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)


Reclamation Claims, Bankruptcy Financing, and You.

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Reclamation rights are an important, but often confusing, tool in a credit manager’s arsenal.  Adding to the confusion, New York and Delaware courts have recently diverged in their treatment of certain aspects of reclamation claims.

Reclamation Rights: The General Rule

In the bankruptcy context, reclamation rights are based on Bankruptcy Code section 546(c). This code section does not create new reclamation rights, but it does recognize otherwise valid state law reclamation claims.

Subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof . . . a seller of goods that has sold goods to the debtor in the ordinary course of such seller’s business [has the right] to reclaim such goods if the debtor has received [them] while insolvent within 45 days before the commencement of a case under this title. 11 U.S.C. § 546(c)

In plain English, the concept is straightforward enough.  Let’s say you manufacture fuzzy eggbeaters.  If you deliver your eggbeaters to a customer as usual but it turns out the company was insolvent, and this all happened in the 45 days before the customer goes bankrupt, you may be able to get your eggbeaters back or assert an administrative claim for the amounts you are owed.  (There are a quite a lot of legal nuances to this.)

Adding Some Complexity: The Pre-Existing Secured Lender

Your reclamation rights, however, are subject to prior rights of a senior secured lender, e.g., the bank that finances your customer’s fuzzy eggbeater and furry teacup retail business. Think about a typical scenario where a bank extends a credit line to a company and takes a security interest in all of its assets. That security interest typically extends to existing and future assets. So when the retailer then goes out and buys your fuzzy eggbeaters, they become part of the bank’s collateral.  When you try to get them back, you may find your reclamation rights trumped by the lender’s pre-existing security interests. If the bank is underwater—often the case in a bankruptcy—your reclamation rights may have no  real value.

More Complexity: Bankruptcy Financing

Still with me?  Now let’s introduce some typical bankruptcy financing terms. Companies are often financed with revolving credit lines. When a company seeks bankruptcy protection, it typically needs to establish new financing. Very often, its existing lender will provide that new financing on terms that include a rollup of pre-petition debt. In other words, as new post-petition credit is extended, payments are applied first to the old, pre-petition debt.  The result is that, over time, the old pre-petition loan is rolled up into a new post-petition loan. (Post-petition loans are treated more favorably in bankruptcy, so there are a lot of advantages to a lender in doing this.)

This is where things get interesting for reclamation claimants and where New York and Delaware bankruptcy courts recently parted ways.

New York’s “Integrated Transaction” Approach: The Lender Wins

In two New York cases decided in 2003 and 2007, the bankruptcy courts considered the relative rights of: (a) a post-petition lender where the post-petition loan proceeds had been used to rollup the debtor’s pre-petition loan; and (b) reclamation claimants.  The new post-petition loans were made after the reclamation rights arose. Since Section 546(c) states that reclamation rights are subject to prior rights of a secured lender, the reclamation claimants argued that their rights trumped those of the new post-petition lender. The bankruptcy courts disagreed, however.  They held that the security interests under the post-petition loans “related back” to the lender’s prepetition rights because of the rollup feature.  Viewing the two loans and resulting liens as an “integrated transaction,” the courts sided with the secured lenders.

You can view the New York opinions here: In re Dana Corp., 367 B.R. 409 (Bankr. S.D.N.Y. 2007); and In re Dairy Mart Convenience Stores, Inc., 302 B.R. 128 (Bankr. S.D.N.Y. 2003).

Delaware’s Approach: Questioning the Integrated Transaction

In a recent opinion, In re Reichhold Holdings US, Inc., Judge Mary Walrath parted ways with the New York decisions. She held that a post-petition lender’s security interest – perfected after the reclamation rights arose – does not trump those reclamation rights even if the loan proceeds were used to payoff a pre-petition loan that would have.

In this case, the debtor’s prepetition lender had a lien on all of the debtor’s inventory.  Shortly after the debtor filed for bankruptcy, the court approved post-petition financing from a new lender.  That new financing was used to payoff the debtor’s old, pre-petition loan. And the new loan was secured by a first priority lien on all of the debtor’s assets, subject to valid, non-avoidable liens in existence as of the petition date.

