Bankruptcy Court Considers When an Attorney Is an “Initial Transferee” of Funds That Were Deposited Into a Trust Account

By Michael Riela

Vedder Price

New York, NY

In Horwitz v.Montroy (In re Select Tree Farms, Inc.), A.P. No. 15-1014, 2015 WL 4594076 (Bankr. W.D.N.Y. July 17, 2015), the United States Bankruptcy Court for the Western District of New York held that an attorney was not an “initial transferee” for purposes of Section 550(a) of the Bankruptcy Code with respect to funds that were deposited into the attorney’s trust account and later used to pay the debtor’s creditors.  However, the bankruptcy court also held that the attorney was an “initial transferee” with respect to funds that were deposited into the trust account and later used to pay the attorney’s own fees.

This case highlights some of the circumstances under which funds that are deposited into a trust or escrow account may be subject to recovery claims in a bankruptcy case.

Facts

George A. Schichtel was the president of Select Tree Farms, Inc. and managed its operations.  Shortly before it commenced its Chapter 11 case on March 7, 2012, Select Tree Farms issued six checks that were payable to three creditors.  Those checks were signed by Mr. Schichtel.  The drawee bank dishonored those checks because of insufficient funds, and the three creditors subsequently filed complaints that resulted in the prosecution of criminal charges against Mr. Schichtel under New Jersey law.

Mr. Schichtel and his wife also filed a joint personal Chapter 11 petition on March 7, 2012.  Both the company’s and the Schichtels’ Chapter 11 cases were subsequently converted to Chapter 7.

Without authorization from the bankruptcy court, Mr. Schichtel hired an attorney in New York State to defend against the outstanding criminal charges.  The attorney negotiated a settlement whereby the criminal charges would be dismissed, on the condition that Mr. Schichtel make restitution to two of the creditors.  Mr. Schichtel wrote two checks (totaling $8,000) from Select Tree Farms’s checking account and delivered them to the attorney.  The attorney deposited those checks in his trust account, and then disbursed over $5,500 of that amount to the two creditors.  The remaining approximately $2,500 was paid to the attorney on account of his legal fees and disbursements.

The Chapter 7 trustee for Select Tree Farms later sought to avoid and recover the $8,000 from the attorney as unauthorized post-petition transactions, pursuant to Sections 549 and 550 of the Bankruptcy Code.

The Bankruptcy Court’s Decision

The bankruptcy court had no difficulty holding that the transfers totaling $8,000 were avoidable as unauthorized post-petition transfers under Section 549 of the Bankruptcy Code.  To the extent the checks were for the payment of pre-petition obligations, the bankruptcy court found that they were outside the ordinary course of Select Tree Farms’s business (and, thus, not authorized by Section 363(c)(1) of the Bankruptcy Code).  To the extent the checks were to pay for legal services, the bankruptcy court never approved the attorney’s retention under Section 327 of the Bankruptcy Code.

This did not end the inquiry, however.  The Chapter 7 trustee sought to avoid and recover the $8,000 from the attorney himself, and the bankruptcy court next had to determine whether the attorney was the “initial transferee” pursuant to Section 550(a)(1) of the Bankruptcy Code.  This is because Section 550(b) of the Bankruptcy Code provides certain defenses to recovery actions that are not available to initial transferees, but that may be available to “immediate and mediate transferees” of the initial transferee.[1]  

The bankruptcy court began its analysis by noting that “the term initial transferee references something more particular than the initial recipient.”  See e.g., Christy v. Alexander & Alexander of New York, Inc. (In re Finley Kumble), 130 F.3d 52 (2d Cir. 1997).  Under the “mere conduit” test (which the Second Circuit has adopted), an entity that serves as a mere conduit of funds would not be the initial transferee.

 The bankruptcy court concluded that the attorney was a mere conduit (and thus not an initial transferee) with respect to the over $5,500 that was deposited into his trust account and later paid to creditors.  Citing Rule 1.15 of the New York Rules of Professional Conduct, the court reasoned that the money did not belong to the attorney while it resided in his trust account.  Rather, those funds still belonged to Select Tree Farms, and the attorney was obligated to disperse those funds only as directed by Select Tree Farms.  Thus, the ownership of funds passed directly from Select Tree Farms to the two creditors when the checks were sent to those creditors.  Therefore, the attorney effectively served as an escrow agent, and the creditors themselves were the initial transferees.  

The court did hold that the attorney was the initial transferee with respect to the remaining approximately $2,500 that was disbursed on account of his legal fees and expenses.  Thus, any recovery from the attorney would be limited to that amount.[2]

The court also deferred indefinitely the attorney’s request for nunc pro tunc professional retention under Section 327 of the Bankruptcy Code, stating that it would be inappropriate for him to retain funds that might constitute a distribution to claims holding a higher or equal priority (such as Chapter 7 administrative expenses).

Conclusion

When a client’s funds are deposited into a trust or escrow account, which is later used to pay a third party at the client’s direction, this case could be useful in defending against a subsequent recovery action in a bankruptcy case.  If your court follows the “mere conduit” test and if your state’s law provides that money in trust or escrow accounts remain the client’s property, the case is even more helpful.

This case also serves as a reminder for attorneys who represent bankrupt clients of the need to be retained under Section 327 of the Bankruptcy Code.  Had the attorney been retained under Section 327, he likely would not have been obligated to return his legal fees.

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[1]  In particular, Section 550(b)(1) provides that the trustee may not recover from such immediate or mediate transferees who take for value (including satisfaction or securing of a present or antecedent debt), in good faith, and without knowledge of the voidability of the transfer avoided (“Protected Transferees”).  Section 550(b)(2) provides that the trustee also may not recover from any immediate or mediate good faith transferees of a Protected Transferee.

[2]  There was an unresolved question about whether a portion of the trustee’s complaint was timely under Section 549(d).  The court granted judgment against the attorney in favor of the trustee for $1,636, but deferred a decision with regard to the remaining $848.