In Golden v. The Guardian Life Insurance Company of America (In re Lenox Healthcare Inc.), the U.S. Bankruptcy Court for the District of Delaware addressed some issues that frequently arise in preference litigation - particularly, what constitutes property of the estate, the defenses available to defendants, and the specificity with which a trustee must plead and offer proof for the elements of a preferential transfer at the initial complaint, answer and discover phase of an adversary action.

On July 10, 2001, Lenox Healthcare Inc. filed a petition for relief under 11 U.S.C. Section 101, et seq. Prior to the petition date, Lenox maintained certain health and dental employee benefit plans, which were qualified plans under the Employee Retirement Income Security Act of 1974. Pursuant to an Administrative Services Agreement, the Guardian Life Insurance Co. of America performed administrative services for the plans including, but not limited to, paying daily eligible claims on the Lenox's behalf.

Guardian invoiced Lenox monthly for the claims that it paid and Lenox paid each invoice by remitting a check for the full balance due. During the 90 days prior to the petition date and in the two weeks after the petition date, Lenox paid - in five separate transfers - approximately, $750,000.

Subsequent to the petition date, the Chapter 11 trustee filed a complaint against Guardian seeking to avoid and recover three of the five transfers as alleged preferential, fraudulent and unauthorized post-petition transfers. Almost two years after the filing of the original complaint, the trustee filed an amended complaint to include the other two transfers.

Guardian subsequently filed a motion for summary judgment seeking a determination that the Transfers could not be avoided and recovered by the trustee pursuant to sections 547, 548, 549, and 550 of the Bankruptcy Code. Specifically, Guardian asserted the following: the transfers were not property of the estate pursuant to Section 541 of the Bankruptcy Code; Guardian was not an initial transferee but a mere conduit of funds to third-party beneficiaries; the trustee could not satisfy his burden under Section 547(b)(5); and the avoidance of the transfers added in the amended complaint is time-barred by Section 546(a).

In response, the trustee argued that the transfers added in the amended complaint related back to the date of the original complaint and, thus, were not time-barred. The trustee also argued that the amended complaint must survive Guardian's summary judgment motion because the issue of whether the transfers consisted partially or wholly of estate property is an issue of material fact.

In issuing its decision, the court first stated that in order for the trustee to be able to avoid the transfers under sections 547, 548, and 549 of the Bankruptcy Code, the transfers must have been property of Lenox's estate under Section 541(a)(1) of the Bankruptcy Code.

Although the court acknowledged that the scope of Section 541(a)(1) is broad, the it also stated that Section 541(d) provides that "(p)roperty in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest . . . becomes property of the estate . . . only to the extent of the debtor's legal title to such property." In other words, property in which a debtor holds only bare legal title is not property of the estate. Therefore, where a debtor holds property in trust for another, the funds in the trust are not property of the debtor's estate and thus, transfers of those funds cannot be avoided.

In this case, the trustee alleged that the transfers consisted of employee payroll deductions that were withheld from employee wages for the purpose of contributing to the plans; employer contributions to the plans; and administrative fees paid to Guardian. As for the withholdings, the court noted that these funds were held in trust for the employees and thus were never property of Lenox's estate. Accordingly, the withholdings could not be avoided by the trustee. However, the employer contributions were not held in trust until they were actually transferred to the employee benefit plan. Thus, the court held that the employer contributions could be avoided.

As for the fees, the court reviewed the evidence submitted with the pleadings and determined it was clear that the transfers did not include fees. The court held, however, that a material fact issue remained in dispute that would require further determination as to what portion of each transfer could be considered withholdings and what portion constituted employer contributions.

As for Guardian's mere conduit defense, the court noted that pursuant to Section 550 of the Bankruptcy Code, a trustee may recover transfers avoided under sections 547, 548 and 549 from the initial transferee or the entity for whose benefit the transfer is made. In order to qualify as a mere conduit, the court noted that a defendant must lack control over the transfers such that the payment "'simply passed through its hands and it had no power to redirect the funds to its own use.'"

In other words, if the transferee is not under any contractual or other obligation to use transfers for the benefit of others but may use the funds freely, it does not qualify as a mere conduit so as to not be liable for avoidance and recovery of transfers. Guardian asserted that it was a mere conduit because pursuant to the agreement, it was a claims paying agent. The court, however, concluded that the transfers were instead reimbursements from Lenox to Guardian for its advance payment of employee claims.

The court noted that had Guardian chosen, as it had the option under the agreement, to establish a funding account from which it could have drawn checks and forward them directly to the employees or to Lenox for distribution, Guardian may have qualified as a mere conduit. Instead, Guardian's advance payment of claims actually made Guardian a creditor of Lenox. A creditor could not be a "mere conduit" as the transfers would then be received as payment on an antecedent debt - which is one of the hallmarks of a preferential transfer. Finally, the court noted that even if Guardian were Lenox's agent, the existence of a principal-agent relationship does not automatically make the agent a mere conduit.

As for Guardian's assertion that avoidance and recovery of the two transfers added in the amended complaint were time-barred by Section 546(a) of the Bankruptcy Code, the court noted that because the amended complaint was filed after the time prescribed by Section 546(a), in order for those transfers to survive Guardian's motion for summary judgment, they must relate back to the date of the original complaint pursuant to Federal Rule of Civil Procedure 15(c) made applicable hereto by Federal Rule of Bankruptcy Procedure 7015. In other words, those transfers must arise "'out of the conduct, transaction, or occurrence set forth or attempted to be set forth in the' original complaint."

The court cited other cases that have discussed whether additional alleged preferential transfers relate back to those originally listed in a complaint. Those cases considered, among other things, the following factors: the frequency and amount of the transfers indicating a scheme or course of conduct; and finding the facts in the original complaint provide the defendant with fair notice that all payments in the relationship are being challenged. Based on its review of case law, the court held that the original complaint did not set forth any specific facts that would have encompassed the transfers added in the amended complaint.

Specifically, the original complaint just listed the three payments by date and amount; it did not reference the agreement nor specify any facts regarding the relationship between Lenox and Guardian. Thus, the amended complaint did not set forth new legal grounds or facts on which to avoid the original transfers but listed additional transfers. Accordingly, the court granted partial summary judgment in favor of Guardian with respect to the transfers added in the amended complaint.

Finally, as for Guardian's argument that the trustee had not satisfied his burden of proof under Section 547(b)(5), the court noted that the trustee has the burden of proving each of the elements of a preference. The trustee admitted that he did not perform an analysis under Section 547(b)(5). Accordingly, the court held that the trustee had failed to carry his burden of proof and thus granted partial summary judgment in favor of Guardian with respect to the Section 547 count of the amended complaint.

This opinion carries important messages for litigants on both sides of a preference action. First, those serving administrative or "conduit" roles with respect to third parties should be certain that their contractual relationship with customers sets forth specifically the terms of this role and, to the extent that any portion of their compensation originates with the customer, that the customer's obligation is either secured or held to a consistent ordinary course payment schedule. Second, in prosecuting preference actions on behalf of the estate, trustees should take pains to investigate and plead not just the transfers originating from the debtor, but also the nature and extent of the relationship of the debtor with the transferee.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors’ rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.

Wendy M. Simkulak is an associate in the business reorganization and financial restructuring practice group at Duane Morris and practices in the area of reorganization and finance law, representing liquidating trustees, secured creditors, large unsecured creditors and insurers in all aspects of a bankruptcy case. Admitted to practice in Pennsylvania and New Jersey, Simkulak is a graduate of the University of Pittsburgh School of Law and Graduate School of Public and International Affairs. She also is a summa cum laude graduate of Muhlenberg College.

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