Key Takeaways

  • The mere conduit defense shields parties who only act as intermediaries without control over funds from being treated as transferees under Bankruptcy Code § 550.
  • Courts distinguish between initial transferees and subsequent transferees using tests like the dominion test and sometimes the control test.
  • Circuit courts vary: the Fourth Circuit bars recovery from conduits, the Eleventh Circuit has extended protection to payroll companies, and the Second Circuit has redefined some conduits as “agents” to fit within safe harbors.
  • The defense is fact-intensive and cannot usually be decided at the motion-to-dismiss stage; full factual records are required.
  • While advantageous, the defense carries risks, including disputes over who qualifies as the “initial transferee.” Careful recordkeeping and legal strategy are critical.

What Is the Fourth Circuit's View on the Recovery of an Avoidable Transfer?

The position of the Fourth Circuit that it's impossible to recover an avoidable transfer from a party which was used as a mere conduit by another party who has direct business dealings with a debtor, under section 550(a) (1) of the Bankruptcy Code.

What Is Mere Conduit Defense?

Based on the provisions of section 550(a) (1) of the Bankruptcy Code, the mere conduit defense restricts the rights of a debtor to recover preferential transfers. The section states that the debtor is allowed to recover transferred property or the value of such property according to the decision of the court, from

1. The party who made the initial transfer or the beneficiary of the transfer, or,

2. Any immediate or mediate transferee of the original transferee.

How Different Circuits Interpret the Mere Conduit Defense

Application of the mere conduit defense is not uniform across federal circuits. For example, the Eleventh Circuit recently expanded its use to protect a payroll processing company that merely routed employee wages without exercising control over the funds.

By contrast, the Second Circuit has focused on whether financial intermediaries should be considered “agents” of the debtor. In Tribune II, the court held that a securities clearing agency acting for Tribune qualified as a financial institution under § 546(e), effectively shielding certain leveraged buyout transactions from avoidance. This shift from calling such entities conduits to “agents” shows how nuanced the analysis has become.

What Is the Difference Between the Liability of an Initial Transferee and a Subsequent Transferee?

The major difference between the liability of the initial transferee and subsequent transferees is that a subsequent transferee is protected from the debtor if it acted on behalf of the initial transferee for the following:

  • For value, to satisfy or secure a future debt
  • In good faith
  • Oblivious that the transfer is avoidable, in essence, lacks knowledge about the avoidability of the transfer

How Can the Mere Conduit Defense Be Supported in Court?

To support the mere conduit defense is legal proceedings, the party must prove that it merely acted as a facilitator for the debtor and had no control over the funds it was moving to claim ownership of same. The mere conduit defense relies heavy upon facts. The parties involved must prove the existence of financial and business relationships as well as documentation and testimony at the Bankruptcy Court.

Why Courts Require a Factual Record

Courts emphasize that the mere conduit defense is a fact-intensive inquiry. It requires evidence of how funds moved, whether the alleged conduit had discretion over them, and the business relationship between parties. Because of this, several courts—including those in New York—have ruled that the defense is not appropriate at the motion-to-dismiss stage. Instead, discovery is usually needed to establish whether a party acted only as a facilitator or exercised control. This means litigants should be prepared to provide detailed records, contracts, and testimony to substantiate their defense.

Disadvantages of Mere Conduit Defense

One of the main disadvantages of the mere conduit defense is that it makes the final recipient of the preferential payment also liable. This can lead to disagreements between the two potential creditors as both try to shift liability to one other.

Advantages of Mere Conduit Defense

However, it's an essential defense that can protect a creditor who paid out the funds it received promptly to the beneficiary from being forced to return money it didn't use. If any creditor who is a beneficiary of payments from a bankrupt party aims to disburse the funds to another creditor entity quickly, it's important to keep good records and get sound legal advice considering the risks involved in such transactions.

Practical Examples of When the Defense Applies

The mere conduit defense has successfully been applied in scenarios such as:

  • Payroll companies forwarding wages from employers to employees without discretion over funds.
  • Clearing agencies distributing payments during leveraged buyouts, where courts analyzed whether the agency acted as an agent of the debtor.
  • Escrow agents who hold but cannot repurpose funds, provided they can show no independent use of the money.

These examples demonstrate how varied the fact patterns can be, reinforcing the importance of proving lack of dominion or control.

Who Pays the Trustee if Amount Is Received Within Ninety Days Before Filing Bankruptcy?

The initial transferee and the beneficiary on whose behalf the transfer was made are responsible for repaying the trustee the amount received within ninety days before filing for bankruptcy.

What Is the Importance of Determining the Initial Transferee?

In cases of mere conduit defense, its essential to determine which party is the real initial transferee as the trustee can recover funds transferred on behalf of the debtor from the party so named.

What Are the Methodologies to Determine the Initial Transferee?

There are two methods used for determining the status of an initial transferee, including:

  1. The Dominion Test, and
  2. The Control Test.

Although dominion and control are synonyms, the two tests are different.

What Test Does the Ninth Circuit Usually Utilize to Identify Initial Transferee?

The Ninth Circuit uses the dominion test to determine initial transferee. It is yet to apply the control test in cases of mere conduit defense.

Initial Transferee Under Dominion Test

According to the dominion test, a transferee is someone who has the right to use the money or asset for any purpose of their choosing. The dominion test aims to determine whether a party has the legal authority over the funds and is entitled to use the money in whatever way it wants.

How Does the Dominion Test Work?

The dominion test aims to determine that a transferee has the right to invest the entire money in uranium stocks or lottery tickets. In this sense, dominion goes beyond mere possession, it must offer full legal control over the money.

Frequently Asked Questions

  1. What is the purpose of the mere conduit defense?
    It protects parties who simply pass along funds without exercising control, shielding them from liability as “transferees” under § 550.
  2. Do all circuits apply the defense the same way?
    No. Circuits differ—some focus on control (dominion test), while others analyze agency relationships or extend protection to payroll processors.
  3. Can a party raise the defense early in litigation?
    Generally not. Courts often hold it inappropriate for motions to dismiss because the analysis depends on a detailed factual record.
  4. How does the dominion test relate to this defense?
    The dominion test asks whether the party had legal authority to use the funds as it wished. If not, the party is likely just a conduit.
  5. What evidence helps prove a conduit defense?
    Financial records, contracts showing limited authority, and testimony confirming lack of control all help establish conduit status.

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