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Memorandum of Decision re Post Petition Transfer (In re Riley & Sons Construction, Inc.)

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In re No. 95-43113 TK
Chapter 7
RILEY & SONS CONSTRUCTIONS,
INC.,

Debtor.
___________________________/

JOHN T. KENDALL, Trustee, A.P. No. 98-4023 AT

Plaintiff,
vs.
WILLIE E. PHILLIPS,
Defendant.
___________________________/
MEMORANDUM OF DECISION
While a chapter 11 debtor-in-possession, the above-captioned debtor (the “Debtor”) made a series of payments totalling $16,900 (the “Payments”) to the defendant, its duly appointed bankruptcy counsel (“Phillips”), without court approval. The case was later converted to chapter 7 of the Bankruptcy Code. In this adversary proceeding, the chapter 7 trustee (the “Trustee”) seeks to avoid the Payments pursuant to 11 U.S.C. § 549(a) and to recover the amount of the Payments from Phillips pursuant to 11 U.S.C. § 550(a)(1). For the reasons stated below, the Court finds in favor of the Trustee.

BACKGROUND
On May 12, 1995, the Debtor filed a voluntary petition seeking relief under chapter 11 of the Bankruptcy Code. Prior to the commencement of the case and thereafter, until the case was converted to chapter 7 on January 6, 1997, the Debtor continued to operate its business as a debtor-in-possession. John Riley (“Riley”) served as the Debtor’s president during this period.
Shortly after the chapter 11 case was filed, Phillips was appointed as the Debtor’s general bankruptcy counsel. Prior to the filing of the bankruptcy petition, Phillips received a retainer of $8,000. Thereafter, during the chapter 11, Phillips performed substantial legal services for the Debtor in connection with the case. Phillips neither applied for interim fees during the chapter 11 nor applied for a final allowance of fees as a chapter 11 expense of administration after the case was converted to chapter 7.
On July 2, 1997, after the case was converted to chapter 7, the Trustee’s counsel, Reidun Stromsheim (“Stromsheim”), met with Riley to collect the Debtor’s business records. In reviewing those records, Stromsheim discovered a series of checks written by the Debtor to Phillips during the chapter 11 case. Stromsheim asked Riley what these checks were for. Riley replied that Phillips had needed money and could not continue to represent the Debtor without being paid.
On January 22, 1998, the Trustee filed this adversary proceeding. In due course, the Trustee filed a motion for summary judgment. Phillips filed an opposition to the motion and a countermotion. In support of the opposition and countermotion, Phillips raised a single factual defense. Phillips conceded receiving the Payments and that no court approval had been obtained for the Payments. However, Phillips contended that he had cashed the checks at Riley’s direction and given the funds back to Riley so that he could purchase supplies for the Debtor’s business. Phillips filed a declaration by Riley containing facts supporting these contentions. According to Riley, Riley and Phillips both tended to work in their offices early in the morning and frequently conversed by phone during these hours. Shortly after the bankrupcy case was filed, Riley told Phillips that he was having difficulty getting to the bank during the day and that, since the Debtor’s credit was not good, he had a need for cash for operating expenses. Phillips offered to go to the bank for Riley and noted that his bank permitted him to obtain immediate cash. Thereafter, from time to time, Riley would leave a check for Phillips in an envelope on the Debtor’s office door. Phillips would pick it up, take it to the bank and cash it, and put the cash in an envelope through the Debtor’s office door. Riley would return during the day, get the cash, and use it to purchase supplies.
The Court concluded that, if believed, the facts set forth in Riley’s declaration would establish a “conduit” defense to the Trustee’s claims. The Court found in favor of the Trustee on all other issues. It was undisputed that there had been transfers of property of the estate post-petition totalling $16,900 and that no Court approval had been obtained for the transfers. The Court concluded as a matter of law that the transfers were not authorized by the Bankruptcy Code. No court approval would have been required for the transfers if they had been in the ordinary course of business. 11 U.S.C.A. § 363(c)(1)(West Supp. 1998). However, the Court concluded that, even if they had occurred in the manner described by Phillips and Riley, the transfers were not in the ordinary course of business. Section 549(a) of the Bankruptcy Code provides in pertinent part as follows:

        ...the trustee may avoid the transfer of property of the estate--
            (1) that occurs after the commencement of the case; and
            (2)...
            (B) that is not authorized under this title or by the court.

