How Much Control Must a Bank Exert to be Considered an Initial Transferee Under 11 U.S.C. § 550? Can Substantive Consolidation be Applied Nunc Pro Tunc to Help ‘Create’ an Avoidance Action? Chief Judge Frank (Bankr. E.D. Pa.) Provides an Answer in In re Universal Marketing, Inc.

By Evan T. Miller, Esq.

Chief Judge Frank of the Bankruptcy Court for the Eastern District of Pennsylvania recently issued an opinion in Goldstein v. Wilmington Savings Fund Society (In re Universal Marketing, Inc.) that deals with certain issues not often seen in avoidance actions.  Specifically, the opinion touches upon the level of control or dominion that a bank must exercise over a disputed conveyance for purposes of determining whether it was an “initial transferee” under 11 U.S.C. § 550.  The opinion also addresses the question of whether a substantive consolidation order can be applied nunc pro tunc to the petition date without violating Owens Corning’s prohibition against “offensive” use of the substantive consolidation doctrine.  The timing of the substantive consolidation order in this case – which provisionally carved out the defendant-bank from its application – is critical to one of the plaintiff-trustee’s avoidance causes of action.

Ultimately, the Court found that the defendant-bank’s actions were essentially administrative in nature and did not rise to the level of dominion or control over funds necessary to satisfy the statute and judicially created tests.  The Court did, however, find that in the circumstances here, applying substantive consolidation nunc pro tunc to the petition date would not be impermissibly offensive vis-à-vis the defendant, as the “carve-out” negotiated with the defendant was meant to be transitory, leaving the chapter 7 trustee free to seek application of the doctrine at a later date.

Background

The facts of this case are extensive and warrant a full review by the reader, but pertinent to this post, they are as follows: the Debtor, Universal Marketing, Inc. (“UMI”), commenced its Chapter 11 case on July 23, 2009 (the “Petition Date”), but was quickly converted to a case under Chapter 7.  Prior to the Petition Date, Universal Delaware, Inc. (“UDI”) acted as the management company for UMI.  Operationally, UMI and UDI had separate banking relationships, the former with TD Bank and the latter with Wilmington Savings Fund Society (“WSFS”), although the cash needs of the various entities were met by numerous intercompany transfers on a daily basis.  In March 2009, UDI and WSFS entered into a line of credit loan transaction (the “Loan”), obligating WSFS to make available a $5 million line of credit.  By July 2009, however, the banking relationships with both UMI and UDI had soured, and within a few days of each other, TD Bank locked down UMI’s accounts and WSFS took similar action.  Specifically as to WSFS, the bank placed a “post no debits” (“PND”) restriction on the UDI accounts effective July 16, 2009, which had the effect of stopping automated debiting and allowing WSFS to review UDI’s account and ensure there were sufficient funds for outgoing transfers.  While the PND was in effect, UDI received over $11.6 million in transfers from UMI and a related entity (the “UMI Transfers”).  On July 20, following discussions among UDI and WSFS, WSFS removed the PND restriction, but offset $5 million to formally repay the Loan (the “Setoff”).  Three days later, UMI filed its bankruptcy petition.

Following conversion to Chapter 7, the Chapter 7 Trustee (the “Trustee”) sought substantive consolidation of the Debtor’s estate and extension of bankruptcy proceedings to certain non-Debtor entities, including UDI.  WSFS initially opposed substantive consolidation, but the parties later settled the issue as approved by an August 4, 2010 order (the “Order”).  This Order, while nunc pro tunc to the Petition Date, specifically provided that substantive consolidation would not impact WSFS’s rights, and that WSFS was excepted from the effects of the Order.  As to WSFS, the parties agreed that UDI would be deemed to have filed a bankruptcy as of August 4, 2010, and that the estates would be treated as jointly administered, not substantively consolidated.  Significantly, the parties agreed that the Trustee retained the right to extend the effect of the substantive consolidation to WSFS nunc pro tunc to the Petition Date, which WSFS could challenge.

On July 18, 2011, the Trustee initiated the adversary proceeding against WSFS based on a variety of legal theories, although this post will focus on the three counts brought under 11 U.S.C. §§ 544, 547, 548, 550, and/or 553.  The parties filed motions for summary judgment in May 2014, which the instant opinion addresses.

The First Counts

The first counts relevant here are based on 11 U.S.C. §§ 544 and 548, by which the Trustee asserted actual fraud allegations based on 6 Del. C. § 1304(a)(1) and 11 U.S.C. § 548(a)(1)(A), as well as constructive fraud.  The Court found no evidence in support of a claim for intentional fraud, so it limited its analysis to constructive fraud.  The pertinent transfers are the UMI Transfers and the Setoff (whereby UDI involuntarily transferred to WSFS an amount that paid off the Loan).  The Trustee argued that the UMI Transfers went directly to WSFS, and that WSFS was an initial transferee under 11 U.S.C. § 550 because it exercised dominion and control over UDI’s depository accounts by placing the PND restriction, then taking the funds for its own benefit to satisfy the Loan.  The Trustee alleged this was for no consideration to UMI, since UMI owed no money to WSFS.  Alternatively, the Trustee asserted that he could recover the Transfers from WSFS as a subsequent transferee, as UMI did not receive reasonably equivalent value for the transfers it made to UDI.  WSFS, of course, asserted that UDI was the initial transferee, and that the Transfers were made in satisfaction of UDI’s outstanding debt in good faith and without knowledge of their avoidability.

