The Ninth Circuit Rejects the “Dominion and Control Test” for Determining the Initial Transferee in Fraudulent Conveyance Actions

Under section 550(a) of the Bankruptcy Code, a trustee or debtor in possession may recover property (or its value) that has been fraudulently transferred “from the initial transferee or the entity for whose benefit the avoided transfer was made.”  While the trustee’s right to recover from an initial transferee is absolute once a transfer is deemed fraudulent, a subsequent transferee may assert affirmative defenses that could prevent recovery by the estate of an otherwise avoidable transfer.  As a result, defendants in fraudulent transfer litigations often take great pains to characterize themselves as subsequent transferees as opposed to initial transferees. 

Section 550(a) does not, however, define the term “initial transferee,” and two competing tests have emerged.  The first, the “dominion test,” turns on whether the transferee received legal title to the funds or property and can use them freely.  The Seventh Circuit, for example, has framed the issue as whether the transferee has unbounded discretion and is “free to invest the whole [amount] in lottery tickets or uranium stocks.” Bonded Fin. Servs, Inc. v. European Am. Bank, 838 F.2d 890, 894 (7th Cir. 1988).  The second test, the “control test,” is more flexible and emphasizes equity under the circumstances, regardless of “facial appearance[s]” Nordberg v. Societe Generale (In re Chase & Sanborn Corp.), 848 F.2d 1196, 1199 (11th Cir. 1988).

While the Ninth Circuit gave its imprimatur to the dominion test in Universal Serv. Admin. Co. v. Post-Confirmation Comm. Of Unsecured Creditors of Incomnet Commc’n Corp. (In re Incomnet), 463 F.3d 1064, 1071 (9th Cir. 2006), courts in the Ninth Circuit applied a hybrid test in special cases in which parties to a transaction insert an escrow agent between the transferor and transferee. See, e.g., McCarty v. Richard James Enters., Inc. (In re Presidential Corp.), 180 B.R. 233 (9th Cir. BAP 1995).  Under this “dominion and control” test, the ultimate beneficiary of the transfer is deemed the initial transferee even though it was not the direct recipient of the transfer because the escrow agent did nothing more than temporarily hold the funds being transferred during the closing of the transaction.  This “dominion and control” test is no longer the standard in the Ninth Circuit, however, as the recent opinion in Mano-Y&M, Ltd. v. Field (In re The Mortgage Store, Inc.), ___ F.3d. __ (9th Cir. 2014), 2014 WL 6844630 (9th Cir. Dec. 5, 2014) rejected the test in escrow cases in favor of the strict dominion test that it traditionally applied.

The facts in The Mortgage Store fit comfortably within the parameters of most traditional escrows arrangements.  Mano-Y&M, Ltd. contracted to sell a shopping center to Lindell, an individual who had been the sole shareholder and president of an entity known as The Mortgage Store and still retained control over the company.  The parties used an escrow company to temporarily take possession of the purchase price, which was loaned to Lindell by The Mortgage Store, deposited directly by the company with the escrow agent, and released to Mano at closing.  Unbeknownst to Mano, Lindell had been using The Mortgage Store as a vehicle to operate a Ponzi scheme.  When the scheme collapsed, a chapter 7 proceeding for The Mortgage Store was commenced and the trustee sought to recover the transfer of the sale proceeds from the company to Mano.

The bankruptcy court avoided the transfer and determined that Mano was the initial transferee. Mano appealed, contending that under the hybrid “dominion and control” test, Lindell should be deemed the initial transferee because the funds were received by the escrow agent from The Mortgage Store and distributed to Mano for Lindell’s benefit (i.e, to facilitate Lindell’s acquisition of the shopping center).  In rejecting this argument and affirming the bankruptcy court, the Ninth Circuit expressly overruled In re Presidential Corp. and re-asserted the primacy of the dominion test.  The Court noted that Lindell never held legal title to the funds and that all conditions precedent to the closing had been fulfilled by the time the funds in the escrow account were transferred to Mano.  Although the Ninth Circuit noted that the result was “harsh,” given the close connection between the buyer and the debtor/transferor and Mano’s lack of involvement in the impropriety that gave rise to the avoidance action, it concluded that its task was to “allocate risk such that the parties tending to have the lowest monitoring costs [] bear the costs of a debtor’s failings.”

The Ninth Circuit opined that Mano, by allowing Lindell to satisfy his obligations through the use of a third party escrow agent, had assumed the risk of The Mortgage Store’s insolvency.  The Court also found that Mano exercised “dominion” over the purchase price when he received it in accordance with the sale documents. Citing  Scholes v. Lehmann, 56 F.3d 750, 761 (7th Cir. 1995), the Court suggested that Mano could have mitigated the risk that the transfer could be avoided by holding cash reserves equal to the purchase price or by obtaining liability insurance.  Although such hedges may be useful in transactions by corporations, their use is generally impractical for sales by individuals.  As such, the steps recommended by the Court are likely unavailable to many parties that engage in transfers using escrow agents.  For these parties, strict application under the dominion test is very harsh indeed.

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