Eleventh Circuit Expands Preference Defense
In a recent decision, the Eleventh Circuit Court of Appeals reversed the decisions of both the bankruptcy court and the district court when the appellate court concluded that an insurance broker was not liable for the return of more than $310,000 wired to the broker by a debtor two days before the debtor filed bankruptcy. In Andreini & Co. v. Pony Express Delivery Servs., Inc. (In re Pony Express Delivery Servs., Inc.), 2006 WL 456361 (11th Cir. Feb. 27, 2006), the Eleventh Circuit determined that the defendant was not a creditor of the debtor, but was merely a conduit or financial intermediary, and consequently, the defendant was not an initial transferee from whom a preference could be recovered under Section 550 of the Bankruptcy Code. As a result of its holding in Pony Express, the Eleventh Circuit appears to have expanded its view of the conduit defense to recovery of avoidable transfers under the Bankruptcy Code.
The Facts
The defendant, Andreini & Co., is a California insurance broker that arranges insurance coverage for its clients and bills them for the premiums due on the policies. As required by California law, Andreini deposits the payments received by its clients into a client trust account. Andreini pays the premiums to the insurance carriers from the client trust funds, less a commission to Andreini for its brokerage services. The debtor was a client of Andreini, and as a result of receiving several invoices from Andreini for premiums due on workers’ compensation insurance policies, the debtor sent a check to Andreini in an amount in excess of $310,000 for the payment of insurance premiums that were due to the insurance carriers under such policies. As required by California law, Andreini deposited the debtor’s check into its client trust account. On the day following the deposit of the debtor’s check, Andreini issued several checks from its client trust account to the various insurance carriers in payment of the insurance premiums. Unfortunately for Andreini, the debtor was experiencing some financial difficulty and the debtor’s check was returned due to insufficient funds. Subsequently, Andreini redeposited the check, but the check was returned a second time.
Andreini contacted the debtor about the twice-returned check and about the deficiency created in Andreini’s client trust account as a result of the debtor having insufficient funds in its account to cover the check. To erase the deficiency, the debtor agreed to wire the necessary funds to Andreini’s client trust account. Approximately three weeks after Andreini first received the debtor’s check to pay the insurance premiums, the debtor wired $310,422 to the client trust account. Two days after Andreini received the funds, the debtor filed a Chapter 11 petition in the Northern District of Georgia.
The Complaint
In its bankruptcy case, the debtor filed a complaint against Andreini and other defendants seeking to recover several payments, including the wire transfer, as avoidable preferences under Section 547 of the Bankruptcy Code. With respect to Andreini, the debtor argued that the funds wired to the brokerage company could be recovered from Andreini under Section 550 of the Bankruptcy Code. Section 550 provides that an avoidable transfer of assets can be recovered from certain parties, including the “initial transferee.” The debtor argued in its summary judgment motion that Andreini was the initial transferee of the wired funds because the funds were paid by the debtor to satisfy a debt owed by Pony Express to the brokerage company. In opposition to the debtor’s motion, Andreini argued that it was not a creditor of the debtor, but that the brokerage company was merely a conduit for the funds which were owed to the insurance carriers as premium payments on the debtor’s workers’ compensation policies.
The bankruptcy court and the district court both concluded that Andreini was the initial transferee and, consequently, was liable for return of the wired funds. The Eleventh Circuit described the lower courts’ reasoning:
The courts reasoned as follows: Andreini paid the premiums due on Pony Express’ insurance policies before the latter’s check to Andreini had been honored. When that check was returned for insufficient funds, Andreini became a creditor to Pony Express in the amount of the premiums advanced. Since the subsequent wire transfer repaid funds Andreini had already advanced from its client trust account, the courts concluded that the wire transfer was not a payment of insurance premiums, assets over which Andreini would have had only limited control due to its fiduciary responsibilities as an insurance broker, but was the repayment of a debt [owed Andreini], over which Andreini necessarily exercised legal control.
Pony Express, 2006 WL 456361, *3 (11th Cir. Feb. 27, 2006).
The Eleventh Circuit’s Decision
To resolve the issue of whether Andreini was the initial transferee of the wired funds, and consequently, a party responsible for the return of the avoided transfer, the Eleventh Circuit determined that the “pivotal question” was “whether Andreini was a mere conduit for funds earmarked for payment of insurance premiums or whether a debt was created by Andreini’s unintentional prepayment of insurance premiums such that it had legal control over funds transferred to satisfy the debt.” Id. at *2.
Acknowledging that the term “initial transferee” was not defined in the Bankruptcy Code, the Eleventh Circuit stated that most circuit courts to have considered whether a party was an initial transferee, including the Eleventh Circuit, had adopted a “control” or “conduit” test. As described by the Pony Express court, under the “control” test, a recipient of an avoidable transfer is an initial transferee “only if they exercise legal control over the assets received, such that they have the right to use the assets for their own purposes, and not if they merely served as a conduit for assets that were under the actual control of the debtor-transferor or the real initial transferee.” Id.
