pop Quiz! How Long After Entry Of Order Confirming A Plan Can The Order Be Revoked? Hint: It’s Not What You Thought!

If an order confirming a Plan of Reorganization is procured by fraud, how many days from entry of order does one have to ask the court to revoke the order?

The answer depends on which chapter of the Bankruptcy Code we’re talking about! In a Chapter 12 or Chapter 13 case, one would have up to the 180th day after the date the order was entered to seek revocation of the discharge. In a Chapter 11 case, one would have up to the 179th day after the date the order was entered to seek revocation. That is a pretty tough lesson to learn the hard way.

The District Court’s decision affirming Judge Ahart can be found here.

The basis of the decision was statutory analysis, compare §§ 1230 and 1330 with § 1144:

§ 1144 “On request of a party in interest at any time before 180 days after the date of the entry of the order of confirmation…”

§ 1230 “On request of a party in interest at any time within 180 days after the date of the entry of an order of confirmation…”

§ 1330 “On request of a party in interest at any time within 180 days after the date of the entry of an order of confirmation…”

Congress apparently intended confirmation orders in Chapter 12 and 13 cases to be revocable if revocation was sought within 180 days but reduced that time by 1 day for Chapter 11 cases.

My first thought was, why not seek revocation of the order under FRCP Rule 60(b)(3) which provides that

“On motion and just terms, the court may relieve a party or its legal representative from a final judgment, order, or proceeding for the following reasons … (3) fraud (whether previously called intrinsic or extrinsic), misrepresentation, or misconduct by an opposing party;”

The time limit under §60(b)(3) is a year:

“A motion under Rule 60(b) must be made within a reasonable time—and for reasons (1), (2), and (3) no more than a year after the entry of the judgment or order or the date of the proceeding.”

But the problem is FRBP 9024 overrides FRCP Rule 60:

“Rule 60 F.R.Civ.P. applies in cases under the Code except that …  (3) a complaint to revoke an order confirming a plan may be filed only within the time allowed by §1144,…”

In turn, FRBP 9024 is protected by FRBP 9006 which explicitly prohibits the Court from extending the time period in FRBP 9024:

“(2) Enlargement Not Permitted. The court may not enlarge the time for taking action under Rules … 9024.”

So what can be done? The Court may allow a party to seek damages caused by the fraud so long as any such award of damages is not an end run around confirmation of the plan.  The plan itself may contain provisions which allow the aggrieved party to obtain some sort of relief.

If any of you have alternate suggestions, please leave a note in the comment box.

As an aside:
The original case and adversary proceeding are: 1:13-bk-11804 | Amber Hotel Corporation; 1:14-ap-01113 | Little v. Amber Hotel Corporation.

It is a shame considering how good the Plaintiff writes, I LOVE a good statement of facts,

On the night of March 24, 2008, Mr. Martini was told by Mr. Post to drive to Malibu to meet Mr. Post in the middle of the night, at a time when there would be no other “witnesses.” When Mr. Martini arrived at Mr. Post’s offices, all the lights were off and Mr. Martini was directed to enter the premises from the rear of the building. Upon doing so, he found Mr. Post sitting in a darkened room lit by a solitary light. Mr. Post handed Mr. Martini several bundles of hundred dollar bills, totaling $100,000. Mr. Post told Mr. Martini that he could never mention this payment to Plaintiff, because—if he did—he was certain that Plaintiff would sue him.

Sometimes Complete Disclosure, Disinterestedness and an Approved Employment Application are Not Good Enough!

On August 24, 2015, Judge Lee, a Bankruptcy Judge in the Eastern District of California, disqualified the Estate’s general bankruptcy counsel even though counsel was properly employed under § 327(a). The Court found that counsel was a disinterested person within the meaning of the code and did not hold or represent an interest adverse to the estate. This is a wild (but proper) result because under California law, a client’s waiver or consent can cure these types of deficiencies and under Bankruptcy law, those defects cannot be cured!

So how is it that under Bankruptcy law, counsel was properly employed but had to be disqualified under California law?

California Rules of Professional Conduct (“State Rule”) § 3-310(E), relates to the representation of adverse interests and states:

“A member shall not, without the informed written consent of the client or former client, accept employment adverse to the client or former client where, by reason of the representation of the client or former client, the member has obtained confidential information material to the employment.”

