Roberta A. Colton, United States Bankruptcy Judge.
Shortly after federal agents executed a search warrant at its headquarters, Taylor, Bean & Whitaker Mortgage Corp. ("TBW") filed for relief under Chapter 11 of the Bankruptcy Code
From January 2006 to August 2009, ADP provided payroll services for TBW and its subsidiaries and affiliates, that included calculating the taxes owed to federal, state, and local entities based upon the gross payroll information uploaded, disbursing net wages and garnishments, and remitting withholdings to the applicable taxing authorities (collectively, the "Payroll Services").
An initial transferee is generally liable to the bankruptcy estate for the amount or value of fraudulently transferred property. A plain reading of § 550(a)(1) might hold those who facilitate an avoided fraudulent transfer, such as a bank or law firm, just as liable as the ultimate recipient of the transferred property. Indeed, § 550(a)(1) can almost be read to impose strict liability on such an initial transferee of an avoided fraudulent transfer.
To mitigate against such a harsh and inequitable interpretation of § 550(a)(1), the Eleventh Circuit created the "mere conduit" exception to initial transferee liability.
So far, the Eleventh Circuit has invoked the mere conduit exception to protect the following initial transferees from liability: (i) a financial institution handling and making payments from deposit accounts;
The Eleventh Circuit refused, however, to extend the mere conduit exception to an attorney who paid out money from his trust account as directed by his unscrupulous client.
Thus, to qualify as a mere conduit in this circuit, the initial transferee of a debtor's fraudulently transferred property must show "(i) that they did not have control over the assets received, i.e., that they merely served as a conduit for the assets that were under the actual control of the debtor-transferor and (ii) that they acted in good faith and as an innocent participant in the fraudulent transfer."
The issue here is whether ADP, a payroll processing company, was a mere conduit when it processed the Transfers pursuant to TBW's instructions, notwithstanding the fact that the Transfers may have been part of a "great big fraud."
The Trustee and ADP have filed and fully briefed three separate motions for partial summary judgment related to the mere conduit defense.
This court has jurisdiction over this adversary proceeding under 28 U.S.C. §§ 1334(b) and 157(a). This is a core proceeding pursuant to 28 U.S.C. § 157(b)(2)(F) and (H).
TBW was a privately held company incorporated in 1991. Lee Farkas ("Farkas") controlled 79.2% of TBW directly, 14.7% through LBF Holding, LLC, and 6.1% through Taylor, Bean & Whitaker ESOP.
Until its sudden collapse in 2009, TBW was the largest independent mortgage lender in the United States. TBW operated three primary lines of business: a mortgage loan origination business, a mortgage loan sales business, and a mortgage loan servicing business. TBW's business model was based on the premise that the mortgage loans it originated or purchased would be sold within days or weeks of origination.
TBW's Payroll and Human Resources Departments managed, respectively, payroll and human resources for all the TBW Entities.
In April 2005, Ms. Potter-Levane contacted ADP about processing payroll for the TBW Entities.
On May 3, 2005, Farkas executed an ADP Master Services Agreement on behalf of TBW, which incorporated several Annexes, including: A (General Terms and Conditions), B (Payroll Services), C (Tax Filing Services), S (PayForce), T (TotalPay), and Z (Pricing), and which was modified by an addendum dated May 3, 2005, and an amendment dated October 1, 2005, that added Annex O (Time and Labor Management Services) and the pricing for Annex O services to Annex Z (Pricing) (collectively, the "MSA").
On May 12, 2005, ADP received a background history report from Dun & Bradstreet that showed TBW to be financially sound.
As of mid-January 2006, the following TBW Entities had been set up for Payroll Services: TBW, Home America Mortgage, Thunderflower, LLC, Nada Restaurant Group (later known as Dine Design, Inc.), Compass Health & Fitness, Chisholm Properties of Atlanta, LLC, Quality Title, LLC, US Family Insurance, and 24/7 Call Capture, LLC.
ADP regularly deals with large employers with thousands of employees and multiple businesses. Accordingly, the ADP representatives who interacted with TBW did not find the diversity of TBW's business interests remarkable. ADP does not involve itself in a client's business decision on "what companies they open and who they pay."
Between 2006 and 2009, ADP provided Payroll Services to the TBW Entities pursuant to the MSA. As explained by Kristin Walle ("Ms. Walle"), a Vice President of Global Money Movement and Compliance, Implementation and Client Experience at ADP:
ADP received each Transfer subject to specific client instructions. Again, Ms. Walle explained:
In sum, ADP was contractually obligated to use the Transfers as directed by TBW to provide Payroll Services.
Annex A (General Terms and Conditions) to the MSA defines the "Client Group" as the "Client, Client's majority owned subsidiaries and affiliates of Client."
At the root of the Trustee's claims are wages, garnishments, and taxes paid by TBW that passed through ADP to or on behalf of employees of various TBW Entities. Due to its size and organizational structure "[p]ayroll processing at TBW [was] a continuous and procedure-intensive routine."
ADP does not execute a new MSA when a client adds a new business or company; rather, the MSA applies to every business established by the client.
Before assigning a Company Code, ADP asked for the following information about the new entity:
ADP also required that TBW sign and return the following forms on behalf of the new entity:
When asked why ADP needed the RAA, Ms. Potter-Levane explained that "[t]he reporting of the agent authorization, the state Limited power of attorney and tax information authorization is because we hired ADP to deduct, hold, escrow, and pay applicable taxes for each employee for each state. So we had to give them a power of attorney, we were saying to ADP as TBW, as TBW employer we're giving you the right to deduct these taxes on our behalf and send to the state, their applicable state."
ADP required the same information for each new company and could not have
The payroll process began with TBW's Human Resources Department ("HR Department"). The HR Department was responsible for maintaining employee and company information on behalf of the TBW Entities, including adding new employees and companies as well as transferring employees between companies.
The Payroll Department maintained the Payroll Master File in Excel to track hours and gross pay.
ADP processed the payroll and then generated a "Preview" (also called a "Statistical Summary Detail") that reported the amount of wages, garnishments, and taxes for each Company Code.
Once payroll was reconciled and approved, the Payroll Department requested wire transfers from TBW's Cash Management Group to fund the payroll.
When TBW hired ADP, Ms. Potter-Levane arranged for TBW to direct wire funds to ADP as opposed to having ADP debit the funds from TBW's bank account. She chose this option because TBW had multiple bank accounts.
Early on TBW and ADP recognized the possibility that ADP might need to issue refunds to TBW. In late October 2005, ADP accepted TBW's banking instruction that "Colonial Bank Account [number 8030377314] will only be used for ADP tax refunds to TBW" as well as "TotalPay [net pay to employees] refunds to TBW."
After ADP received the Transfers from TBW, ADP released the payroll and honored payroll checks and direct deposits and paid taxes.
Each payroll for the TBW Entities was recorded on TBW's general ledger in a multistep process by the TBW Accounting Department.
ADP's expert deemed TBW's internal reallocation of payroll from TBW to its subsidiaries and affiliates a complex process for two primary reasons. First, different entities' payrolls were often funded together and paid to ADP in a single set of wires (one for wages, and one for taxes and garnishments).
Second, TBW paid individuals who worked for a TBW subsidiary or affiliate under TBW's company code GCC and internally accounted for the payroll and benefits costs of those employees as the costs of the other TBW Entities ("Recharacterized Employees").
To allocate the GCC employees (who received W-2s from TBW) between TBW and the subsidiaries and affiliates, the Accounting Department undertook a reallocation process.
For each payroll funded by TBW, subsidiaries and affiliates recorded the payroll on their books as an expense and as a payable due to TBW.
Even though the ADP Text files identified TBW as the employer making the disbursements to and remitting withholdings on behalf of Recharacterized Employees, Ms. Emig accounted for such wages and taxes as those of other TBW Entities on TBW's internal books and records. In so recording the payroll of the Recharacterized Employees, Ms. Emig did not believe she was facilitating a fraud.
ADP's bank structure has two primary components. One component controls ADP's corporate funds ("ADP Funds"), which include fees paid by clients for the services provided by ADP as well as disbursements for ADP operational expenses. The second component controls client funds held by ADP for the purpose of remitting payroll, taxes, and other similar transfers on behalf of its clients ("Client Funds").
ADP Funds are segregated from Client Funds via separate and independent bank accounts. As a matter of ADP policy and practice, ADP Funds are never in the same bank account or otherwise commingled in any manner with Client Funds.
ADP clients are expected to fully fund their payrolls in advance.
The MSA is consistent with these procedures. ADP is contractually authorized to commingle TBW's funds with the funds of other ADP clients. To identify each client's funds, ADP uses a funds control system that maintains general ledger entries by client and maintains an accounting for the aggregated Client Funds.
ADP regularly makes refunds to clients of Client Funds, at the request of clients and for various other reasons.
ADP's handling of Client Funds is consistent with common practices within its industry.
From 2002 through 2009, Farkas and certain other employees of TBW (collectively, the "Farkas Parties") engaged in a scheme to defraud, among others, Colonial Bank, Ocala Funding LLC, a mortgage lending facility owned by TBW ("Ocala"), Ocala's secured lenders and other creditors.
On August 3, 2009, in connection with an ongoing investigation of Colonial Bank, federal agents executed a search warrant at TBW's headquarters. The next day, the United States Department of Housing and Urban Development suspended TBW's HUD/FHA origination and underwriting approval, Ginnie Mae terminated TBW's authority to act as a Ginnie Mae issuer and to service its $26 billion mortgage portfolio, and Freddie Mac terminated TBW's eligibility to sell loans and to service its $51.2 billion portfolio. Terminations by these agencies dealt a death blow to TBW's business operation. On the afternoon of August 5, 2009, TBW laid off approximately 2,000 employees, reduced its business operations to the minimum level believed necessary to preserve the value of its assets, and began planning for an orderly restructuring or liquidation of the company, resulting in the filing of the underlying chapter 11 bankruptcy.
After confirmation of TBW's liquidating chapter plan, the Trustee brought suit in state court against TBW's accountants Deloitte & Touche, LLP ("Deloitte"). In his lawsuit, the Trustee outlines his understanding of the scope of the fraud and its coverup since 2002. The Trustee further alleges that from 2002 through 2008, Deloitte purported to conduct an audit of each of TBW's fiscal year-end financial statements and incorrectly certified that TBW was a solvent viable company with financial statements free from material misstatements. Finally, the Trustee alleges that for years Deloitte certified financial statements overstating assets and revenues and failed to detect the massive fraud orchestrated by Farkas.
No one at ADP had actual knowledge of any fraudulent activity at TBW until the FBI raided TBW's headquarters in 2009.
Ms. Walle testified that she "would be surprised" if anyone at ADP "knew or had reason to know that there was a fraud occurring at TBW."
Ms. Potter-Levane, one of TBW's key contacts with ADP, testified that she never discussed with ADP any concerns regarding TBW's payroll processes, TBW's use of Location Codes, the funding of TBW's payrolls, or TBW's financial condition. Nor did she ever ask ADP to do anything that she perceived to be against ADP's or TBW's policies, that she thought was wrong, or that she thought was against TBW's interests. Indeed, when Ms. Potter-Levane worked at TBW, she had no knowledge of any fraud taking place at TBW.
ADP never deviated from its established policies, practices, and procedures throughout its relationship with TBW in its processing of the TBW Entities' payroll and its handling of the Payroll Funds.
Summary judgment is proper "if the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law."
The moving party bears the initial burden of articulating the basis for its motion and identifying evidence which shows that there is no genuine issue of material fact.
The parties have filed three separate motions for partial summary judgment on ADP's mere conduit defense.
A defendant is an initial transferee only if it "exercise[s] legal control over the assets received, such that [it] ha[s] the right to use the assets for [its] own purposes, and not if [it] merely served as a conduit for assets that were under the actual control of the debtor-transferor or the real initial transferee."
The lack of control of by a bank over a deposit account is the quintessential example of a mere conduit. Still, a bank/customer relationship is nothing more than a debtor/creditor relationship.
Société Generale stands for the rule that when a bank receives money into a customer account, it never has legal control of the funds.
ADP argues that the relevant attributes of its business model are like those of a bank. ADP aggregates Client Funds in a common account and uses a general ledger control system to account for each client's funds. The MSA expressly permitted ADP to commingle TBW's funds with the funds of other ADP clients. The MSA also permitted ADP to invest the funds received from TBW and to keep any income earned for ADP's own benefit.
Like a bank, ADP also may use money from the commingled Client Funds to make loans to other ADP clients. If an ADP customer has a shortfall for its payroll obligations, ADP can satisfy that client's obligation by drawing from the commingled Client Funds. This is not unlike an overdraft, except that ADP does not charge interest to its clients or otherwise profit from a payroll shortfall that is temporarily covered with commingled Client Funds.
While ADP's business model is akin to a bank operating account, TBW's control over its Client Funds is comparable to a bank customer directing payments by issuing checks or wire transfers from its operating account. TBW's Payroll and HR Departments directed and controlled the money transferred to ADP for the payment of employee wages, taxes and garnishments. And much like a bank, ADP
Initially, the Trustee's response to ADP's bank analogy is compelling. He argues that banks are different because (i) banks are extensively regulated and (ii) banks have an obligation to return their customer's money.
With respect to bank regulation, the Trustee does not identify any specific regulation to distinguish a bank's lack of control over deposited funds from ADP's business model. Rather, the Trustee refers vaguely to regulations controlling a bank's use of customer deposits. ADP responds that it has a contract that similarly controls the use and direction of Client Funds. But more importantly, the cases recognizing banks as "mere conduits" do not rely on, or even mention, any state or federal regulations to support their conclusion. Rather, they focus on the customer's ultimate control over the money in the "account" — withdrawal at will or directing payment by check, wire or electronic transfer — or on the policy implications of requiring a bank to question the source of a customer's deposit.
Other than perhaps its legal obligations for withholding and paying taxes under the Internal Revenue Code and applicable state tax laws, ADP admittedly is not subject to laws and regulations in the same way as a state or national bank. But the critical inquiry, as explained by the Eleventh Circuit, is TBW's ultimate control over the funds wired to ADP.
Under the terms of the MSA, and as implemented by the parties, TBW, through its Payroll and HR Departments, always directed and maintained control of its payroll. TBW made all payroll decisions, and TBW did not share its internal operations and allocations with ADP. TBW simply outsourced its payroll processing to ADP.
ADP also had contractual obligations to, and, in fact, did return money to TBW on demand. TBW gave ADP instructions, including specific bank account information, for this express purpose. The MSA permitted TBW to stop payment of ADPChecks (employee paychecks) within 24 hours. TBW also had the ability to reverse Full Service Direct Deposits (direct deposit of employee pay) up to five business days from the payroll check date. ADP also returned payroll funds received from TBW that were never cashed by employees.
In short, ADP's contractual obligations are analogous to a bank's obligations when it accepts money into a deposit account. But "mere conduit" status is not limited to a bank. ADP's contractual obligation to remit funds to satisfy its clients' payroll and tax obligations also has many of the same attributes of the defendant in Pony Express who the Eleventh Circuit also found to be a mere conduit.
Pony Express,
Pony Express contracted with the broker to arrange for insurance and was billed and paid for premiums due over the course of several months. The broker then received a check from Pony Express for of $310,422 which it deposited in its client trust account. The next day the broker issued checks to Pony Express' insurance carriers for insurance premiums. Unbeknownst to broker, Pony Express was in serious financial difficulty and its check bounced, twice. To correct the deficiency, Pony Express wired the full amount of the check directly into the broker's client trust account. Two days later, Pony Express filed for bankruptcy. Pony Express filed a complaint against the broker to recover the wire transfer as an avoidable preference. In response, the broker claimed to be a mere conduit.
In analyzing the broker's status as a mere conduit, the Eleventh Circuit initially focused on whether the broker was a creditor at the time of the transfer. After all, the broker had already advanced payment of the insurance premiums when Pony Express' check bounced. Still, like the bank with an overdraft, the broker was deemed a mere conduit of the funds transferred to it. The court reasoned that the broker "did not intend to become a creditor" when it sent checks to the insurance carrier. The broker also had "every expectation" that the funds would be immediately forthcoming. The fact that the funds came three weeks later was deemed not to have "dispositive significance." The temporary deficiency was ultimately cured, and this was enough to satisfy mere conduit requirements.
The broker's position as an agent and fiduciary is a factor in the analysis of whether the broker exercised legal control over the funds transferred to it. The funds were "earmarked" for the insurance premiums and subject to the broker's legal duty to use those funds as instructed and as required under California law. Thus, the court explains that the mere conduit test "takes on special significance where the recipients of avoidable transfers are agents or fiduciaries of the debtor-transferor ... who are duty-bound to take only limited actions with respect to the funds received."
To the extent that ADP held a limited power of attorney for payroll tax services under the MSA, ADP has some attributes of a fiduciary.
But the essence of the transactions between TBW and ADP is simply that ADP was obligated to use TBW's Client Funds to pay wages, garnishments, and taxes as directed by TBW. TBW's control over the Client Funds was facilitated by PayForce and was implemented by TBW's HR Department. ADP always followed TBW's instructions in moving Client Funds to the tax authorities, designated employees, and respective garnishors.
The court is directed to consider all aspects of the transactions between TBW and ADP in this "flexible, pragmatic, equitable approach."
But lack of control is not enough to establish mere conduit status in this circuit. ADP must also prove that it acted in good faith and as an innocent participant in the fraudulent transfers.
Nothing in the record suggests that ADP had actual knowledge of TBW's financial condition or Farkas's fraudulent conduct until the FBI raided TBW's offices in August 2009. In challenging ADP's good faith, the Trustee instead identifies certain "red flags" that he argues should have put ADP on inquiry notice.
