The plaintiff trustee and defendant in this fraudulent conveyance action clash on the elemental question of who was the “initial transferee” of payments made by checks issued with the payee left blank.   At stake is the availability to Defendants of the “good faith” subsequent transferee defense under Section 550(b)(2).  These adversary proceedings arise out of the infamous Ponzi scheme and bankruptcy case of Marc S. Dreier pending in the Southern District of New York (Manhattan) before the Honorable Stuart M. Bernstein.

[Update April 18, 2012:  The Honorable Stuart M. Bernstein, United States Bankruptcy Judge for  the Southern District of New York sides with the Trustee.  The Plaintiff Trustee’s motion for partial summary judgment was granted; the Defendant’s cross motion for partial summary judgment was denied.  The three page order generally references the Plaintiff Trustee’s briefing and supporting affidavits but otherwise is without any discussion of the legal issues.  LaMonica v. Hemby, Adv. Proc. No. 11-01504 (SMB) Dkt. No. 47 (Bankr. SDNY  April 18, 2012).]

On February 23, 2011, (“Plaintiff”) filed adversary proceedings against Abraham Heby and four other defendants (collectively “Defendant”) seeking to avoid the transfer of and recover approximately $500,000.  Although the complaints provide a plethora of grounds for avoidance, fraudulent conveyance is the principal ground for recovery and the gravamen of the briefing. The transfers at issue revolve around 211 checks, described by Defendant as follows:

In the instant case, Mr. Schachner received a total of 211 checks from Mr. Dreier with no payee stated. Of those 211 checks, Mr. Schachner filled in his own name as the payee as to approximately fifty-three (53) checks… . Furthermore, of the 211 checks received from Mr. Dreier, Mr. Schachner chose to subsequently transfer fifty-seven (57) of the checks to his daughter … .  Lastly, of the 211 checks Mr. Schachner received from the Mr. Dreier, Mr. Schachner chose to subsequently transfer 101 checks to Mr. Heby who then completed sixteen (16) checks with his own name as the payee, and he subsequently transferred eighty-five (85) checks to the other defendants in this action.

Each of the checks were drawn on a bank account in Dreier’s name.  The Trustee alleges that, although each of the checks may have been received from the initial holder, Mr. Schachner, each was ultimately “received by and deposited by the respective defendant….”

The issues are presented in the unique procedural posture of a motion for partial summary judgment filed by the Plaintiff Trustee.  The Defendant, citing Fed. R. Civ. P. 56(f), has requested summary judgment as the non-moving party in his response. 

The issues were framed in the final two briefs filed by the parties:

(Both briefs are available to registered users by clicking the preceding links).

The chart below provides a side by side comparison of selected arguments from each of these briefs on the key issue presented by the briefing.

When were the transfers? The Trustee and the Defendant each seek summary judgment based on the premise of the date of the first transfer determines who is the initial transferee. For Defendant, the date of Dreier's transfer of the checks to Mr. Schachner establishes Mr. Schachner as the initial transferee. For the Trustee, the date of honoring of the checks by Dreier's bank establishes the depositor of the checks as the initial transferee. In either case, equating "initial transferee" with the time of first transfer, seems overly simplistic and relegates section 550(a) absolute liability to a game of hot potato.

Trustee's Argument  - 

The Opposition asserts that the Supreme Court decision Barnhill v. Johnson, 503 U.S. 393 (1992), has no bearing on the issue before the Court today. In that case, the Supreme Court concluded that “for the purposes of payment by ordinary check, . . . , a ‘transfer’ as defined by § 101(54) occurs on the date of honor, and not before.” Id. at 400. As was discussed in detail in the Motion, Bankruptcy Code § 101(54) defines “transfer” and is applicable to all other provisions in the Bankruptcy Code. See 11 U.S.C. §§ 101 & 103(a). Accordingly, for purposes of transfers by ordinary check sought to be avoided under Bankruptcy Code §§ 544 or 548, those transfers occur on the date such checks were honored by the transferee’s bank, and not before. This conclusion is fully supported by relevant state law, as will be discussed below in Point II.B.

