What’s In a Name? Fifth Circuit Rejects Formulaic “Legal Title” Standard of Ownership In Favor of “Control” Test

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IFS Financial Corporation and its affiliates (collectively, “Interamericas”) operated in the insurance, mortgage and banking service industries.  Many of the Interamericas entities were offshore shell companies created solely to channel money between Interamericas’ investors and actively operating Interamericas organizations.  Even though each Interamericas entity had a separate corporate structure, the Pimienta family effectively controlled all Interamericas entities through a single advisory board.

Interamericas’ investors would deposit contributions into one of three bank accounts in Texas, including an account in the name of “Integra Bank” at the Southwest Bank of Texas.  Investors apparently believed that these funds were held in a bank by the name of Integra Bank, rather than in an account under the name “Integra Bank”.  An organization named Integra Bank did in fact exist, however, it was unclear what actual function the bank served.  Integra Bank operated out of a physical structure in Curaçao, but lacked tellers and had little interaction with depositors.  Notably, Integra Bank appeared independent from Interamericas only on paper.  IFS’ investment relations managers would forward checks from investors directly to IFS for deposit into the bank accounts, and when investors wanted to withdraw funds, they contacted IFS directly.  No one at Integra Bank had independent authority to withdraw funds from the account held in its name – only the Interamericas advisory board could approve withdrawals.

Between 1998 and 2002, a series of events led to Interamericas financial demise.  During this time, the Interamericas advisory board covertly removed funds belonging to Interamericas from the Integra Bank account and loaned millions of dollars to IFS’s shareholders and insiders.  By 2002, the advisory board had sold off most of Interamericas, leaving IFS as its only functional entity.  Shortly following Interamericas’ liquidation, IFS filed for chapter 7 bankruptcy protection.  The appointed trustee subsequently sought to avoid approximately $3 million in allegedly fraudulent transfers from IFS to a group of insiders pursuant to section 544(b) of the Bankruptcy Code, which permits a trustee (or debtor in possession) to “avoid any transfer of an interest of the debtor in property … that is voidable under applicable law by a creditor holding an [allowable] unsecured claim.”  As the disputed funds concerned Texas bank accounts, section 24.005 of the Texas Business and Commercial Code, which allows creditors to avoid transfers made by a debtor with actual intent to hinder, delay, or defraud any creditor of the debtor, provided the applicable law for purposes of section 544(b) of the Bankruptcy Code.

In 2009, the Bankruptcy Court found that IFS’s transfers to the insiders were fraudulent because, among other things: (i) the funds received by the insiders were paid from an account legally titled in the name “Integra Bank” but actually owned and controlled by IFS and (ii) IFS exercised exclusive control over the account.  The District Court affirmed the Bankruptcy Court’s decision.  On appeal, the Fifth Circuit considered whether the District Court erred in determining that IFS was the de facto owner of the Integra Bank account through which the alleged fraudulent transfers passed.

Ownership of the Integra Bank account was essential to the question of whether the funds on deposit in the account constituted an “interest of the debtor in property” that could be voided under the applicable Texas fraudulent transfer statute.  The insiders argued that the debtors did not have legal title to the bank accounts where the funds resided because those accounts were in the name of “Integra Bank”, and not the debtors.  The insiders also argued that IFS lacked signature authority over the account, and neither IFS nor the advisory board owned any interest or exercised any authority over Integra Bank.

Conceding these facts, the trustee did not dispute IFS’s lack of legal ownership of the Integra Bank account, or contend that IFS owned or held shares in Integra Bank or that anyone at IFS was an officer, director or employee of Integra.  Furthermore, the trustee agreed that no formal document evidenced IFS’s authority over Integra Bank or its account.  Instead, the trustee asserted that these lack of formalities evinced IFS’s intent to defraud by intentionally avoiding a paper trail which would allow creditors to easily identify assets.  Moreover, the trustee argued that as a functional matter, the IFS debtors controlled the Integra Bank account.  Also, the trustee noted that IFS was Interamericas only remaining operating entity during  its final years and, moreover, its only shareholder with any value.  Accordingly, the trustee reasoned that any money in the Integra Bank account was effectively IFS’s, and argued IFS should not be permitted to perpetuate fraud through an intentionally obscure organizational structure.