The analysis under State Rule 3-310(E) in the bankruptcy context was addressed by Judge Bufford in In re Muscle Improvement, Inc., 437 B.R. 389 (Bankr. C.D. Cal. 2010). In that case, the subject attorney consulted twice with the prospective debtors regarding the filing of a bankruptcy petition, but she was not retained to do so. She then undertook the representation of the debtors’ primary creditor after the petition was filed by another attorney. Although the debtors had not retained the attorney, the debtors successfully disqualified that attorney from representing the adverse creditor because there was a “substantial relationship” between the debtors’ consultation with the attorney and the attorney’s subsequent representation of the creditor. That “substantial relationship” created an IRREBUTTABLE PRESUMPTION that confidential information had been divulged and, therefore, in light of the debtors’ objection, the attorney could not represent the party with adverse interests.

The public policy at issue here was explained in the Ninth Circuit case, Trone v. Smith, 621 F.2d 994 (9th Cir. 1980).

The interest to be preserved by preventing attorneys from accepting representation adverse to a former client is the protection and enhancement of the professional relationship in all its dimensions. . . . These Objectives require a rule that prevents attorneys from accepting representation adverse to a former client if the later case bears a substantial connection to the earlier one. Substantiality is present if the factual contexts of the two representations are similar or related.

Id. at 998

In the Ninth Circuit the relevant test for disqualification is whether the former “representation” (here, consultation) is “substantially related” to the current representation of Charlotte and her bankruptcy estate. In the course of the consultation, it does not matter whether or not confidential information has actually been exchanged.

[I]t is immaterial whether [the attorney] actually obtained confidential information in the course of her meeting with debtors’ agents. The two dispositive issues are whether the subject matter of their meetings is substantially related to the subject matter of this case and whether [the attorney’s] relationship with debtors was one in which confidential information would ordinarily be disclosed.

Muscle Improvement, Inc., 437 B.R. at 396.

The rule is necessary to, inter alia, implement canons of professional ethics:

Canon 1 (maintaining integrity and confidence in the legal profession);
Canon 4 (preserving confidences and secrets of a client);
Canon 5 (exercise of independent professional judgment);
Canon 6 (representing a client competently);
Canon 7 (representing a client zealously within bounds 61 the law);
Canon 9 (avoiding even the appearance of professional impropriety).

The court must consider whether the attorney was in a situation where the attorney was likely to receive confidential information. However, the court may not inquire as to that information, which would require disclosure of the very confidential information that is being protected. Instead, the “substantial relationship” test is used as a substitute.

Where there is a “substantial relationship” between the consultation with a potential client, and the subsequent representation of an adverse client, an irrebuttable presumption arises that confidential information has been exchanged and disqualification of the attorney is mandatory.

The case can be found here.

Fair Use is a Defense to DMCA Takedown Notices and Could Subject Copyright Holders to Attorney Fees

The Digital Millennium Copyright Act provides a potent mechanism for copyright owners to demand that certain copyrighted materials be taken off of websites. This is because online services providers are given immunity from liability as long as they “expeditiously” remove content after receiving notification from a copyright holder that the
content is infringing.

The idea behind giving service providers immunity is rooted in the idea that if all the service provider is dong is allowing people to post content, then the content poster, and not the provider, should be liable for the copyright violation. That makes sense. Service providers like YouTube would go out of business if they were held liable for all the copyrighted videos posted on there.

The process requires the copyright holder to send a notice to the service provider which essentially identifies the infringement and provides a statement that the copyright holder believes in good faith the infringing material “is not authorized by the copyright owner, its agent, or the law. This is often referred to as a “takedown” notice.

The alleged copyright infringer then can restore the content by sending the service provider something referred to as a “put-back” notice. At that point, the service provider will restore access to the allegedly copyrighted material unless a lawsuit is filed within 14 days against the alleged infringer.

Here is the catch. Violating a copyright has some severe consequences so accidentally filing a takedown notice carries reciprocal consequences. If the copyright holder made a mistake either in identifying the alleged violation or in assuming the content was an infringement, they are hit with the following:

“…shall be liable for any damages, including costs and attorneys’ fees, incurred by the alleged infringer, by any copyright owner or copyright owner’s authorized licensee, or by a service provider, who is injured by such misrepresentation, as the result of the service provider relying upon such misrepresentation in removing or disabling access to the material or activity claimed to be infringing, or in replacing the removed material or ceasing to disable access to it.” 11 U.S.C. 512(f).

