A Tale of Fraud and Overzealousness:  How the Judicial Shrinkage of “Initial Transferee” Saved an Innocent Immigrant From a Corrupt Car Dealer and a Troublesome Trustee

A Tale of Fraud and Overzealousness:  How the Judicial Shrinkage of “Initial Transferee” Saved an Innocent Immigrant From a Corrupt Car Dealer and a Troublesome Trustee

What happens when a shady businessman transfers $1 million from one floundering car dealership to another via the bank account of an innocent immigrant? Will the first dealership’s future chapter 7 trustee be allowed to recover from the naïve newcomer as the “initial transferee” of a fraudulent transfer as per the strict letter of the law? Or will our brave courts of equity exercise their powers to prevent a most grave injustice?

SPOILER ALERT! The Second Circuit Court of Appeals, finding in favor of our faultless friend, recently ruled that the recipients of fraudulent transfers will not be held liable as initial transferees unless they have had both the right to put the money to their own purposes and a “realistic opportunity to do so.”1 While our courageous companion certainly had the right to put the money to her own purposes—brief as it was—she never had a realistic opportunity to do so, as you will discover below.  The court saved her from having to pay $1 million to the estate simply because the sum rested, momentarily, in her bank account. 

I. Facts and Procedural History

Veniamin Nilva had a problem. It was 2016, and his Brooklyn-based car dealership, Kings Automotive Holding LLC (“Kings Automotive” or “Kings”), had run into some “cash flow issues” and needed to “rearrange its capital structure.” In layman’s terms, it was broke and needed some money.

Though Nilva’s other car dealership, BICOM NY, LLC (“Bicom”), had the funds that Kings Automotive so desperately needed, Nilva was unable simply to wire the money from one entity to the other. That’s because Bicom’s loan with JPMorgan Chase & Co. (“Chase”) prohibited all transfers out of the company that were not made in the ordinary course of business. And the contemplated transfer from Bicom to Kings Automotive was most definitely not in the ordinary course of business.

Normally, this would not have presented any real obstacle. Like all “good businessmen,” Nilva had a secret stash: a Wells Fargo account held in Bicom’s name that Chase knew nothing about. The secrecy was for good reason—the separate account breached Chase’s financing agreement with Bicom. Nilva could wire the money from Bicom’s Wells Fargo account to Kings Automotive, and Chase would be none the wiser. The only problem was that Kings’ bank account was also held with Chase. A direct transfer from Bicom’s Wells Fargo account to Kings’ Chase account would alert Chase to the illicit existence of the Wells Fargo account! Nilva was at a loss…

Then, inspiration struck. Eight years earlier, Nilva’s friend, Irina Gryaznova, had approached him with an idea. Ms. Gryaznova was a Russian immigrant pursuing permanent residency in the United States through the U.S. government’s EB-5 program. The program required that Ms. Gryaznova hold a U.S. bank account with a minimum balance of $10,000. Erroneously, Ms. Gryaznova believed that she would not be able to open a U.S. bank account on her own due to her lack of a U.S. Social Security number. Consequently, she proposed to Nilva—a U.S. citizen—that the two of them open up a joint account together! Though Irina alone would have signatory authority, the account would be under both of their names and Nilva would have monthly statements mailed to his address. Nilva agreed. Anything to help his friend…

Now, eight years later, Nilva’s joint account with Ms. Gryaznova could provide him the means to get money from Bicom’s Wells Fargo account to Kings’ Chase account without alerting Chase! He could use the joint account to disguise the source of the funds.

On June 20, 2016, without the knowledge of Ms. Gryaznova, Nilva wrote a check for $1 million from Bicom’s Wells Fargo account, payable to Irina Gryaznova. He endorsed the check himself, forging Ms. Gryaznova’s signature. Nilva then wrote a second check for $1 million, this one drawing from the joint account and payable to Kings Automotive.

The first check was deposited on the day it was signed, June 20. The second check, however, took two days to clear, meaning that from June 20 until June 22, 2016, Irina Gryaznova had $1 million in her bank account which she knew nothing about. And Chase was kept in the dark as to the original source of the funds.