After the bankruptcy filing, a vendor delivered a reclamation demand to the debtor and filed an administrative claim based on its reclamation rights. The trustee objected, stating that the reclamation claim was rendered valueless when the pre-petition loan was repaid. The vendor fought back, arguing that the new lender had not assumed the old, pre-petition lender’s liens but rather had obtained entirely new, post-petition liens. Since only prior liens defeat a reclamation claim, the vendor asserted that its reclamation claims trumped those of the new, post-petition lender.

The Delaware bankruptcy court rejected the logic of the New York bankruptcy courts, following a Six Circuit case, In re Phar-Mor, instead. Finding that the two loans, which were made by different lenders at different times, were not an integrated transaction, the bankruptcy court overruled the trustee’s clam objection.

“[W]hen the Prepetition Loan was paid from the DIP Loan, the Prepetition Lender’s lien was satisfied but [the vendor’s] reclamation rights remained in force.  The fact that funds obtained from the DIP Loan were used to satisfy the Prepetition Loan, or that the Debtor granted the DIP Lenders a lien in inventory to obtain such funds, is irrelevant.  [The vendor’s] reclamation rights arose before the DIP Lenders’ security interest attached, and the DIP Lenders’ lien was expressly subject to reclamation rights under section 546. . . .  Nor can the Court find that the DIP Loan and the Prepetition Loan are an ‘integrated transaction.’  They were two different loans by two different lenders at two different times.  Because [the vendor’s] rights arose before the DIP Lenders had any rights in the goods, the Court concludes that the DIP Lenders do not have prior rights in the goods under section 546(c).”

You can view the Delaware opinion here: In re Reichhold Holdings US, Inc., 2016 WL 4479286 (Bankr. D. Del. Aug. 24, 2016); see also In re Phar–Mor, 301 B.R. 482 (Bankr. N.D. Ohio 2003), aff’d, 534 F.3d 502 (6th Cir. 2008).

Some Concluding Thoughts

This is certainly good news for vendors with reclamation claims.  It is worth noting, though, that most post-petition loans are made by existing, pre-petition lenders.  This loan was made by a new and different lender group, which was a factor that the court noted when it held that the two loans should not be viewed as an integrated transaction. The result could be different if the pre-petition and post-petition loans were made by the same lender.

Mette H. Kurth

Fraud Claims: Don’t Throw Good Money After Bad

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Nobody likes wasting money, especially on legal fees.  Clients don’t like it.  And courts don’t like it.  As Judge Shannon admonished in a recent opinion:

The Court has previously expressed and now reiterates its profound concerns with respect to the dissipation of monies otherwise available for distribution to stakeholders being burned up in litigation of dubious merit and questionable collectability.

The best outcome for everyone, of course, is to avoid pursuing questionable litigation in the first place.

My colleague, John Bird, has written two articles illustrating some of the challenges and considerations that lawyers and clients should take into account when pursuing fraud claims.

Motion to Dismiss Second Amended Complaint – Another AgFeed Opinion

Opinion in AgFeed USA – Another (Mostly) Successful Motion to Dismiss

Simply put, the Delaware Bankruptcy Court, like other courts across the country, takes a hard look at fraud allegations and requires them to comply with elevated pleading standards under the Federal Rules of Civil Procedure.

To avoid spending money litigating claims that may be dismissed, it is important to take a hard, objective look at the fraud allegations in your complaint to make sure that they are based on particular, specific factual allegations (e.g., the who, what, when, where and how of the fraud, including the time, place, and content of alleged misrepresentations) and not just conclusory statements.  For example:

Very Bad: The defendant induced plaintiffs to invest in his business.

Bad: Throughout 2007, the defendant strongly encouraged Larry, Curley and Moe to continue investing by making statements such as “stay with the business.”

Better: On July 4, 2007, Larry, Curley and Moe received a letter signed by defendant and delivered to their offices in Miami, Florida soliciting a $1 million investment in defendant’s spray-on hair business and stating that the business had been valued at $10 billion by New York Investment Bank, LLP.

This requires that you conduct a pre-complaint investigation in sufficient depth to make sure that your allegations of fraud are supported by facts rather than being merely defamatory and extortionate.  (To make sure your analysis is completely objective, it may be a good idea to have a fresh set of eyes review the complaint before it is finalized.)