Fair use is an exception to copyright infringement. So what happens when the alleged violation is fair use? On September 14, 2015, in Lenz v. Universal Music Corp., the 9th Circuit Court of appeals made it clear that the copyright owner must be certain that it does not issue a takedown notice in situations where the alleged infringement is allowed due to fair use.

The Court also took it a step further. Typically, a copyright holder need only form a subjective good faith belief that a use is not authorized but the Court allowed for a “willful blindness theory” which means that if the copyright owner fails to consider fair use, one way, or another, then under the willful blindness theory, it could never have formed a subjective belief and is therefore, liable under the statute. The actual test is:

(1) the defendant must subjectively believe that there is a high probability that a fact exists and
(2) the defendant must take deliberate actions to avoid learning of that fact.

You can find a copy of the 9th Circuit decision here.

Landlords Are Entitled To Priority Treatment of Lease Payments Which First Come Due During the Gap Period of an Involuntary Bankruptcy

In a case of first impression, Judge Montali had to decide whether a landlord’s claim for payment of rent during the gap period of an involuntary bankruptcy is entitled to priority.

Before delving into the facts of the case, a quick primer is appropriate. The treatment of a commercial landlord’s claims in bankruptcy is too complicated and will be discussed in more depth in a future article so this “quick primer” is very limited.

When a company files for bankruptcy, the landlord in a nonresidential context is usually the most powerful player in the scene. The landlord is entitled to be paid contract rate lease payments until the Debtor decides to either reject or assume the lease. This is provided for under § 365(d)(3) which states that “The trustee shall timely perform all the obligations of the debtor … arising from and after the order for relief under any unexpired lease of nonresidential real property … until such lease is assumed or rejected, notwithstanding section 503 (b)(1) of this title….”

That last bit, the “notwithstanding section 503 (b)(1)” portion means that the landlord is entitled to payment until the lease is rejected; even if it is not an actual, necessary cost or expenses of preserving the estate. Not only is the landlord entitled to an administrative claim, but the payments must commence immediately (for the most part).

Howrey LLP was a global law firm that practiced antitrust, global litigation and intellectual property law. At its peak Howrey had more than 700 attorneys in 17 locations worldwide. In early 2011, Howrey began to wind down its business and was hit with a petition for an involuntary Chapter 7 petition. For simplicity, we are going to assume the case was never a Chapter 7 case; meaning it went from an involuntary Chapter 7 to a voluntary Chapter 11.

 

Section 502(f) states that “In an involuntary case, a claim arising in the ordinary course of the debtor’s business or financial affairs after the commencement of the case but before the earlier of the appointment of a trustee and the order for relief shall be determined as of the date such claim arises, and shall be allowed … the same as if such claim had arisen before the date of the filing of the petition.”

Furthermore, even though the claim is an unsecured prepetition claim, it is entitled to priority under § 507(a)(3): “(3) Third, unsecured claims allowed under section 502 (f) of this title.”

The creditors’ committee and Chapter 11 Trustee argued that the landlord’s claims did not fall under § 502(f) because § 502(f) “only applies to claims arising in the ordinary course of a debtor’s business or financial affairs after the commencement of the case.” The court rejected this argument for several reasons including that the code was designed to protect landlords and that the landlord’s claim arose during the gap period and not when the lease was signed.

The creditors’ committee also argued that § 502(g)(1) applied to this situation. That argument was summarily dismissed because § 502(g)(1) applies to rejected leases; the leases were not rejected during the gap period.

Most surprising was the Court’s relatively short discussion on whether the landlord’s claims were incurred during the ordinary course of Debtor’s business.  The creditors’ committee argued that since the Debtor was winding down its business, the rents were no longer in the ordinary course of the Debtor’s business. In rejecting that argument, the Court took the position that “the focus is on the circumstances under which the right to payment of current rent “arises”, which is when the occupancy continues, when the status quo vis-a-vis the Landlords continues.”

The result is fair but I am not sure whether it is technically correct. I would have expected a more detailed vertical and horizontal dimension analysis. Assuming no bankruptcy, would creditors or even the landlord expect the Debtor to stay current on rent? If not, why is this payment ordinary course?

You can find the case here.

Bankruptcy Judges Might Not Be Able to Remand Removed Cases!

This is a dangerous article to write but I am hoping the comments will be worth it.

So the Wellness case came out and the Supreme Court seems to have taken a pragmatic view by allowing parties to consent (implied or explicit) to the jurisdiction of bankruptcy courts. Fine. But is there more to this story?