Nilva might have thought that Ms. Gryaznova would never find out about the events of June 2016. But a year later, on July 10, 2017, Bicom filed a voluntary petition for relief under chapter 11 of Title 11 of the United States Code (the “Bankruptcy Code”). And two years after that, Craig Jalbert, the Liquidation Trustee appointed under Bicom’s Second Joint Plan of Liquidation, went after Ms. Gryaznova, alleging that (i) the transfer from Bicom’s account to her joint account was void as a fraudulent transfer under section 548 of the Bankruptcy Code and (ii) under section 550 of the Bankruptcy Code (the fraudulent transfer remedies section), Ms. Gryaznova, as the initial transferee, was obligated to return the entire $1 million amount to Bicom’s estate—even though that money left her account just a few days after it was put in. It took over three years for Ms. Gryaznova to become aware of her brief windfall in 2016, the news finally broken by way of an adversary proceeding…Quite the unpleasant surprise.

Over the course of nearly three years and through three levels of the court system, the Trustee asserted his case. He brought his claim against Ms. Gryaznova in front of the Bankruptcy Court for the Southern District of New York, the District Court for the Southern District of New York, and the United States Court of Appeals for the Second Circuit. One by one, year after year, they rejected his claims.  Yet, he refused to give up on his pursuit of Ms. Gryaznova.

II. Analysis

a. Avoidance of Fraudulent Transfers Under Section 548

In alleging that the transfer to Ms. Gryaznova’s account was void, the Trustee had a strong point. The Bankruptcy Code grants the trustee of a debtor’s estate broad powers to avoid, for the benefit of the estate, certain categories of payments made by the debtor within specified periods of time before the filing of the petition. These powers are called “avoidance powers,” and they are one of the hallmarks of our nation’s bankruptcy system. They allow a bankruptcy estate to undo property transfers which a debtor may have dishonestly, preferentially, or unwisely executed prior to bankruptcy, thus maximizing the property of the estate and ensuring the fairest possible treatment of creditors. Among the avoidance powers is the ability to void “fraudulent transfers.” Section 548 of the Bankruptcy Code defines a “fraudulent transfer” and provides (as relevant here) that the trustee may avoid “any transfer . . . of an interest of the debtor in property,” made within two years of the filing of the petition, “with actual intent to hinder, delay, or defraud” a creditor.2

Every court that heard the case against Ms. Gryaznova agreed with the Trustee’s baseline reading of section 548. As Judge Rakoff of the New York Southern District Court stated, “There is no dispute here that the payment of $1 million from [Bicom] to Kings Automotive was a fraudulent transfer under this definition, because [Bicom]’s owners acted with the actual intent to defraud JPMorgan Chase by structuring the transfer so as to deceive Chase as to the source of the funds, and because the payment occurred within the relevant two-year window.”3

Nevertheless, all three courts also understood that section 548 merely gives a trustee the power to avoid a transaction. To actually recover property that was transferred away, a trustee must rely upon section 550. At all three levels of the court system, it was the Trustee’s misguided view of section 550 that sunk his case.

b. Recovering Fraudulent Transfers under Section 550: Interpreting “Initial Transferee”

Under section 550(a)(1) of the Bankruptcy Code, the “initial transferee” of a fraudulent transfer is liable to the debtor’s estate when a trustee avoids that transaction. Unlike any subsequent transferee thereafter, “initial transferees” are strictly liable; that is, they are liable even if they received the funds “in good faith, and without knowledge of the voidability of the transfer avoided.”4

The Bankruptcy Code does not tell us who or what constitutes an “initial transferee.” In its most literal sense, the term theoretically encompasses anyone who receives the initial transfer. However, since 1988, courts have recognized that defining “initial transferee” too broadly and too literally could lead to absurd results, such as holding simple couriers strictly liable for sums of money that they innocently delivered.5 Accordingly, courts took the liberty of narrowing the scope of the term, thus limiting the category of persons upon whom strict liability would be imposed and generating outcomes that were more justified in their view. Some might call it judicial shrinkage. Yet, in the face of decades’ worth of such interpretation, the Trustee in our case tried to interpret “initial transferee” both too broadly and too literally.

