The debtor, a title agency, facilitated a series of loans by having both the loans and the loan repayments pass through its trust account. Unfortunately, checks deposited to repay loans totaling $4.8 million bounced, and the $4.885 million check that replaced them was a forgery drawn on a non-existing account. The bank teller did not place a hold on the second check, and before the check cleared, the title company issued checks totaling $4.885 million to the lenders in repayment of the loans. The question for the 6th Circuit was whether the payment to the lenders was an asset of the title company for purposes of making a fraudulent transfer claim against the lenders.
The title company was able to issue the checks to the lenders because the bank issued a “provisional credit” to the title company for $4.885 million while the forged check was clearing, making the funds “available.” However, after the bank learned of the forgery it charged back the $4.885 million provisional credit. Since only ~$740,000 was in the account prior to deposit of the forged check, that left a negative balance of ~$4.1 million. The issue was whether the portion of the lender payment made using the provisional credit (i.e., ~$4.1 million) was an asset of the bankruptcy estate, and if so, whether the payment was a fraudulent conveyance that could be avoided.
After the bank froze the title company’s account, it was forced to file bankruptcy. The bankruptcy estate sued the lenders seeking to avoid the $4.885 million transfer using fraudulent transfer theories under both Section 548 of the Bankruptcy Code and state law (using the strong arm powers under Section 544). The bankruptcy court held that all but ~$700,000 was fraudulent, while the district court held that all but ~$21,000 was not fraudulent.
Under both federal and state law, a transfer may be voidable as a fraudulent conveyance if (1) the debtor does not receive reasonably equivalent value in exchange for this transfer, and (2) the debtor is left with unreasonably small capital, or it intended or believed that it would be unable to pay its debts as they became due. It was clear that the debtor did not receive reasonably equivalent value from the lenders and that it was left with unreasonably small capital since it was unable to continue in business.
So, the only question is whether there was a “transfer.” To be a transfer, the asset must be property of the debtor. In considering the source of the payments to the lenders, the title company had three categories of funds in its accounts: (1) ~$21,000 that constituted fees and expenses owed to the title company in connection with closings, (2) ~$722,000 that the title company was holding on behalf of third parties, and (3) ~$4.1 million that came as a result of the provisional credit that was then charged back after the check was returned.
Both the bankruptcy and district courts concluded that the first part was property of the estate, and that the second part was not. So the only dispute was whether the transfer of the funds resulting from the provisional credit was a transfer of the debtor’s property.
In the first instance, the lenders argued that the funds they received were trust funds, and therefore not assets of the title company. The theory is that if the debtor does not have an equitable interest in property that he holds in trust for another, that property is not property of the estate.
The 6th Circuit examined state law to determine whether a trust had been created and found that establishment of a trust required (1) an explicit declaration or circumstances showing that a trust was intended, (2) together with an intention to create a trust, (3) followed by an actual conveyance of property, (4) vesting legal title in a person capable of holding it. In this case the court concluded that the provisional credits were not held in trust for a third party.
The title company was obligated to pay the lenders only if it received funds from the borrower. There was no trust because there was no actual conveyance from the borrower to the title company. The title company received funds from the bank as part of its contractual arrangements with the bank and not from the borrower. The bank did not itself place funds in trust, and there was no evidence that the title company would hold property from the bank in trust. The bottom line was that because the borrower never actually deposited any funds, no trust relationship was created.
The district court drew an analogy to a case involving embezzled money and check kiting. However, the 6th Circuit distinguished this case because the title company never received any funds that were to be held in trust.
The court next addressed an argument that the title company had only legal, and not equitable, title because the bank had a security interest in the provisional funds under the Uniform Commercial Code (UCC). It reviewed the check collection process in detail: First, the depositor presents the check to a bank and the bank agrees to act as the collecting agent. The bank may also advance a provisional credit and receive a security interest in the check and its proceeds. Next the depositor’s bank will pass along the check until it reaches the bank of the checkwriter. That bank withdraws funds from the checkwriter’s account and passes the funds back to the depositor’s bank. The third and final step is when the depositor’s bank receives the funds from the check, keeps those funds in satisfaction of its security interest, and converts the provisional credit to a final payment to the depositor. The court concluded that the security interest is only in the check itself and its proceeds, and provisional credit funds are not proceeds of the check.
Consequently, the provisional credit funds were not encumbered by a lien and were assets held by the title company for purposes of the potential fraudulent conveyance claims.
A concurring opinion argued that this result is fair: Although it might seem unfair to penalize the lenders by taking back the money, their business was with the borrower, not the title company; and they would not have had the money in the first place if they had been dealing directly with the borrower. Similarly, if the title company had simply endorsed the check to the lenders without depositing it in its trust account, then the lenders would have had nothing but a worthless check. One might blame the bank for advancing provisional credit without waiting for the check to clear, but that is not consistent with how commercial law works in order to facilitate commerce.
This scenario is something worth keeping in mind when funding closings through a title company escrow account. Any sense of security may be false.
Vicki R. Harding, Esq.