The Court believed the central question that must be answered was “whether allowing bankruptcy courts to decide Stern claims by consent would ‘impermissibly threate[n] the institutional integrity of the Judicial Branch.’ Schor, 478 U. S., at 851.”

The court then concluded that allowing parties to consent to adjudication of Stern claims does not usurp the constitutional prerogatives of Article III courts for several reasons:

  1. Bankruptcy judges, like magistrate judges, “are appointed and subject to removal by Article III judges;”
  2. They “serve as judicial officers of the United States district court;” and
  3. collectively “constitute a unit of the district court” for that district.

But I wanted to quote this language in particular:

“Furthermore, like the CFTC in Schor, bankruptcy courts possess no free-floating authority to decide claims traditionally heard by Article III courts. Their ability to resolve such matters is limited to “a narrow class of common law claims as an incident to the [bankruptcy courts’] primary, and unchallenged, adjudicative function.” Id., at 854. “In such circumstances, the magnitude of any intrusion on the Judicial Branch can only be termed de minimis.” Id., at 856.”

It seems to indicate that since the magnitude of the intrusion is de minimis, waiver is okay.

But what if the Bankruptcy Court enters an order divesting the District Court of jurisdiction? Can it do that?

On June 8, 2015, in Flam v. Flam, the US Court of Appeals for the Ninth Circuit joined other sister circuits in holding that a motion to remand is a dispositive motion and that it is beyond the scope of a magistrate judge’s authority to issue a remand order under 28 U.S.C. § 1447(c) . You can find the case here.

In Flam, the Court focused on the fact that an order granting remand is final and not subject to review by the District Court. 28 U.S.C. § 1447(d). It conclusively takes away the litigant’s right to federal courts, as was previously held, the effect of a remand order is to end all federal proceedings.

A Bankruptcy Court’s order granting remand is also final and not subject to review by the District Court. 28 U.S.C. § 1334(d). It conclusively takes away the litigant’s right to federal courts. In effect, a Bankruptcy Court’s order has the effect of ending all federal proceedings. This is certainly not de minimis.

So why can a bankruptcy judge do it when a magistrate can’t?

Not All Expenses Of A Professional May Be Compensable By The Estate, Even In The Face Of A Clear Retainer Agreement And An Approved Employment Application!

The facts of the situation are not in dispute. The Debtor in a Chapter 11 case needed to hire a forensic accountant. The Debtor applied for permission to hire the accountant under § 327(a) of the Bankruptcy Code. The employment application did not contain any special provisions but the engagement letter contained the following clause:

In the event we are requested or authorized by Debtor or are required by government regulation, subpoena, court order, or other legal process to produce our documents or our personnel as witnesses with respect to our engagements for Debtor, Debtor will, so long as we are not a party to the proceeding in which the information is sought, reimburse us for our professional time and expenses, as well as the fees and expenses of our counsel, incurred in responding to such requests.

No objection to employment was filed and the Court entered an order approving the application.

Flash forward and after the forensic accountant had finished preparing its report, the Bank decided to subpoena and depose the accountant.  Debtor’s counsel refused to defend the accountant so the accountant was forced to hire an attorney for the deposition. The attorney cost the accountant about $8,000.

The Court did not allow the expense. It reasoned that under § 330(a)(1)(B) only reimbursement of actual, necessary expenses would be allowed. Under the standard articulated by the court, only those expenses necessary to accomplish the task the professional is hired to accomplish are compensable. The Court’s reason was that Without such a limitation, potentially, whenever a bankruptcy court-approved professional deems it necessary to employ another professional to protect its interests in the bankruptcy case, that cost would be taxed to the bankruptcy estate, effectively negating the Code’s regimen requiring prior notice to other interested parties, and the necessary scrutiny by the court, before committing the limited resources of the bankruptcy estate to the payment of professional compensation.

Author’s comments: The case noted a split of authority in the Southern District of New York and no binding law in the 9th Circuit which necessarily means there is a lot more room to litigate this matter.

The Court focused on the fact that the retainer agreement contained a clause which would allow the accountant to be paid by the debtor but focused on the fact that the employment application itself did not contain the language or allude to it. One workaround for this rule may be to clearly articulate any special clauses for attorney fees inside the application to employ the professional.

In my experience as debtor’s counsel, most professionals rely on me to obtain court approval of their employment. At the same time, my duty is to the Estate. So what am I supposed to do?

You can find the full case here.