The question of defining “initial transferee” first reached the Court of Appeals for the Second Circuit in In re Finley in 1997.6 Because of the harsh penalty that the strict liability rule imposed on “initial transferees,” the court sought to maintain equilibrium by narrowly defining who exactly constitutes a “transferee.” Not all recipients are “transferees,” they said, and the “initial transferee”—the party strictly liable under section 550(a)(1)—will not necessarily be “the first pair of hands” or “the first entity to touch the disputed funds.” Rather, the court distinguished recipients that are “mere conduits” from recipients that are “initial transferees.” This distinction has been called the “Mere Conduit Defense.”

In elaborating on this distinction, the Second Circuit adopted the “Dominion and Control Test” (or “Mere Conduit Test”), which originated in the Seventh Circuit.7 Under the Dominion and Control Test, “the minimum requirement of status as a ‘transferee’ is dominion over the money or other asset, the right to put the money to one’s own purposes.”8 By creating requirements that must be met before a recipient of funds can be deemed an “initial transferee,” prior courts, and now the Second Circuit, limited the term.9 Each court that heard this case utilized the Dominion and Control Test in interpreting “initial transferee.” As Judge Wiles of the Bankruptcy Court wrote, “[I]t is emphatically not the case that every ‘recipient’ of funds is automatically liable as an ‘initial transferee.’”

Unswayed by the judicial trend of narrowing the definition of “initial transferee,” the Trustee argued that even under the Dominion and Control Test, Ms. Gryaznova should be deemed an initial transferee because she did, theoretically, have “the right to put the money to [her] own purposes.” After all, she did have the ability to withdraw $1 million at any point between June 20 and June 22, 2016…

But the courts were not buying what the Trustee was selling. Each court that heard the Trustee’s argument pointed out that the wording of the Dominion and Control Test described dominion and control as a “minimum requirement of status as a ‘transferee.’”10 To them, this meant that the right to use disputed funds is not, by itself, enough to create liability under section 550(a)(1). Rather, each court declared that under the Dominion and Control Test, a recipient of funds is not an “initial transferee” until it has the right to put the money to its own purposes and a “realistic opportunity to do so.”11 The courts recognized that Ms. Gryaznova never had a realistic opportunity to put the funds to her own purposes because she had absolutely no knowledge of the deposit of the funds in her account. Accordingly, she was a “mere conduit” rather than an “initial transferee.”

The courts thus rejected the Trustee’s interpretation of the Dominion and Control Test. Though he was only trying to uphold his fiduciary duty to the bankruptcy estate, three courts (and five different judges) tossed the Trustee out of court, writing that his overly literal approach “pushes legal fictions to extremes”12 and only has merit “if one takes the most formalistic view of the law.”13

In ruling against the Trustee and finding that Ms. Gryaznova could not be held liable for the $1 million briefly held in her account, each court focused on the inequitable result that would be generated by the Trustee’s attempted application of the Dominion and Control Test. Perhaps there was no other way for the Trustee to recover the $1 million that Nilva fraudulently transferred away.  Perhaps the Trustee saw Ms. Gryaznova as the only avenue through which he could fulfill his fiduciary duty to the estate. Nevertheless, the courts objected to his attempt at recovering money from an innocent woman who never knew she held even a single dime. As Judge Wiles noted, “The Trustee is trying to apply strict liability standards in deciding whether someone is a transferee in the first place.” By adding the requirement that a recipient must have a realistic opportunity to use the funds they receive to be deemed an “initial transferee,” the courts’ opinions reflected the Second Circuit’s agreement with the trend of narrowing the definition of the term, as set forth in opinions issued by the Eighth, Ninth, and Eleventh Circuits.14 By failing to convince the courts to reverse this legal trend, and also, perhaps, by failing to predict how the inequitable outcome he sought might impact the courts’ opinions, the Trustee doomed his case.

Key Takeaways

The moral of our satisfying saga is that before commencing an action under the Bankruptcy Code, would-be litigants and their lawyers must carefully analyze their case and decide whether it is worth spending money and time pursuing the action.  They should be mindful of not only existing case law, but the trend in which the law is moving and the reasons behind it.  They should also remember that bankruptcy courts are courts of equity and that all courts (like juries) are made up of human beings who want to apply the law to achieve fairness, particularly where there is a clearly supported legal path to do so.  Lawyers may benefit from putting themselves in the place of the judge and imagining how that person will view the case and the result they are seeking – a good old fashioned “gut check” can go a long way to saving both sides, and the courts, much time and expense on a losing case.

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Amer Mustafa

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