The Court noted that the most heavily litigated issue in section 548 actions is whether the debtor received reasonably equivalent value in the transaction.  In the Third Circuit, courts employ a two-step process in determining whether a debtor received reasonably equivalent value in the form of indirect economic benefits in a particular transaction: (1) whether any value is received, and (2) whether that value was reasonably equivalent to the transfer made. In re R.M.L., 92 F.3d 139, 152 (3d Cir. 1996).  I.e., what the debtor gave up and what it received that could benefit creditors, be it direct or indirect.  As to section 544, the Trustee invoked 6 Del. C. §§ 1304 and 1305 as his authority to step into the shoes of an actual creditor who existed at the beginning of the case and avoid the Transfers pursuant to state law.

Is WSFS an initial transferee?

The Court found that the Trustee’s theory hinged on the notion that WSFS was the initial transferee of the Transfers, but since that term is not defined in section 550, courts (although not the Third Circuit) have developed tests for determining whether a party is an initial transferee.  The first of these tests is referred to as the “dominion-and-control test”, as articulated in Bonded Fin. Servs. v. European Am. Bank., 838 F.2d 890 (7th Cir. 1988): “the minimum requirement of status as a “transferee” is dominion over the money or other asset, the right to put the money to one’s own purposes.” Id. at 893.  This is related to the “conduit theory” doctrine, that says if an entity receives a transfer, it may not be a transferee at all, but only a mere conduit if the transfer is for the limited purpose of allowing the entity to pass the asset through to another party.

The Ninth Circuit made a distinction between “dominion” and “control” in In re Incomnet, Inc., 463 F.3d 1064 (9th Cir. 2006), stating the “focus of the dominion standard is “whether an entity had legal authority over the money and the right to use the money however it wished.” Id. at 1070. The transferee has dominion if it has “the right to put the money to one’s own purposes.” Id.  In contrast, the “control” standard may involve a broader, more flexible approach, in which the courts look at the entire transaction as a whole to evaluate which party truly had control of the money”. Id.

The Trustee pushed the Court to employ the “dominion-and-control test”, and focus on the transferee’s relationship to the property; WSFS encouraged application of the “dominion test” as set forth by Incomnet, since it never exercised dominion over the UMI Transfers because it had no legal right to use those funds – the PND was just a temporary cautionary measure.  Moreover, WSFS argued that the Setoff was a subsequent transaction, performed only after UDI had taken title and dominion over the UMI Transfers.

The Court agreed with WSFS that it was only a subsequent transferee, not an initial transferee.  It found that the measures taken by WSFS at the time of the PND did not restrict all outgoing transfers from UDI’s account.  In addition, there was no evidence of any legal title change to the funds in UDI’s account, nor is there any indication that UDI was helpless and without access to funds.

As to the Trustee’s subsequent transferee argument, the Court found that the Trustee failed to prove that UMI did not receive reasonably equivalent value for the UMI Transfers.  Beyond the fact that the Trustee submitted no evidence to substantiate his supposition that UDI did not provide value to UMI, WSFS offered evidence that the Transfers were made in exchange for value in the form of receivables UMI owed to UDI and liquidity obtained through cash management services WSFS provide to UDI.

The Second Count

The Trustee also sought to avoid the Setoff under 11 U.S.C. §§ 550 and 553(b).  That section permits a trustee to avoid the amount by which a creditor improved its position by setoff during the 90 day period prior to the petition date.  In this case, 90 days before the Petition Date, there was an “insufficiency” (the amount by which a claim against a debtor exceeds a mutual debt owing to the debtor by the claimholder) of $5.75 million, and on the day of the Setoff, there was no insufficiency.  This depends, of course, on a finding that UDI’s estate was substantively consolidated with UMI’s as to WSFS, making the Petition Date July 23, 2009 – not August 4, 2010 as the Order provides.  If the latter, then the Trustee’s argument could not satisfy the 90 day requirement in section 553(b).

Can the Trustee seek substantive consolidation as to WSFS?

WSFS, relying on In re Owens Corning, 419 F.3d 195 (3d. Cir. 2005), argued that the Trustee could not wield substantive consolidation offensively, i.e., in a manner to single out and create a section 553(b) claim against WSFS.  The Trustee argued he was not singling out WSFS and that a major aspect of substantive consolidation is to allow the estate to bring actions on behalf of the consolidated estates; in his opinion, the issue was merely deferred as to WSFS, not waived.

The Court agreed with the Trustee.  Having walked through the seminal Owens Corning decision – and specifically WSFS’s favored tenet that while “substantive consolidation may be used defensively to remedy the identifiable harms caused by entangled affairs, it may not be used offensively (for example, having a primary purpose to disadvantage tactically a group of creditors in the plan process or to alter creditor rights)” Id. at 211 – the Court found that that tenet simply did not control here.  Rather, the Trustee was not seeking to isolate WSFS impermissibly, and the Order clearly stated the parties reserved their rights to seek or contest further substantive consolidation.  In effect, the Court found the agreement approved in the Order to be a “standstill agreement”, and to give effect thereto, the litigation should be treated as resuming the dispute when they declared a truce in August 2010.  The Order should not now be read to have essentially waived the parties’ rights.  As such, the Court found that the issue could be considered on its merits and refused to grant summary judgment in favor of WSFS, as neither party discussed whether the Trustee has evidence to support substantive consolidation or the elements of a setoff claim under section 553(b).

Can parties carve themselves out of a substantive consolidation order?

An interesting side note to this section of the opinion is the Chief Judge’s acknowledgement that Owens Corning left open the question whether a creditor may carve itself out of the effects of consolidation.  Nevertheless, the Court states that “right or wrong, that is what occurred in this case…”

A copy of the opinion is attached here.

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