    11 U.S.C.A. § 549(a)(West 1993).
    As a result, a trial was conducted on the factual issue of under what circumstances and for what purpose the Payments were made. Phillips and Riley both testified consistently with the facts alleged in Riley’s declaration. Phillips’ bank records were presented. The records failed to reflect deposits of all of the checks. Phillips explained that some of the checks were cashed rather than deposited. The records also revealed that, on the days the checks were deposited, there were not withdrawals of equal amounts. Sometimes there were no withdrawals; sometimes, there were withdrawals of lesser amounts.
    Phillips explained that it was his custom to keep large amounts of cash at his house. When Riley requested that he cash a check for him, if Phillips had sufficient cash on hand, he would leave the cash at the Debtor’s office when he picked up the check. If he had some cash but not enough to satisfy the Debtor’s needs, Phillips would supplement the cash he had on hand with funds withdrawn from his account. At the conclusion of the trial, the Court took the matter under submission.
    DISCUSSION
    Having considered the evidence, the Court concludes that it is more probable than not that the account given by Phillips and Riley for the Payments is false. But for one consideration, the Court would have concluded that the consistency and thoroughness of the Phillips’ and Riley’s testimony balanced equally the inherent implausibility of the story. As a result, the outcome would depend on who bore the burden of proof as to the “conduit” theory.
    However, one element of the evidence tips the scale in favor of the Trustee regardless of who bears the burden of proof on this issue. Stromsheim testified credibly that, when initially questioned, Riley admitted that the Payments had been made for Phillips’ attorneys’ fees. At trial, Riley failed either to deny having made this statement or to explain it in a manner consistent with Phillips’ theory of the case. Moreover, as discussed below, the Court concludes that, when the “conduit” theory is asserted by a defendant, the defendant should bear the burden of proof with respect to the facts supporting the theory.
    The “conduit” theory is a judicially created doctrine that is applied in various contexts in avoidance actions. Most commonly, it supplies the rationale for determining that a defendant who received property of the debtor or of the bankruptcy estate should not be deemed a transferee within the meaning of 11 U.S.C. § 550(a) and therefore should not be held liable for the avoided transfer. Section 550(a) of the Bankruptcy Code provides, in pertinent part, as follows:
            ...to the extent that a transfer is avoided under section...549...of this title, the trustee may recover, for the benefit of the estate, the property transferred, or, if the court so orders, the value of such property, from--
                (1) the initial transferee of such transfer or the entity for whose benefit such transfer was made; or
                (2) any immediate or mediate transferee of such initial transferee.

    11 U.S.C.A. § 550(a)(West 1993). See In re Bullion Reserve of N. Am., 922 F.2d 544, 548 (9th Cir. 1991); Bonded Fin. Servs., Inc. v. European Am. Bank, 838 F.2d 890 (7th Cir. 1988). As stated in Bonded Financial:
            Although the Bankruptcy Code does not define “transferee”, and there is no legislative history on the point, we think 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....

    ...
            ...“Transferee” is not a self-defining term; it must mean something different from “possessor” or “holder” or “agent”. To treat “transferee” as “anyone who touches the money” and then to escape the absurd results that follow is to introduce useless steps; we slice these off with Occam’s Razor and leave a more functional rule.

    Id., at 893-94.
    A closely related doctrine, sometimes referred to as “earmarking,” is used to defeat an action to avoid a transfer as a preference. Section 547(b) of the Bankruptcy Code permits a trustee to avoid a transfer of property of the debtor to a creditor on account of an antecedent debt made within 90 days before the filing of the bankruptcy while the debtor was insolvent that permitted the creditor to receive more than it would have received in a liquidation. 11 U.S.C.A. § 547(b)(West 1993). This doctrine is applied when funds are supplied by a third party to the debtor with express directions to pay a creditor and are used by the debtor for that purpose. Under these circumstances, courts have concluded that, although the property was at some point in the possession of the debtor, it was never the debtor’s property in a legal sense. As a result, there was no transfer of the debtor’s property as required by 11 U.S.C. § 547(b). See In re Chase & Sanborn Corp., 813 F.2d 1177, 1180-82 (11th Cir. 1987).
    It is possible, however, for a plaintiff to assert the “conduit” theory for its benefit. For example, an initial transferee pursuant to 11 U.S.C. § 550(a)(1) has no defense to a recovery action. An immediate or mediate transferee, on the other hand, is not liable for the avoided transfer if it received the transfer for value, in good faith, without knowledge of the voidability of the transfer. 11 U.S.C. § 550(b)(1). If the initial recipient of the property transferred is judgment proof or otherwise not amenable to suit, the plaintiff may prefer that the initial recipient not be deemed a transferee within the meaning of 11 U.S.C. § 550(a) but rather a mere “conduit” so as to deprive the party sued of a defense under 11 U.S.C. § 550(b)(1). In each of these three examples, the “conduit” or “earmarking” theory relates to an element of the plaintiff’s claim. However, in the first two instances, the theory is used by the defendant as a shield, to protect itself from liability; in the third, the theory is used by the plaintiff as a sword, to establish the desired defendant’s liability. It seems most appropriate to place the burden of proving the facts upon which this equitable theory is based on the party attempting to use it for its benefit.
    Nothing in the statutes or rules expressly allocates the burden of proof with respect to the “conduit” or “earmarking” theory. Rule 6001 of the Federal Rules of Bankruptcy Procedure places the burden of proof as to the validity of a post-petition transfer pursuant to 11 U.S.C. § 549(a) on the defendant. Fed.R.Bankr.P. 6001 (West 1984). However, in this context, the issue is not the validity of the transfer but rather whether the transfer of the Payments to Phillips should be given any legal significance for purposes of 11 U.S.C. §§ 549(a) and 550(a).
    The Court has been unable to locate any reported cases addressing the appropriate burden of proof on the “conduit” theory. However, the Court has found several cases that address the issue with respect to “earmarking.” These cases reach different conclusions. In three of the cases, the courts concluded that, because the theory relates to an element of the plaintiff’s claim, the plaintiff should bear the burden of proof. See In re Heitkamp, 137 F.3d 1087, 1089 (8th Cir. 1998); In re International Ventures, Inc., 214 B.R. 590, 594 (Bankr. E.D. Ark. 1997); In re Safe-T-Brake of S. Fla, Inc., 162 B.R. 359, 364-65 (Bankr. S.D. Fla. 1993). In two others, the courts concluded that the burden of proof should be placed on the defendant. For example, in In re Chase & Sanborn Corp., 813 F.2d 1177, 1181, the court stated that:
            ...where a debtor has paid existing debts, the funds used as payment are presumed to be the debtor’s property absent some proof to the contrary offered by those defending the transfer.