The Defendants argue that the Barnhill “date of honor” rule does not apply to these Adversary Proceedings. The only case cited by Defendants in support of this argument is Child World, Inc. v. Service Merchandise Co. (In re Child World, Inc.), 173 B.R. 473 (Bankr. S.D.N.Y. 1994). In that case, the Bankruptcy Court for the Southern District of New York was required to determine, in the context of preferential transfers under Bankruptcy Code § 547, whether certain payments by check were on account of an antecedent debt, not determine when the transfers by check occurred. Id. at 475. In order to be avoidable as a preference, a transfer must have been made on account of an antecedent debt. 11 U.S.C. § 547(b)(2). Notably, subsection (c) of Bankruptcy Code § 547 specifically addresses what constitutes an antecedent debt for purposes of avoiding preferential transfers. Accordingly, the Child World court concluded that Barnhill’s rule with respect to when the transfer occurred was not applicable to whether such transfer was on account of an antecedent debt. Child World, 173 B.R. at 477. For purposes of Child World, the physical delivery of the checks suspended the obligations being paid by those checks, thus when the checks cleared, such transfer was no longer on account of an antecedent debt. Id.

Defendant's Argument  - 

Although the Trustee insists that the only transfer of a check must occur upon honor by the drawee bank, the transfer of the rights of a holder can occur through a change in possession. While the Trustee relies on the Supreme Court’s decision in Barnhill v. Johnson, that case has been held to be “tailored narrowly to the issue of the 90-day preference period i.e. 11 U.S.C.A. § 547(b)(4) (West) and not to all of 11 U.S.C.A. § 547.” In re Child World, Inc., 173 B.R. 473, 477 (Bankr. S.D.N.Y. 1994). In the Child World case, the Bankruptcy Court declined to extend Barnhill and the “date of honor rule” to all § 547 preference actions. Certainly if the Court was wary to extend the “date of honor rule” to a different subsection of § 547, it should not be further extended to a different section of the Code altogether, i.e. § 548. In fact, the Barnhill Court acknowledged that the legislative history of § 547 indicates that for the purposes of § 547(c), payment is to be considered when the check is delivered, not when it is honored by the drawee bank. While the Barnhill Court ultimately decided not to extend the “date of tender rule” the reasoning behind it was mainly because it was a preference action under § 547(b) of the Code and none of the applicable exceptions of § 547(c) were applicable. In the instant case, not only is § 547 not involved, thereby making the “date of honor rule” articulated in Barnhill irrelevant, the legislative history indicates that payment is not always deemed to occur on the date of honor.

When a holder transfers a negotiable instrument to another party, the transferee receives the same rights the transferor had. N.Y. U.C.C. Law § 3-201(1). Therefore, in the instant case, because Mr. Schachner had the implicit authority to complete the check, any transferee of Mr. Schachner had the same right. As fully outlined supra, Mr. Schachner had dominion and control over the funds and the check because he possessed the implicit authority to complete the otherwise incomplete checks. The right to complete the check and the dominion and control over the funds passed from Mr. Schachner to Mr. Heby when the checks were transferred. To hold otherwise would inhibit the free flow of commercial instruments amongst commercial parties.

Was Schachner a "Conduit", the "initial transferee" or neither? Defendant argues that the fact the checks were issued without a named payee rendered the initial holder the "initial transferee" for purposes of Section 550. The Trustee cites authority that a mere "conduit" can not be an initial transferee. However, the Trustee then argues that Schachner was neither "conduit" nor "initial transferee"... mere receipt of the checks was a non-event. But what would the Trustee have said if the checks had named Schachner as "Payee" and Schachner had endorsed the checks to the Defendant?