The Eleventh Circuit agreed that the lower courts had rightly concluded that, under the control test, the initial transferee question turns on whether a debt existed for the purposes of Section 550. If Andreini was a creditor, the brokerage company would be the initial transferee because the wire transfer would be a reimbursement for Andreini’s own expenses rather than a transmittal of funds that the brokerage company was obligated to pay to the insurance companies. In such circumstances, Andreini would have legal control over the assets and could use them for its own purposes. Without specifically acknowledging that a debt existed (even though it appeared that such was the case), the Pony Express court noted that although such an interpretation had some “initial appeal,” it did not hold up to closer inspection under the control test precedent in the Eleventh Circuit.
Looking to existing precedent within the Eleventh Circuit, the Pony Express court compared the case to the situation addressed by the Court in Nordberg v. Societe Generale (In re Chase & Sanborn Corp)., 848 F.2d 1196 (11th Cir. 1988). In Societe Generale, the Eleventh Circuit considered whether a debt existed when a bank honored a check drawn on the debtor’s account in advance of the bank receiving funds sufficient to cover the check, creating an overdraft in the debtor’s account. Despite the appearance that the overdraft created a debt, the Societe Generale court found that no debt existed between the debtor and the bank.
The Pony Express court determined that Andreini was in the same position as the bank in Societe Generale. Like the bank in Societe Generale, the brokerage company did not intend to become a creditor when it sent the checks to the insurance carriers. Further, the Pony Express court emphasized that, as with the bank in Societe Generale, Andreini “had every expectation that the actual funds the check was drawn upon would be immediately forthcoming ...” Pony Express, 2006 WL 456361, *4 (11th Cir. Feb. 27, 2006). Also, the appellate court noted that Andreini did not charge any interest or fees for its “loan” to the debtor. The Eleventh Circuit noted that in both cases the avoidable payments were earmarked as a deposit to a client account held in trust by the client’s fiduciary and were not intended as a payment of a debt. While the deficiency lasted only one or two days in Societe Generale instead of three weeks, the Pony Express court stated that “the length of this period should not have dispositive significance.” Id. at *5. In that regard, the Pony Express court observed, “More important to the control test, an inadvertent and temporary deficiency settled with a reasonably prompt wire transfer further indicates than Andreini was merely a conduit for Pony Express’ insurance premiums.” Id.
Based on its own precedent and the facts in the record, the Eleventh Circuit concluded that no debt was created for the purposes of Section 550 and that Andreini did not exercise legal control over the wire transfer. Accordingly, the appellate court determined that the brokerage company was not an initial transferee and, consequently, was not liable for the recovery of the avoided transfer.
Has the Eleventh Circuit Expanded the Conduit Defense? Comparing Pony Express With Societe Generale
In Pony Express, the Eleventh Circuit emphasized the precedent within the circuit, as embodied by Societe Generale, in concluding that Andreini was not a creditor of the debtor and, accordingly, not an initial transferee. A comparison of the two decisions, however, clearly evidences that the Pony Express court adopted a more expansive view of the conduit defense than that held by the Societe Generale court.
In Societe Generale, the debtor issued a check on its account at Societe Generale, a French bank with a branch office in New York City. The debtor did not have sufficient funds available in its account to cover the check, resulting in a negative balance in the debtor’s account. When Societe Generale learned of the negative balance, the bank contacted the debtor to determine if the debtor was going to deposit sufficient funds to cover the check. The debtor informed the bank that two wires were coming from another bank to cover the check. Societe Generale contacted the second bank and confirmed that the wires were being sent. Instead of waiting for the wire transfers to arrive, however, Societe Generale honored the debtor’s check, resulting in an overdraft. The wires arrived the next day and were deposited in the debtor’s account, eliminating the overdraft.
The Eleventh Circuit acknowledged in Societe Generale that by honoring the debtor’s check before receipt of the wire transfers, the bank created an overdraft. The Court further acknowledged that overdrafts have traditionally been considered debts. The Societe Generale court also stated that if the Court determined that the overdraft constituted a debt owed to the bank, the money wired to the bank for the express purpose of paying off the overdraft would actually have been sent to the bank, the bank would have control of the money and the bank would have been an initial transferee liable for the return of the avoidable transfer. Societe Generale, 848 F.2d at 1200-01. Looking to the transaction as a whole, however, the appellate court concluded that the bank’s decision to honor the debtor’s check did not establish a debtor-creditor relationship and that the bank was a mere conduit not liable for the recovery of the avoidable transfer. As illustrated below, the two most significant factors in the Societe Generale court’s analysis were: (i) that the transaction was “effectively simultaneous”; and (ii) that the bank knew “with absolute certainty” that the second bank had wired enough money to cover the check. Id. at 1201.