Lawyers Cannot Be Held Liable For Malpractice If The Bad Advice They Give Leads To A Result That Was Not Foreseeable

For those of you who do not like analysis: lawyers cannot be held liable for malpractice if the bad advice they give leads to a result that was not foreseeable. In the case summary below, the client was given bad advice which led to her being prosecuted for forgery. Under the particular facts of the case, forgery was a legal impossibility, so the court found that the lawyer’s bad advice (to forge a signature) did not have a causal connection to the crime the client was charged with.

Those of us who are lawyers remember the Palsgraf case written by Cardozo. Guard pushes man onto train. Fireworks drop from man’s hands. The fireworks cause commotion. The commotion causes a scale on the other side of the train station to fall onto a lady. Lady sues train station. Result: lady loses lawsuit!

I did not understand it back then but I do now. There is “causation” and there is “legal causation.” In other words, almost any bad act can be traced to a series of events. But for any of those events, the bad act would not have happened. So are all those people responsible?

For example: A stranger is born. Twenty years later, I see him on the highway and give him a ride to your house, just in time, because you were just about to leave the city. The guy stabs you. Now, you can sue the guy for the harm he caused but can you sue me? But for me, he would not have made it in time. What about the stranger’s mom? But for her giving birth to him, this would not have happened! So the law has to put a stop somewhere and that is the root of “legal causation.”

The details.

To sue an attorney for legal malpractice, you have to show four things:

(1) the duty of the attorney to use such skill, prudence, and diligence as members of his or her profession commonly possess and exercise;
(2) a breach of that duty;
(3) a proximate causal connection between the breach and the resulting injury; and
(4) actual loss or damage resulting from the attorney’s negligence.

This article/case brief is about the 3rd element: proximate causal connection between the breach and the resulting injury.

When poor legal advice results in litigation that could have been avoided, that is surprisingly not enough to sue your lawyer. That’s just “but for” causation. You need to show that the advice was the proximate cause of the litigation! This means you have to find a causal connection between your lawyer’s breach of his duty and the injury you’ve suffered.

The fact pattern is as follows: A client comes into your office with a problem. The problem is she is the true owner of a bank account which hasn’t been used in ages. The account is in the name of her now dead husband and two former partners who disclaim any interest in the account. Your client accidentally deposited $36,000 into the account and needs the money ASAP!

The proper advice would be to update the account card so your client would be the proper signatory, but that slipped your mind. Instead, you told her to forge a check in her own name as if one of the named account holders had signed it. Malpractice? What is she is later prosecuted for forgery!?

First, we have to know more about writing checks (my apologies). The negotiation of a check is a matter of private contract between a financial institution and a depositor. A check is a signed instrument by which the depositor (the drawer) instructs the financial institution (the drawee) to transfer the depositor’s funds to a check bearer in accordance with the account agreement.

In summary, an instrument is a “note” if it is a promise to pay and a “draft” if it is an order to pay. A check then, is a draft payable on demand and drawn on a bank. The purpose of a signature on a check is to authorize and obligate the financial institution to pay out the funds in accordance with the depositor’s prior instructions.

Here is the catch, even though the prior instructions state which signatures must be accepted, under the California Commercial Code, a valid signature may be made by penning “any name, including a trade or assumed name, or by a word mark, or symbol” so long as the signer intends to effectuate a transaction.

So when your client signed the check, she impersonated the named owners. This is not a crime but a breach of the agreement with the bank! To make “imposter” a crime, there must be an intent to defraud. Since your client owns the account, it’s impossible for her to defraud anyone with the transaction just described!

Consequently, there is no way you could have predicted she would be charged for forgery.

California has adopted the substantial factor test set forth in the Restatement Second of Torts, section 431. This means the conduct is a legal cause of harm if it is a substantial factor in bringing about the harm. This happens when the conduct is recognizable as having an appreciable effect in bringing about the harm.

Courts have found that the link between the conduct and harm suffered is closely related to foreseeability in the inquiry because a defendant owes no duty to prevent a harm that was not a reasonably foreseeable result of his negligent conduct.

A key element to the crime of forgery is intent to defraud, and a depositor cannot intend to defraud herself. Therefore it was legally impossible to foresee a district attorney trying to prosecute forgery as a crime under these facts.

Therefore, the Court found no causation between the crime charged and the advice given.

The full case can be found here.

Judge Bauer Reversed, Trustee Clawback Power Strengthened

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.