Trustee's Argument  - 

As noted above, an initial transferee under Bankruptcy Code § 550(a)(1) is strictly liable for its receipt of an avoidable transfer. See Carroll v. Tese-Milner (In re Red Dot Scenic, Inc.), 351 F.3d 57, 58 (2d Cir. 2003) (holding that “if the recipient of debtor funds was the initial transferee, the bankruptcy code imposes strict liability and the bankruptcy trustee may recover the funds” directly from the initial transferee (citing 11 U.S.C. § 550(b)). Courts in the Second Circuit apply a “mere conduit” test to determine whether the recipient of a transfer is the initial transferee, looking first to whether the transferee was a mere conduit of the debtor’s property, and, if not, determining whether the transferee exercised dominion and control over the transferred property. See Christy v. Alexander & Alexander Inc. (In re Finley, Kumble, Wagner,  Heine, Underberg, Manley, Myerson & Casey), 130 F.3d 52, 57 (2d Cir. 1997); Bear, Stearns  Sec. Corp. v. Gredd (In re Manhattan Inv. Fund Ltd.), 397 B.R. 1, 14–15 (S.D.N.Y. 2007) (citations omitted).

Relying on its faulty interpretation of New York UCC law, the Opposition argues that because Schachner received each of the Checks with the payee line blank, his authority to complete those Checks vested him with dominion and control over the sums reflected on the Checks. According to this logic, Schachner was the initial transferee of the Transfers and each of the Defendants was a subsequent transferee entitled to assert the good faith defense under Bankruptcy Code § 550(b). This argument is tenuous at best.

As was fully explained above in Point II, a transfer of funds by ordinary check does not occur until the check is honored. The ability to complete a check by filling in a blank payee line does not affect a transfer of the sums reflected on that check. Thus, even assuming the Defendants’ factual allegations with respect to Schachner’s role in these Transfers are correct, Schachner was not the initial transferee of the Transfers because the Transfers did not take place until the Checks were deposited into the Defendants’ respective bank accounts. Indeed, Schachner would not even qualify as a mere conduit because he simply never had possession of the Debtor’s funds reflected on the Checks.

Defendant's Argument  - 

The Trustee asserts that Mr. Schachner was a mere conduit in the Heby and Cohen transactions. However, a mere conduit is someone who facilitates the “passing of mere possession.” In re Finley, Kumble, Wagner, Heine, Underberg, Manley, Myerson & Casey, 130 F.3d 52, 57 (2d Cir. 1997). A mere conduit is similar to a courier. See id. A party is a mere conduit when that party is “a commercial entity that, in the ordinary course of business, acts as a mere conduit for funds and performs that role consistent with its contractual undertaking in respect of the challenged transaction.” Id. at 57-59. Essentially, a mere conduit is a party that receives money or assets for the purpose of simply passing the money or assets to a third party. Bonded Fin. Services, Inc. v. European Am. Bank, 838 F.2d 890, 891 (7th Cir. 1988). A mere conduit, unlike an initial transferee, has no dominion or control over the property. Rather, a mere conduit “is a party with actual or constructive possession of the asset before transferring it to another person.” In re Robert Plan of New York Corp., 456 B.R. 150, 159 (Bankr. E.D.N.Y. 2011) (citing In re Warnaco Group, Inc., 01 B 41643 (RLB), 2006 WL 278152 (S.D.N.Y. Feb. 2, 2006)).

In contrast to a mere conduit, a “transferee” is one who has dominion over the money or asset and the right to put the money to one’s own purposes. In re CNB Intl, Inc., 440 B.R. 31, 38 (W.D.N.Y. 2010). “An initial transferee is the person who has dominion and control over the subject of the initial transfer to the extent that he or she may dispose of it as he or she pleases.” In re Tronox Inc., 429 B.R. 73, 110 (Bankr. S.D.N.Y. 2010) (citing Sec. Sec. Investor Prot. Corp. v. Stratton Oakmont, Inc., 234 B.R. 293, 313 (Bankr. S.D.N.Y. 1999)).