The Perils of Using a Client Trust Account as an Informal Escrow

An escrow agreement provides protection when you want to be certain the other side will fulfill its obligations before moving forward.  People also often take shortcuts, instead placing funds into a client trust account held by one party’s counsel to be disbursed at the agreed-upon time.  Since attorneys are subject to ethics rules and serve as fiduciaries, this can be a pragmatic, less expensive alternative to a formal escrow.

But what happens when attorneys go rogue?

You may find yourself relegated to the status of an unsecured creditor with little protection.

Cosmetics Plus: A Cautionary Tale

In a recent New York case, a debtor reached a $350,000 settlement with its insurance company and placed the funds into the client trust account held by its counsel, the Dreier law firm. It so happened that the trust account also contained the proceeds of Mark Dreier’s fraud scheme.  The comingled funds totaled over $3 million at the time of the transfer, but the account balance later fell to zero before increasing to $48 million. The judge ultimately dismissed the debtor’s case and directed distribution of all cash on hand.

About two month later, before the funds were disbursed under the settlement agreement, Drier was arrested for fraud. The debtor’s new counsel quickly succeeded in having the settlement funds sent from the Dreier trust account to its trust account about two weeks before Drier landed in his own bankruptcy case.

Drier’s bankruptcy trustee then demanded the return of the $350,000 as a preferential transfer.  The insurer countered by filing secured proofs of claim in Dreier’s case asserting an interest in the returned settlement proceeds.

The New York district court ruled in favor of the trustee, holding that creditors of the original debtor were not entitled to priority claims against Drier’s estate based on the fact that the Drier had been required to hold those funds in trust, because Drier had, in fact, commingled those funds with his own and dissipated them before attempting repayment.  The transfer of the funds to the original estate was an avoidable preference, and its creditors were entitled to only general unsecured claims against Drier.  Among the arguments considered by the Court:

  1. The creditors argued that the wired funds were not property of Drier’s estate because they were required to be held in escrow for the original debtor, creating an express trust in the creditors’ favor.  The Court rejected this argument, finding that the dissipation of all funds in the account between the receipt of the settlement proceeds and the wire to the debtor’s estate made it impossible to trace creditor funds, thus defeating the preference defense.
  2. The creditors contended that the wired funds were not on account of an antecedent debt because the Dreier firm held the settlement proceeds in a fiduciary capacity.  A debt created while acting in a fiduciary capacity, they asserted, is a “special,” non-dischargeable debt.  The court rejected this argument as well, noting that a “special” debt is still a debt.
  3.  The creditors asserted that original court order requiring the Dreier firm to disburse the settlement funds gave their claims “priority” in Dreier’s bankruptcy.  The Court shot down that argument as well, noting that the bankruptcy court order did not create a security or other interest in the transferred assets.
  4. Finally, the creditors asserted that what happened to them was simply unfair, and that a constructive trust should be imposed to prevent exploitation of the bankruptcy system.  The Court’s answer?  Life is unfair.

 “While it is undisputed that Dreier breached its fiduciary duty and did grievous injury, imposing a constructive trust on its remaining assets does nothing to punish Dreier or address any arguable abuse by Dreier of the bankruptcy system. . . . Equity is not served by disadvantaging one set of victims in order to restore another, where the only source of assets is a limited common pool.”

Cosmetics Plus Group Ltd. v. Gowan (In re Dreier), 2016 WL 3920358 (S.D.N.Y. July 15, 2016)

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