Without the necessary preparation, you may just find yourself throwing good money after bad.

Mette H. Kurth

When is a Settlement Not a Settlement? When It Is an Asset Sale.


For business people, whether you are settling a dispute or selling an asset may seem obvious. But for lawyers, the distinction can be surprisingly tricky, and it has serious ramification for our clients.

The confusion arises because the Bankruptcy Code allows you to either sell or settle a claim that a debtor has against someone else. What happens if the trustee settles a claim against a defendant in exchange for a cash payment, and a creditor objects because it believes the claim is worth more than is being paid? What if a trustee wants to sell claims that the debtor has against third parties? Whether these transactions are treated as settlements or sales matters quite a bit.

When selling an asset under Bankruptcy Code section 363, you must demonstrate that you have maximized the asset’s value. To settle a claim, the bar is much lower. Bankruptcy Rule 9019 requires that you show that the settlement is fair and equitable, which generally means that it does not fall below the “lowest point in the range of reasonableness.” Moreover, you cannot appeal a bankruptcy sale to a good faith purchaser unless you obtain a stay. (This is meant to encourage bidding in bankruptcy sales by protecting good faith purchasers). A settlement, in contrast, can be appealed without a stay.

The Ninth Circuit Court of Appeals recently adopted the BAP’s earlier reasoning in Mickey Thompson (decided in 2003) and the reasoning of the Fifth and Third Circuits, holding that a bankruptcy court has the discretion to apply the more stringent standards and procedures for sales to a settlement agreement in order to maximize value.

In Adeli v. Barclay, the bankruptcy trustee had entered into a settlement agreement with a creditor under which the creditor would purchase the estate’s claims against it in exchange for both cash and a waiver of the creditor’s claims against the estate. The trustee filed a motion to approve the settlement under Rule 9019 and presented evidence regarding the settlement’s reasonableness. It also noticed the matter as a sale subject to overbidding under Section 363. Nobody submitted an overbid. The debtor then appealed the settlement to the district court—but without seeking a stay pending appeal. The Ninth Circuit concluded that, because the bankruptcy court determined that the creditor/buyer was a good faith purchaser of the potential claims, and the debtor did not seek a stay pending appeal, the appeal was moot under Bankruptcy Code section 363(m) and was properly dismissed.

While the Ninth Circuit’s decision adopted Mickey Thompson’s reasoning and does not appear to significantly change current practice, it does serve as a stark reminder of the very real differences between sale and settlement procedures. Meanwhile, its time for the lawyers to update their form files to replace references to Mickey Thompson with a citation to Adeli v. Barclay.

Adeli v. Barclay (In re Berkeley Delaware Court, LLC), No. 14-55854 *10 (9th Cir. August 23, 2016). Download in PDF

Mette H. Kurth

Help! I Can’t Afford a Bankruptcy Lawyer.

Going broke is not free.  The Bankruptcy Court charges a fee of $355 or more to file your case.  Bankruptcy cases involve a lot of paperwork, statutes, rules, deadlines, and legal jargon.  If you can afford to hire a reputable lawyer to help you, that is generally the best option. If you can’t, there are some alternatives that could be right for you.

There are many self-help websites that are just a Google search away.  Noll Press, for example, has been publishing  do-it-yourself legal guides since  1971.  They cover a range of topics from debt management, bankruptcy planning, costs, whether you need a lawyer, the types of bankruptcy cases, and how to file them.  They have books, forms, and free on-line articles.  They also have a referral service.   Nolo Press

The American Bankruptcy Institute also offers self-help resources. The ABI is an organization dedicated to research and education on bankruptcy matters.  Their materials are free!  They have a more academic tone, so you might find them a little less user-friendly than Nolo Press.   ABI Bankruptcy Resources

If the idea of a DIY bankruptcy is daunting , you can also find help at free legal societies and legal clinics, or a pro bono attorney might take your case free of charge. lists a number of legal aid societies in the Los Angeles area, including the Legal Aid Foundation, Public Counsel, Bet Tzedek, and others.

Outside the Los Angeles area, try a Google search like “free bankruptcy resources Chicago” to locate similar legal clinics.

Mette H. Kurth