On October 5, 2011, the Delaware Bankruptcy Court, in In re Lambertson Truex, LLC (Truex), issued an opinion holding that a party exercised sufficient "dominion and control" over funds transferred to it by a debtor to qualify as an initial transferee under section 550 of the Bankruptcy Code where the debtor had simply reimbursed it for a payment made to a third party. The bankruptcy court found that because it retained the assets it received from the debtor, the transferee was not a "mere conduit" for the transfer of the funds. The transferee was therefore subject to an avoidance action for the funds as the recipient of an unauthorized postpetition transfer under section 549 of the Bankruptcy Code.

The bankruptcy court ruled that to avail itself of the mere conduit defense to an avoidance action under the Bankruptcy Code, a transferee must lack the power to redirect the assets it receives from the debtor. The bankruptcy court found that the transferee in Truex failed to satisfy this dominion and control test because it failed to demonstrate that it had actually transferred the funds it received from the debtor.

The Truex transferee, a law firm, argued that it was a mere conduit for transfer of the funds from the debtor to the third party, another law firm, because it merely passed along the majority of the funds at issue.

However, the bankruptcy court disagreed because the transferee had paid the third-party law firm on behalf of the debtor months earlier and had simply retained the funds subsequently transferred to it by the debtor in reimbursement for that payment. The bankruptcy court ruled that this did not satisfy the mere conduit test and that the law firm therefore qualified as an initial transferee under section 550, subject to an avoidance action for return of the funds to the debtor's estate.

The case indicates that bankruptcy courts are likely to require a party looking to invoke the mere conduit defense to an avoidance action under the Bankruptcy Code to demonstrate that it has at least transferred the funds to a third party.

The mere conduit defense is relevant to a transferee determination for the purposes of avoidance actions under the Bankruptcy Code, including:

For more information on fraudulent and preferential transfers in bankruptcy, see the following Practice Notes: