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MONTH-IN-BRIEF (Apr 2018)

Bankruptcy Law

First Circuit Treats Funds Held by Debtor As a Bailment

Michael Enright, Robinson & Cole LLP

The U.S. Court of Appeals for the First Circuit recently affirmed the dismissal of a trustee’s fraudulent transfer suit to recover funds paid by a debtor to creditors from the proceeds of the sale of the debtor’s rail line. The money from the sale of the rail line, which was subject to a mortgage in favor of the Federal Railroad Administrator (FRA), was used by the debtor with the FRA’s consent to pay other creditors, pursuant to a waterfall agreement which employed escrow language, but in fact did not utilize a third-party escrow agent. Although the trustee alleged that the debtor had dominion over the funds at the time the payments were made such that its payments to other creditors could be clawed back, the court held that the arrangement was akin to a bailment of personal property, thus limiting the debtor’s rights in the funds and rendering the transfers not voidable under Section 544(b). Keach v. Wheeling & Lake Erie Railway Company (In re Montreal, Maine & Atlantic Railway, Ltd.), No. 17-1912 (1st Cir. April 18, 2018). The FRA’s consent to the use of the funds and waterfall were embodied in an amendment to the FRA’s loan agreement, and the court relied on (i) the fact that the rail line could not have been sold without the FRA’s express consent as mortgagee, and (ii) the court’s determination from a review of the amendment that the FRA’s consent was clearly conditioned on the payments to the creditors in question from the sale proceeds. After holding that under state law this arrangement resembled a bailment, the court turned to Section 544(b) to examine whether these funds would have been property of the debtor if the transfers had not been made. Holding that the funds were never the debtor’s property, the court noted that where “the debtor holds funds as a mere disbursing agent pursuant to a contract that prevents it from putting the funds to any use other than that designated in the contract, the trustee cannot avoid the debtor’s transfer of the funds in compliance with the contract.” Fraudulent transfer defendants are likely to take refuge in this holding in circumstances where they can identify similar restrictions covering the flow of funds that resulted from dispositions of collateral that benefited them.

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