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Innocent Third Parties Can Be Held Liable For Fraudulent Transfers In Bankruptcy Cases
January 18, 2018

You do business with a person associated with several companies, and he pays you with checks written from one company's bank account. Later the company files bankruptcy. Can you breathe a sigh of relief because you provided valuable goods or services in return for the payments, and before the company filed bankruptcy?

Unfortunately, no. Under state and federal laws, bankruptcy trustees, chapter 11 debtors and creditors’ committees may recover pre-bankruptcy asset transfers if the transfers are determined to be fraudulent conveyances.

The legal theory of a fraudulent conveyance is that a company was insolvent at the time it transferred money or property to third parties, and did not receive fair value in return. The recipients of fraudulent transfers can be sued to recover what they received. We will write more on this topic in future newsletters.

Fraudulent conveyances are not the only reason payments may be clawed back in a bankruptcy case. Creditors can be required to return payments that arguably “preferred” them over similarly-situated creditors. 

This article describes a recent decision by the Ninth Circuit Court of Appeals regarding two innocent parties and allegations of fraudulent transfers. One party provided business services to a company's owner; the other sold real property at a fair price to the same owner.

The third parties were neither family members nor otherwise affiliated with the owner, but nevertheless must pay over $220,000 each to the bankrupt company as alleged fraudulent conveyances. The case is called Matter of Walldesign, Inc., 872 F.3d 954 (9th Cir. 2017), a 2-1 decision.

Michael Bello was the sole shareholder, director, and president of Walldesign, a company that installed drywall in construction projects in California, Nevada, and Arizona. Walldesign maintained its primary bank account at one bank, but Mr. Bello secretly opened a second account in Walldesign’s name at a different bank, deposited rebates from suppliers into the second account and used that account to support his lavish lifestyle.

Mr. and Mrs. Buresh did business with Mr. Bello by selling real property to another company he controlled named RU Investments for $220,000, in an arm’s-length transaction. The Bureshes took back a promissory note as part of the sale and received payments towards the note over two years from checks drawn on Walldesign’s second account.

Separately, an interior design firm owned by Ms. Henry provided services to Mr. Bello over nine years, at her company’s standard rates in arm’s length transactions. Her company received a total of $230,000, paid from the second Walldesign account. Neither the Bureshes nor Ms. Henry had a pre-existing relationship with Mr. Bello, his family, or any of his businesses.

When Walldesign filed chapter 11, the creditors’ committee sued the Bureshes and Ms. Henry to recover the payments as fraudulent transfers, arguing that they had not provided goods, property or services to Walldesign.

The legal issue was whether the Bureshes and Ms. Henry are “initial transferees” of the payments from the second Walldesign bank account that Mr. Bello controlled, such that they are strictly liable, or if they are “subsequent transferees,” entitled to a safe harbor defense: that they accepted the payments in good faith, and without knowledge that the transfers may be recoverable.

The Ninth Circuit analyzed the majority and minority approaches of other appellate courts and decided to follow the majority approach, holding that Mr. Bello was not the “initial transferee” of funds in the account, even though Mr. Bello misappropriated Walldesign’s corporate funds for personal use, since the checks were written against the second bank account in Walldesign’s name. Rather, the Bureshes and Ms. Henry were the “initial transferees,” and therefore strictly liable to repay the bankruptcy estate.

The court said the Bureshes and Ms. Henry should have noticed that the payments were from an unrelated entity (Walldesign), rather than the company or person with whom they actually did business (Mr. Bello or other companies he owned), and thus they should have been aware the payments might not be legitimate.

The dissent in Walldesign noted bankruptcy courts are courts of equity and should not hold the Bureshes or Ms. Henry liable for the fraudulent transfers, since they conducted legitimate business with Mr. Bello and did not know the second bank account he created and used to pay them, was fraudulent. The dissent also argued that it is not unusual for closely held companies to use corporate checks to pay for services provided to company owners, like Mr. Bello did.

This ruling should enable more bankrupt companies to sue and recover payments made to innocent third parties as fraudulent conveyances. The lesson from this case is that it’s better to insist on payments directly from your customer rather than from a “friend” of the customer, a stranger to the transaction, or a company owned by or related to your customer.

For media assistance, please contact Maura Fisher at 202-580-7714.