Significantly, the issue of whether legal title is necessary to establish a debtor’s ownership of an account was a matter of first impression for the Fifth Circuit.  The Court initially noted that in making this determination it should apply Texas law because “the trustee’s successor rights [to establish a fraudulent transfer claim] arise under federal law, but the extent of those rights depends entirely on applicable state law.”  Id. at 9 [citations omitted].  Accordingly, the Court began its analysis noting that the “scant” Texas law on the subject demonstrates that “control is more decisive than ownership.”   Relying on Silsbee State Bank v. French Mkt. Grocery Co., 132 S.W. 465, 466 (Tex. 1910), the Court found that under Texas law, courts are directed to look not to the legal relationship between parties, but rather the individual facts of each case.  Accordingly, the legal titleholder to a bank account may not always be the owner of its content.  In Silsbee, the legal titleholder to an account deposited funds into the account as an “agent”, and an unknown third party withdrew the funds from the account later that same day.  On these facts, the Texas Supreme Court held that the legal titleholder to the account could not be considered the “owner of the funds”, as a third party had exercised actual control over the funds and the legal titleholder was not in full possession and control of the deposited money.

The Fifth Circuit found additional support for a control theory of ownership in the context of voiding preferential transfers under section 547 of the Bankruptcy Code.  The Court cited to its earlier decision in In re Southmark, 49 F.3d 1111 (5th Cir. 1995), a preference case in which the Court held that control over funds in an account is the predominant factor for determining an account’s ownership.  At issue in Southmark was a payroll check drawn from an account in the debtor’s name.  Although the debtor legally owned the account, the debtor and its parent and affiliate companies all commingled funds in the account.  However, rather than focus on the debtor’s legal title to the account, the Court emphasized the debtor’s control over the account, explaining that “primary consideration in determining if funds are property of the debtor’s estate is whether payment of those funds diminished the resources from which the debtor’s creditors could have sought payment.”  Ultimately, the Court concluded that the debtor’s “unfettered discretion to pay creditors of its choosing” supported the control requisite to a finding of ownership.

Finally, while acknowledging that the Bankruptcy Court did not permit the trustee to proceed under earmarking or corporate veil-piercing theories, the Fifth Circuit observed that the law underlying these theories was nevertheless instructive and further buttressed the Court’s holding.  Pursuant to the earmarking doctrine, if a third party provides funds for the specific purpose of paying a creditor of the debtor, the funds may not be recoverable as a preferential transfer.  The earmarking doctrine is applied narrowly, however, and the Fifth Circuit previously rejected application of the doctrine where a debtor had dispositive control over loan proceeds deposited into its account.  Similarly, the Court noted that the general principle that a parent company’s ownership of a subsidiary does not equate to complete control over that subsidiary is not absolute.  Rather, where a parent entity dominates its subsidiary to such an extent that the subsidiary is nothing more than a proxy for the parent, courts may find sufficient control to disregard the artificial boundaries between parent and subsidiary.  Accordingly, both of these legal theories underscore substance over form by recognizing the significance of actual control.

Applying these principles to the facts of the case, the Fifth Circuit concluded that the trustee established IFS’s de facto ownership of the Integra Bank account via control.  In reaching this conclusion, the Court was particularly motivated by the fact that IFS had the ultimate power to transfer funds from the account and Interamericas obscured its power to transfer in an “intentionally complicated” corporate structure.  Although the Fifth Circuit found that legal title of the Integra Bank account was irrelevant in IFS’s particular case, the Court reiterated that fact-specific nature of the inquiry and cautioned that while control is primary, it may not always be decisive and, therefore, legal ownership is not per se irrelevant.  The Court went on to explain that where evidence of fraud and a debtor’s strict control are both strong, disputed legal ownership is less compelling.  However, where evidence of fraud is weak, legal ownership may weigh heavier in the Court’s calculus.

The IFS decision puts debtors on notice that the Fifth Circuit will not rely on legal title alone in determining whether an account is properly included in a debtor’s bankruptcy estate.  IFS heralds the triumph of substance over form, and compels Fifth Circuit courts to focus the inquiry, at least in the first instance, not on the name of the account holder but rather on the identity of the entity exercising actual control over the account.  Accordingly, debtors are well-advised to not rely on legal title alone when evaluating whether funds in a particular account could be subject to potential fraudulent transfer claims.