Societe Generale learned of the negative balance in the debtor’s account on November 29, 1982. On that same date, Societe Generale confirmed with the second bank that it had wired funds to cover the debtor’s check and Societe Generale honored the debtor’s check. Societe Generale received the wired funds to cover the debtor’s check on November 30, 1982. Consequently, the overdraft existed only on the night of November 29. Because of the short time frame involved, the Societe Generale court concluded that the transaction was effectively simultaneous and that the overdraft existing on the night of November 29 did not constitute a debt owed by the debtor to the bank. Id. Additionally, the Eleventh Circuit found it “significant” that the bank only honored the check because it knew “with absolute certainty” that the second bank had wired enough money to cover the debtor’s check. By relying on the “guaranty” of another bank that the funds were on the way, the appellate court did not believe that the bank intended to become a creditor of the debtor. Id.
Taking the discussion and analysis of the Eleventh Circuit in Societe Generale at face value, the Eleventh Circuit’s view of the conduit defense clearly is more expansive in Pony Express. Although not specifically acknowledged by the Court, it is apparent from a review of the dissent in Pony Express that when Andreini received the wire transfer three weeks after the brokerage company sent the checks to the insurance carriers, the premiums were no longer due to the insurers, Andreini no longer had any obligation to forward the transferred funds to the insurers and, in fact, Andreini did not forward the transferred funds to the insurers. See Pony Express, 2006 WL 456361, *7 (11th Cir. Feb. 27, 2006). Consequently, by the time that the transferred funds were deposited into the client trust account, Andreini had satisfied the debtor’s obligation to pay the insurance premiums and the only debt remaining unpaid when the transferred funds were received by Andreini was that held by the brokerage company for advancing the premium payments on behalf of the debtor. See id.
The extremely short duration of the overdraft in Societe Generale was a significant factor in the Eleventh Circuit’s determination that the overdraft did not result in a “real” debt. Societe Generale, 848 F.2d at 1201. In Pony Express, however, the appellate court described the three weeks between Andreini’s advancing the payments to the insurers and Andreini’s receipt of the transferred funds as not having “dispositive significance.” Pony Express, 2006 WL 456361, *5 (11th Cir. Feb. 27, 2006). Further, the Pony Express court stated that when Andreini issued the checks to the insurance carriers, the brokerage company had “every expectation that the actual funds the check was drawn upon would be immediately forthcoming … ” Id. at *4. This “expectation” was based upon Andreini’s prior course of dealings with the debtor and the lack of any knowledge of the debtor’s financial difficulties. Andreini’s expectation was certainly less than the “absolute certainty” that the bank had in Societe Generale that the funds had been wired to cover the debtor’s check in that case, but the Pony Express court did not attempt to reconcile the difference between “expectation” and “absolute certainty” in its analysis.
Based on the analysis of the Societe Generale court, it would have been reasonable to expect the Pony Express court to agree with the lower courts that the brokerage company was a creditor who had exercised control over the transferred funds, resulting in the determination that Andreini was an initial transferee under the control test. Instead, the Court, somewhat surprisingly, reached the opposite conclusion.
In reaching its decision in Pony Express, the Eleventh Circuit deemed it significant that the wire transfer was deposited to a client trust account held by a fiduciary and that the fiduciary had only limited legal control over the funds. These characteristics were common to both Societe Generale and Pony Express. However, these characteristics were not the “significant” considerations upon which the Societe Generale court based its decision. Those “significant” considerations, the deemed “virtually simultaneous” transaction resulting from the short duration of the overdraft and the bank’s “absolute certainty” that funds had been wired to cover the debtor’s check before the bank honored the check, were not present in Pony Express. Instead of basing its decision on the factors emphasized by the Societe Generale court, the Pony Express court focused on the actual destination of the wire transfer and the recipient’s legal rights and obligations toward the transferred assets while only paying lip service to the factors that the appellate court had found so significant in Societe Generale.
Conclusion
As a consequence of the Pony Express decision, the conduit defense in the Eleventh Circuit would apply to a transfer made to the debtor’s account maintained by a party who is a fiduciary, agent or other party with legal obligations to the debtor – even if that party might otherwise be determined to hold a claim against the debtor directly related to the asset transfer. Accordingly, in the Eleventh Circuit, it is not enough for a debtor or a bankruptcy trustee to establish that the party who first received an avoidable transfer was a creditor who had legal control of the transferred asset for a court to conclude that the party was an initial transferee, if the avoidable transfer was deposited to a client account held in trust by such party. In fact, in such circumstances, it might be difficult indeed for the debtor or the bankruptcy trustee to establish that such a party was an initial transferee liable for the recovery of an avoidable transfer under Section 550 of the Bankruptcy Code.