As if California real property sellers didn’t have enough to worry about, on July 17, 2015, the Federal District Court in Los Angeles sent a shiver down the spines of sellers when it handed down its order in In re Walldesign, Inc.
In Walldesign, Donald Buresh and his wife Karen Philips sold a piece of commercial real estate in 2009 to Michael Bello, the president and sole shareholder of Walldesign, Inc. Walldesign later filed Chapter 11 on January 4, 2012. During the bankruptcy case, the creditor’s committee sued the unsuspecting sellers to recover the purchase price on the grounds that the funds used to buy the property belonged to Walldesign and not to Mr. Bello. The theory was that the payment of the Walldesign’s money to the sellers was a “fraudulent conveyance,” because the money used to purchase the property would otherwise have been available to pay Walldesign’s creditors.
The bankruptcy court ruled that if Mr. and Mrs. Buresh had sold the property in good faith, then they would not have to return the purchase price. This “good faith” defense is available under the bankruptcy code to “subsequent transferees,” but not to “initial transferees.” 11 U.S.C. §550(a). The creditor’s committee appealed to the Federal District Court for the Central District of California.
On appeal, the District Court recognized that the “distinction between an ‘initial transferee’ and a subsequent transferee is critical,” because the “trustee’s right to recover from an initial transferee is absolute. ” The District Court went on to hold that Mr. and Mrs. Buresh were “initial transferees,” not subsequent transferees, and as such they are not entitled to assert the “good faith” defense under §550:
“Although ‘the result this case produces may seem harsh,” the Ninth Circuit has stated that ‘Congress’ intent in enacting §550 must govern. Congress placed the risk of fraudulent conveyances on initial transferees because they are in the best position [compared to other creditors] to monitor fraud. Bello—as a Walldesign principal—did not have the proper incentive to monitor Walldesign for fraud.”
Once found to be initial transferees, it would not have mattered if the sellers had been Mother Teresa and Mahatma Gandhi; they were required to return the purchase price.
Can’t Mr. and Mrs. Buresh at least get their property back or a refund from Mr. Bello? The Walldesign court doesn’t address this issue, but the answer is probably not. Presumably, the sellers could have sued Mr. Bello, but he may have become judgement proof. Also, he might have sold the property, borrowed against it, or it could have been subject to judgment or tax liens. In other words, the poor sellers could well be without any meaningful recourse.
The District Court’s ruling is no doubt counter-intuitive to non-bankruptcy lawyers, because in the “real world” it is so common for one to accept payment for goods and services from a company belonging to an individual. How could a payment be fraudulent if it is made on behalf of a corporation’s sole shareholder and president? A bankruptcy lawyer would suggest that you’ve asked the wrong question; the focus of fraudulent conveyance law is on the creditors of the entity whose funds are transferred, no the entity itself.
How then could the sellers have protected themselves to avoid such a disastrous result? For starters, their purchase agreement could have explicitly required that the funds used to purchase the property come from an account owned by the buyer. If the purchase agreement permits the buyer is to be an undisclosed “designee,” then the name of the designee should match the name on the account from which the purchase price is paid. That account must not be in the name of the buyer’s affiliate, parent company, or principal. Next, Escrow should be instructed that the sale must not close until the source of funds is verified. At a minimum, this means that the name on the buyer’s check must match the name of the person or entity taking title. Can anything else that can be done to avoid the fate of the poor sellers in Walldesign? Perhaps, but much will depend on the particular facts and circumstances of the transaction. Most importantly, have your lawyer review the purchase agreement and escrow instructions. And finally, if you get a letter from a bankruptcy trustee or creditor’s committee, take it very, very seriously.
© Marc Lieberman 2015