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