    Similarly, in In re Sierra Steel, Inc., 96 B.R. 271, 275 (Bankr. 9th Cir. 1989), the court stated that:
            Although cases applying the earmarking doctrine do not expressly state that a defendant was required to trace the earmarked funds,....[p]olicy reasons support a tracing requirement as a prerequisite to application of the earmarking doctrine.

    The Court agrees with the first line of cases cited above that the “conduit” theory, as asserted in this case, relates to an element of the Trustee’s claim: i.e., whether Phillips was a transferee of an unauthorized post-petition transfer. However, the Court also agrees with Chase & Sandborn and Sierra Steel that, when the defendant attempts to use this theory to defeat the plaintiff’s claim, the defendant should bear the burden of proving the facts upon which the theory is based.
    A plaintiff does not always bear the burden of proving facts relating to the elements of its claim. As stated by Wright and Graham in Federal Practice & Procedure:
            The assignment of the burden of proof is determined in accordance with a group of factors sometimes referred to as the Three P’s: Policy, Probability, and Possession of Proof. Thus, in deciding whether an element ... will be treated as part of the plaintiff’s cause of action to be pleaded and proved by him, or as an affirmative defense whose burdens of pleading and proof are to be put on the defendant, courts first consider the impact of the allocation on the policies to be furthered by the law....They then ask” “what will be the probable state of facts in most cases?” so that the burden of showing an idiosyncratic course of events can be placed on the party asserting the unusual. Finally, the decision is sometimes based upon assumptions as to which party can more easily prove a fact....

    21 Charles Alan Wright & Kenneth A. Graham, Jr., Federal Practice and Procedure: Evidence, § 5122, 556-67 (2d ed. 1987). A consideration of the policies underlying 11 U.S.C. § 549(b) and 550(a) does not lead to any obvious conclusion about who should bear the burden of proving the facts underlying the “conduit” theory under these circumstances. However, the latter two bases cited above--probability and possession of proof--argue in favor of allocating the burden of proof to the defendant.
    Cases in which the “conduit” theory applies are infrequent and may even be fairly characterized as “idiosyncratic.” As a result, it makes more sense to require the defendant to plead and prove the facts underlying the theory, in those few cases in which the theory applies, than to require the plaintiff to deny the applicability of the theory in every case. In addition, at least in those cases in which the “conduit” theory relates to whether the defendant should be deemed a transferee, the defendant necessarily has easier access than the plaintiff to the evidence of the facts upon which the theory is based. For that reason, the defendant should bear the burden of proving those facts. In sum, the Court concludes that, regardless of whether the “conduit” theory is viewed as an affirmative defense or as part of an element of the plaintiff’s claim, when the theory is asserted as a shield by a defendant so as to protect the defendant from liability, the defendant should bear the burden of proving the facts upon which the theory is based.
    CONCLUSION
    The Court concludes that Phillips bears the burden of proving the facts supporting his conduit defense to the Trustee’s action pursuant to 11 U.S.C. §§ 549(a) and 550(a)(1). The Court finds that Phillips has failed to meet that burden. The Court further finds that, even if Phillips did not bear that burden of proof, Riley’s
    failure to contradict or explain his initial admission to Stromsheim that the Payments to Phillips were for attorneys’ fees would compel the entry of judgment in favor of the Trustee. Counsel for the Trustee is directed to submit a proposed form of judgment in accordance with this decision.
    Dated: July 16, 1998
    _________________________________
    United States Bankruptcy Judge


CANB DocumentsNorthern District of California