In a recent ruling, the Ninth Circuit held that a seller was liable under the law of fraudulent conveyance to the bankruptcy trustee for the portion of the purchase price funded by a company controlled by the buyer, which was actually a Ponzi scheme, that later filed bankruptcy. Mano-Y&M Ltd. v. Field (In re Mortgage Store, Inc.), 773 F.3d 990 (9th Cir 2014). This holding was reached notwithstanding the fact that there was no allegation that the seller had no knowledge of the source of funds or that the funding company was a Ponzi scheme.
The Court’s stated rationale was as follows:
By placing the risk on initial transferees rather than creditors, Congress ensured that creditors “need not monitor debtors so closely,” the idea being that “savings in monitoring costs make businesses more productive.” [Bonded Financial Services, Inc. v. European American Bank, 838 F.2d 890, 892 (7th Cir. 1988)] (citing Douglas G. Baird & Thomas H. Jackson, Fraudulent Conveyance Law and Its Proper Domain, 38 Vand. L. Rev. 829 (1985); Robert Charles Clark, The Duties of the Corporate Debtor to Its Creditors, 90 Harv. L. Rev. 505, 554-60 (1977)); see also Tese-Miller v. Brune (In re Red Dot Scenic, Inc.), 293 B.R. 116, 121 (S.D.N.Y. 2003) (noting that strict liability for initial transferees “lowers the cost of credit”). Id. at 997.
In so holding, the Mano Court noted that “[the seller] could [have held] cash reserves or obtain[ed] liability insurance to hedge against the possibility of a fraudulent conveyance.” Id. at 998, n.1 citing by comparison to Scholes v. Lehmann, 56 F.3d 750, 761 (7th Cir. 1995). Ironically, the Scholes court itself recognizes the impartialities of these alternative solutions when describing them.
The summary of seller’s saga is as follows: George Lindell (Lindell) was the president and sole shareholder of The Mortgage Store, which was in the business of soliciting funds to make loans to other individuals to purchase real estate and make investments. According to an insolvency analysis prepared for the trustee after the fact, the Mortgage Store became irreversibly insolvent around June 30, 2007, and thereafter used money collected from new investors to pay prior investors (i.e., a Ponzi scheme). Although Lindell had purported to transfer control of the The Mortgage Store to his daughter in 2008, in connection with an early 2009 purchase of real estate from Mano-Y&M Ltd. (“Mano”), The Mortgage Store transferred over $300,000 to the escrow agent at closing to fund the purchase. When The Mortgage Store filed bankruptcy in late 2010, nearly two years later, its Trustee sought to recovery the fund paid to Mano.
Recognizing that Mano had nothing to do with sourcing the funds from which it was paid, the Court rejected Mano’s arguments that Lindell was the initial transferee and Mano was a mere subsequent transferee. Instead, the Court held Mano liable as the “initial transferee” of the transfer from The Mortgage Store, finding that Lindell never had control of the funds himself. This deprived Mano of the defenses a subsequent transferee might have, including the defense of taking in exchange for value, making it strictly liable for the transferred amounts. While the case in interesting to lawyers due to the fact that the opinion resulted in the 9th Circuit over-ruling a prior Bankruptcy Appellate Panel decision, McCarty v. Richard James Enters., Inc. (In re Presidential Corp.), 180 B.R. 233 (9th Cir. BAP 1995) (using a “dominion and control” test as oppose to purely a dominion test), the practical implication of the ruling for sellers is more than a legal quirk. Assuming that sellers do not want to reserve cash against potential liabilities for assets they are selling and cannot find insurance, the question remains what can a seller really do to protect itself in the situation Mano-Y&M Ltd. found itself. While each situation is different, sellers should be sure they know who the buyer is and what the sources of funding the transaction are. If the seller discovers that the buyer is sourcing the funds from third parties , the Mano decision suggest that the seller should be sure that the actual buyer entity first receives the funds in a manner that the buyer has the ability to use the funds as he sees fit. See Bonded Financial, 838 F.2d 890, 894 (7th Cir. 1988) (an individual will have dominion over a transfer if, for example, he is “free to invest the whole [amount] in lottery tickets or uranium stocks.”)