On December 5, 2014, in Mano-Y&M, Ltd. v. Field (In re The Mortgage Store, Inc.), the US Court of Appeals for the Ninth Circuit adopted a strict "dominion test" to determine initial transferee status under section 550(a) of the Bankruptcy Code for purposes of allocating fraudulent transfer liability (773 F.3d 990 (9th Cir. 2014)). In so holding, the Ninth Circuit abrogated the US Bankruptcy Appellate Panel for the Ninth Circuit Court of Appeal's decision in McCarty v. Richard James Enterprises, Inc. (In re Presidential Corp.), which had applied a hybrid "dominion and control" test for this purpose (see 180 B.R. 233 (9th Cir. BAP 1995)).

In December 2008, Mano-Y&M, Ltd. (Mano) contracted to sell a shopping plaza to Lindell, the sole shareholder and president of The Mortgage Store, Inc. (Debtor), for $2.2 million. Under the contract, Lindell was to pay $300,000 cash, and a seller-financed mortgage was to cover the remainder of the purchase price. Lindell was also to pay $10,000 of the purchase price immediately as earnest money.

The contract between Mano and Lindell also assigned responsibilities to two third-parties:

On January 20, 2009, the Debtor wired $311,065.25 to the Attorney in satisfaction of Lindell's obligations under the contract. The Attorney deposited the money in a trust account he held with Compass Bank. On January 21, 2009, the Attorney disbursed the money paid by the Debtor under the contract.

An audit later revealed that the Debtor was operating a Ponzi scheme. In November 2010, the Debtor filed for bankruptcy protection under Chapter 7. The trustee sought to avoid, as a fraudulent transfer under sections 544(b) and 548(a)(1) of the Bankruptcy Code, the Debtor's transfer in connection with the shopping plaza transaction and thereby recover the funds from Mano.

The bankruptcy court avoided the transfer as fraudulent and determined that Mano was the initial transferee, rather than a subsequent transferee. On appeal, the US District Court for the District of Hawaii affirmed the bankruptcy court's decision that Mano was the initial transferee.

Mano appealed the District Court's ruling to the Ninth Circuit.

On appeal, the Ninth Circuit applied the "dominion test" to determine that Mano was the initial transferee under section 550(a) of the Bankruptcy Code.

Under section 550(a) of the Bankruptcy Code a trustee may recover fraudulently transferred property or the value of that property from the initial transferee or the entity for whose benefit the avoided transfer was made. These parties face strict liability as to recovery of avoided fraudulent transfers. Although a trustee may also recover from a subsequent transferee, subsequent transferees are allowed to assert affirmative defenses that, if successful, will prevent recovery.

Noting the absence of a statutory definition of "initial transferee" in section 550(a), the Ninth Circuit applied the "dominion test" to determine whether Mano was the initial transferee. Under the dominion test, "a transferee is one who . . . has dominion over the money or other asset, the right to put the money to one's own purposes." Key factors in the dominion test are whether the recipient of funds has:

Under the dominion test, the initial transferee is the first party to establish dominion over the funds after they leave the transferor. Other transferees are subsequent transferees.

In adopting the dominion test, the Ninth Circuit rejected the hybrid "dominion and control test," which it had previously used to identify initial transferees. The dominion and control test included elements of the dominion test, but it also drew from the alternative "control test," which the Ninth Circuit has rejected. Jurisdictions following the control test require courts "to step back and evaluate a transaction in its entirety to make sure that their conclusions are logical and equitable." The Court noted that it previously rejected the control test's flexible, equitable approach in favor of the pure dominion test (see Universal Serv. Admin. Co. v. Post-Confirmation Comm. of Unsecured Creditors of Incomnet Commc'ns Corp. (In re Incomnent), 463 F.3d 1064, 1071 (9th Cir. 2006)).

Applying the dominion test to this case, the Ninth Circuit rejected Mano's argument that Lindell had dominion over the funds from the time they were received by the Attorney to the time the Attorney transferred them to the parties as specified under the contract. Mano argued that the Attorney's receipt and distribution of the funds on Lindell's behalf was sufficient to give Lindell dominion, even though Lindell did not actually possess the funds. In rejecting Mano's argument, the Ninth Circuit first determined that Lindell never held legal title to the disputed funds, a factor that Ninth Circuit precedent has identified as highly significant in the dominion analysis. Although Lindell may have had some equitable interest in the funds while they were in the Attorney's possession, that interest was too constrained to satisfy the dominion test. The Court reasoned that Lindell had no right to control the distribution of the disputed funds, because the conditions precedent had been satisfied by the time the Debtor transferred the funds to the Attorney. The Ninth Circuit noted that whether the Attorney was acting on Lindell's behalf when he received the funds was immaterial; rather, what mattered was whether Lindell had the ability to manipulate the funds on his own accord. The Court found that he did not have that ability.

While noting that the result was "harsh," the Court concluded that, because Lindell was not a transferee and Mano did not argue that any other party was the initial transferee, the District Court did not err in deeming Mano the initial transferee of the disputed funds.

This case serves as a reminder that, despite the possibility of harsh outcomes, some courts are still willing to apply the strict "dominion test" rather than the more equitable "control" and "dominion and control" tests. The Court explained that the result was compelled by the Congressional intent underlying section 550, which was to allocate fraudulent transfer risk to the parties having the lowest monitoring costs. These parties tend to be initial transferees, who have relationships and influence with the debtor, rather than subsequent transferees and other creditors. Deeming Lindell to be the initial transferee in this case would have undermined the structure of section 550, as a party in his position would not have the proper incentives to monitor the debtor for fraud. Further, the Court suggested that Mano could have mitigated fraudulent transfer risk by holding cash reserves equal to the purchase price or by obtaining liability insurance.

For more information on fraudulent transfers, see the following Practice Notes: