It is not particularly surprising that some individuals will engage in the questionable and risky practice of paying for personal items by using their business/corporate accounts and credit cards. The classic example is a corporate officer who uses his business credit card to take his friends or family out for dinner. It seems preposterous to suggest that the restaurant cashier should conduct due diligence to confirm whether the executive is legitimately entitled to pay for her dinner with a company credit card. But under recent caselaw, that might not be such a bad idea in order to prevent an innocent vendor from getting caught in a web of litigation involving fraudulent conveyances and Bankruptcy law.
One fairly recent instance in which innocent third-parties learned this fundamental lesson the hard way is found in the Walldesign case. In a decision issued October 2, 2017 on appeal from the decision of the Bankruptcy Court, the United States Court of Appeals for the Ninth Circuit maintained that a committee of unsecured creditors could recover over $450,000 from not only the shareholder who was misappropriating corporate funds for his personal use into a hidden secondary account under the corporate name, but also from the third-parties who unknowingly received payments from this secondary account for services that they provided and assets they had sold to the shareholder. At first glance, the outcome of the case seems harsh and controversial because it logically does not seem viable from a public policy perspective for a third-party vendor, who is in no manner involved in a scheme to commit corporate fraud, should be liable to repay the defrauded company’s creditors, simply because the company files for bankruptcy.
In Walldesign, Michael Bello was the sole shareholder, director, and president of Walldesign, Inc., a California corporation that installed drywall, acoustical material, and plaster in construction projects. Although Walldesign maintained its primary bank account at Comercia Bank, Bello opened a different secondary account in Walldesign’s name at another bank in order to divert funds. Bello used Walldesign’s tax identification number, a Unanimous Consent of Shareholders to Corporate Action, a signature card granting him authority as an agent of Walldesign, and provided the bank with other Walldesign information when opening the account. He did not disclose the existence of this account in Walldesign’s records, and tried to conceal the account during Walldesign’s subsequent bankruptcy proceedings.
Although most of Walldesign’s expenses and income flowed through its primary account, Bello used the funds diverted into the second account to fund his lavish lifestyle, including his family vineyards, horseracing stable, Las Vegas casino bills, homeowner’s association and country club fees for two private golf courses, personal expenses charged on his American Express credit card, and for other unrelated business entities he controlled.
In total, Bello paid roughly 130 individuals and entities an estimated $8 million from the secondary account. This is how Donald Buresh and his spouse, Sharon Phillips, and Lisa Anne Henry ultimately became involved in Bello’s fraudulent conveyances. The Bureshes sold real property that they owned to another Bello-controlled entity for roughly $200,000. The property was sold for fair market value at arm’s length, for which Bello made payments to the Bureshes for two years, with checks drawn from the secondary account bearing the name “Walldesign Incorporated.”
Similarly, Ms. Henry was an owner of a small interior design firm, and was referred to Bello for design and construction-related services on a building owned by Bello, which was not related to Walldesign. She provided Bello design services for over nine years at standard rates for fair value. Bello paid her over $230,000 using checks from Walldesign’s secondary account.
Eventually, Walldesign filed a petition under chapter 11 of the Bankruptcy Code, and a committee of creditors was appointed. The Committee was given court authority to recoup payments by recovering the fraudulent transfers that Bello had made into and from the secondary account. These transfers included the $453,298.16 in payments that were made to the Bureshes and Ms. Henry. The Bureshes and Ms. Henry filed motions for summary judgement seeking dismissal of the actions brought by the Committee. They argued that they were not liable for any fraudulent transfers because they were subsequent transferees of the fraudulent conveyance (which would make them immune to recovery), given that the funds had been diverted by Bello, rather than initial transferees from Walldesign, who could be held liable since Walldesign did not receive fair consideration for the money that was paid. Following the conflicting opinions in the bankruptcy court and district court, the issue that faced the 9th Circuit on appeal was determining whether the Bureshes and Ms. Henry were initial transferees and thereby liable for the avoidable transfers in the bankruptcy proceedings.
The Court of Appeals applied the “dominion” test to determine whether the innocent recipients of the funds were initial transferees. Under the dominion test, legal title and the ability of the transferee to freely appropriate the transferred funds are the qualifications of initial transferee status. The first party to establish this dominion over the funds after they leave the transferor is the initial transferee and any other transferees that follow are subsequent transferees.
At first glance, Bello seems to adequately fit the definition of initial transferee under the dominion test, considering that he was the first person to obtain the funds from the transferor (Walldesign) via his diversion of funds into the secondary account. However, the court found that the Bureshes and Ms. Henry qualified under the test as initial transferees from Walldesign. Therefore, they could not employee the safe harbor defense afforded to subsequent transferees by 11 U.S.C. § 550(b)(1). Accordingly, it was fair game for the Committee to come after both the corporate cheat for fraud and the innocent third parties for the unknowing fraudulent conveyance.
In making its decision, the Court of Appeals reasoned that the mere power of a principal to direct the allocation of corporate funds and resources does not constitute legal dominion and control. Various principals exercise de facto control over their corporation’s funds and misusing the funds is a choice that they make. A misappropriation of funds would only qualify as a breach of the principal’s duty to the corporation, rather than confer a status of initial transferee. Instead, a principal may only be considered as an initial transferee and establish dominion by first transferring the funds into his personal bank account and then making payments from that personal account. Bello cleverly did not do that in this case—the secondary account was under Walldesign’s name with Bello and his wife as the only authorized signatories. This key factor prompted the court to agree with Walldesign’s creditors in transferring the burden of repayment of the money diverted by Bello to the innocent third-parties, the Bureshes and Ms. Henry.
Notably, the dissenting opinion in this case raised a variety of issues—the Bureshes and Ms. Henry were not Bello’s friends, family, or even associates. Instead, they were a couple who innocently sold their property in order to fund their retirement, and a small business owner going about her regular course of business in providing design services to Bello. There were no viable means by which these third-party vendors could have recognized that the corporate checks that they were receiving from Bello were in fact drawn from a bank account set up with defalcated funds, especially since they were able to cash the checks without a hitch. Nonetheless, each of these parties were forced to turn over hundreds of thousands of dollars to Walldesign’s creditors, which effectively reduced the amount Bello owed for his wrongful conduct and fraud.
The lesson to be learned from this case is that routine transactions can quite easily transform into financial nightmares, if one is not careful. Seeing the court’s strictly “form-over-substance” approach to this case, the deference that the black-letter law tends to have over what we may view as equitable becomes more apparent. Accordingly, regardless of whether one is a physician receiving payment for medical services, a business selling its inventory to customers in the regular course of business, or even an individual simply selling a used car, you might be best to avoid accepting payments from anyone other than the person or entity receiving those goods or services. Otherwise, you may find yourself in need of the services of an attorney!