Funds Transferred From a Client Trust Account Can Be Property of the Debtor That Is Subject to a Fraudulent Transfer Claim

By: Adam C.B. Lanza

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

 

In In re Dayton Title Agency, Inc., where a title company’s bankruptcy estate sued a paid-off lender to recover a fraudulent transfer,[1] the Sixth Circuit Court of Appeals held that the funds paid out of the debtor’s trust account constituted property of the debtor at the time of transfer for purposes of avoiding a fraudulent transfer.[2] In Dayton Title, the chapter 7 trustee (“trustee”) commenced an adversary proceeding to avoid, as a constructively fraudulent transfer, a payment the debtor had made to its client’s lender from the trustee’s client trust account without waiting for a forged check to clear.[3]  The funds used to make the payment were from a provisional credit that the debtor’s bank extended to it.[4]  In response to the fraudulent transfer action, the lender argued, among other things, that the transfer was not constructively fraudulent because the money that the lender received was not property of the title agency, as the money was being held in trust for a third party.[5] The bankruptcy court entered summary judgment in favor of the trustee, holding that majority of the payment was constructively fraudulent.[6]  On appeal, the district court held that only a small portion of the payment was fraudulent.[7]  However, the Sixth Circuit reversed the district court and affirmed the bankruptcy court’s ruling.[8]

Under section 544 of the Bankruptcy Code, the chapter 7 trustee brought the constructive fraud claim under state law.[9]  The Ohio fraudulent transfer statute provides that a transfer may be avoided as constructively fraudulent if (1) it is “[a] transfer made . . . by the debtor”; (2) “the debtor made the transfer . . . [w]ithout receiving a reasonably equivalent value in exchange for the transfers”; and (3) “either of the following applies: (a) The debtor was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; (b) The debtor intended to incur, or believed or reasonably should have believed that he would incur, debts beyond his ability to pay as they became due.”[10]  As it was undisputed the second and third elements of the claim were present, the issue on appeal in Dayton Title was whether the transaction was a “transfer” under the Ohio fraudulent transfer statute.[11]  Under Ohio law, a “transfer” is defined as a means of disposing “property of the debtor.”[12]  Accordingly, assets held in trust, which are excluded from the debtor's estate, are not subject to fraudulent transfer claims because the holder of a trust has only legal title.[13]

The Sixth Circuit held that the transfer of funds from the trust account was constructively fraudulent because the court found that the funds were not being held in trust.[14]  The Dayton Title court determined that the funds were not being held in trust for the debtor’s client under Ohio law notwithstanding the fact that they were being held in a trust account because the debtor’s bank, and not its client, transferred the funds into the account.[15]  Accordingly, the Dayton Title court found that the funds were property of the debtor because the debtor had both equitable and legal title to the funds at the time of the transfer.[16]  Therefore, under Ohio law, the transaction at issue qualified as a transfer.[17]  Thus, the court concluded that the trustee established all three elements of a constructive fraud claim under Ohio law.[18]

Dayton Title has significant implications in bankruptcy because a bankruptcy trustee may be avoid a transfer of such funds transferred from a debtor’s client trust account.  In light of Dayton Title, a bankruptcy trustee should carefully scrutinize transactions from a debtor’s trust account and not assume that the funds were being held in trust.  If the trustee finds that the debtor transferred funds that were advanced by the debtor’s bank in connection with a forged or bounced check, the trustee may be able to avoid the transfer, especially since the first two elements of a constructive fraud claim will likely be present.  With respect to the first element, Dayton Title demonstrates that funds held in a debtor’s client trust account can be property of the debtor despite the parties’ intention that the funds would be held in trust in the trust account if the funds were deposit by a third party, such as the debtor’s bank.[19]  As to the second element, the debtor will likely not have received reasonably equivalent value in exchange for a transfer from his trust account because such a transfer will typically have been made for the benefit of the debtor’s client instead of the debtor itself.  While the viability of such a constructive fraud claim will depend on whether the trustee can establish the third element of the claim, a trustee should remember Dayton Title in cases in which the debtor has a client trust account.

 

 


[1] The White Family Co. v. Slone (In re Dayton Title Agency, Inc.), 724 F.3d 675 (6th Cir. 2013).

[2] Id. at 678.

[3] Id.

[4] Id.

[5] Id. at 680.

[6] Id. at 678

[7] Id.

[8] Id. at 686.

[9] Id. at 678.

[11] In re Dayton Title, 724 F.3d at 679.

[13] In re Dayton Title, 724 F.3d at 680.

[14] Id.

[15] Id.

[16] Id.

[17] Id.

[18] Id. at 680­–81.

[19] Id. at 680.