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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Paying With Other People’s Money: A Close Look at Avoidance Actions

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Section 502(d) Typically Applies to Avoidance Actions By the Debtor

One of the weapons in a debtor’s arsenal is its ability to disallow a vendor’s claim until the vendor satisfies any fraudulent transfer or preference exposure it might have.

The court shall disallow any claim of an entity . . . that is a transferee of a transfer avoidable under section . . . 548 . . . unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable under section . . . 550 . . . of this title.”  –11 U.S.C. § 502(d).

Broadly speaking, Section 502(d) has two purposes. First, it is about fundamental fairness. It prevents certain creditors who owe money to the bankruptcy estate from sharing in distributions until their debt is paid. Second, it incentivizes parties to comply with court orders by allowing the debtor to withhold distributions until those debtTypical.PNGs are satisfied.

This makes a lot of sense in your typical situation, where a debtor seeks to recover prepetition payments that it made to one of its vendors. In practice, preference defendants threatened with disallowance of their entire claim often agree to offset amounts they owe the estate against distributions on their claims.

But when one of the debtor’s affiliates paid your bill, things get more complicated.

It May Not Apply to Avoidance Actions by Non-Debtors

Tthe-transactionhat was the situation in In re Hoku Solar. A vendor received payment on its invoice from the debtor’s parent, after which both companies filed separate bankruptcy cases. The trustee for the parent then sought to avoid and recover the payment that it made to the vendor as a fraudulent transfer. The vendor, in turn, asserted a contingent claim in the debtor’s case, seeking to assert a claim for any invoices that would be reinstated if it disgorged the payments.

The trustee’s next move was to look to the language of Section 502(d), which states only that the court shall disallow any claim of an entity that has received an avoidable transfer. It does not say that the avoidable transfer has to have been made by the debtor. Based on this literal reading of Section 502(d), the trustee argued that the creditor’s claim against the debtor’s estate should be disallowed.

The Idaho bankruptcy court rejected this approach, observing that even though the language of Section 502(d) arguably applied, the section’s purposes would not be served by disallowing the creditor’s claim. Disallowing the claim, it said, would be unfair to a vendor that could be left with no place to turn for payment on its underlying (and potentially unpaid) invoice. This would be exacerbated by the fact that the parent’s creditors—not the debtor’s—would be the ones to benefit from any disgorged payments. As for using Section 502(d) to incentivize the vendor to satisfy any fraudulent transfer claims, the court similarly felt that a creditor’s distributions in one case should not be used to impact claims in another case.

Change Up.PNGThe bankruptcy court therefore held that the creditor—an avoidance action defendant in a parent company’s bankruptcy case—could file a claim in the subsidiary’s case that is not subject to disallowance under Bankruptcy Code section 502(d).  (If the vendor had received its payment directly from the debtor, however, its claim would have been disallowed.)

The Bottom Line?

Avoidance actions are complex, and small details can make a big difference. S0 make sure you understand all of the nuances before bringing a claim or responding to a demand.

As a more esoteric point, the case also illustrates the tension that sometimes arises between strict construction and more liberal or equitable interpretations of the Bankruptcy Code. When the two collide, the results can be unpredictable.

See In re Hoku Solar, Inc., 2016 WL 563036 (Bankr. D. Idaho Feb. 12, 2016)

Mette H. Kurth