First, the Trustee argues that ADP breached the MSA because it paid employees of TWB's subsidiaries and affiliates that were unrelated to mortgage banking.
Second, the Trustee argues that ADP breached the MSA because it failed to demand that the MSA be approved by TBW's board of directors. The Trustee does not point to any legal requirement for board approval. But, even if he is correct, such approval presumably should have occurred in May 2005 when the MSA was originally signed. The reason this argument still fails is that the MSA was signed by Farkas as TBW's "Chairman of Board/Secretary." It is undisputed that Farkas controlled TBW in 2005 and his title certainly implies enforceable apparent authority.
On the issue of inquiry notice, the Trustee challenges ADP's good faith based on its failure to investigate three emails, the contents of which the Trustee labels as "suspicious" and enough to put ADP on notice that a "storm was a-brewin" over at TBW. An email dated October 20, 2005, from Trisha Russo, ADP's National Accounts District Sales Manager, to Robb Young, TWB's Director — Human Resources, states:
A second mail dated November 2, 2005, from Javier Soto, ADP Implementation Consultant, to Trisha Russo, states:
And a third, dated nearly three years later, on August 4, 2008, from Trisha Russo to Jessica Vega at TBW, reads, in part:
The first two emails were sent in 2005, almost four years before the FBI raid of TBW's headquarters. They are nothing more than communications between ADP and TBW during the Client Group onboarding process as contemplated by the MSA. ADP and TBW entered into the MSA on May 3, 2005. They amended the MSA on October 1, 2005 to add an additional service, specifically Time and Labor Management Services. The first email expressly refers to the implementation of this additional service, i.e. "we never set up Lee's other companies up for time and labor."
The third email was sent in 2008, but it does not reveal anything new. Ms. Bush is simply asking for a recommendation based on ADP's work with a restaurant that Farkas owned. Nada Restaurant Group (later known as Dine Design, Inc.) was signed up for Payroll Services in April 2005. No reasonable inference can be drawn from the content of this email that it is suspicious or should have alerted ADP to a massive fraud that TBW's own auditors apparently missed.
The emails are, in the court's view, a red herring. ADP does not dispute that it provided Payroll Services to TBW Entities. The Payroll Services were requested by TBW and managed and directed by its HR, Payroll and Accounting Departments. Large conglomerates often include different types of businesses. And by every available measure, TBW was a growing and successful conglomerate when the MSA was signed. Even the Dun & Bradstreet Report ADP ordered in May 2005 confirmed that TBW was financially sound.
ADP was hired to processes the payroll data TBW input into PayForce and provide related customer support. ADP does not advise clients on how to operate their businesses — just payroll processing. It is up to the client to decide what companies they open, who to pay, and how to pay those individuals.
Finally, even if ADP had become suspicions as the Trustee suggests it should have been, what should ADP have done with the information? Certainly, a thorough review of TBW's financial statements would not have detected fraud or insolvency. TBW's books and records were not shared with ADP. But from 2006 to 2008, apparently Deloitte certified the bona fides of TBW's ongoing financial condition. Inquiries to Ms. Potter-Levane would have been useless as she had no knowledge of the fraud. And there is no evidence to suggest that Farkas was likely to confess his misdeeds to ADP.
The Trustee struggles to respond to this question, but finally lands on the answer that ADP should have gone directly to TBW's Board of Directors — a board not only controlled by Farkas but also in possession of TBW's (auditor-certified) rosy financial statements. Moreover, as a result of TBW's internal reallocation process, the net balance due from each subsidiary or affiliate for funds advanced by TBW for payroll was reflected on TBW's general ledger, and on its consolidated financial statements and the TBW Board Financial Review reports. So, TBW's Board of Directors should have known what the Trustee argues ADP should have told them.
Admittedly, "good faith" is not usually an issue ripe for summary judgment.
ADP has established its good faith and status as an innocent participant in the Transfers. The Trustee raises interesting theories and speculative possibilities, but ultimately not a triable issue. Accordingly, ADP is entitled to partial summary judgment on the issue of its good faith for purposes of its mere conduit defense.
There is no doubt that TBW's creditors were victims of a massive fraud and that the Trustee has a responsibility to pursue all viable claims for the benefit of those creditors. But here, even if the Trustee can avoid the Transfers as fraudulent under state or federal law, ADP was a "mere conduit" and as such shielded from initial transferee liability under § 550.
The court separately will enter partial summary judgment in favor of ADP on Counts II-VI of the Complaint (seeking to avoid the Transfers) and on Count VII to the extent it seeks to recover the Transfers.
ORDERED.
