MARK HOULE, Bankruptcy Judge.
In October 2012, Innovation Ventures, LLC, and International IP Holdings, LLC ("Defendants") filed an anti-counterfeiting lawsuit in the United States District Court for the Eastern District of New York (the "District Court Action"). In November and December 2012, the complaint was amended to add Leslie & Donna Roman as defendants ("Debtors").
On November 30, 2012, the district court entered an order stating, among other things, that:
On December 28, 2012, the district court entered a substantively similar order with respect to Donna Roman.
Pursuant to these asset restraining orders (the "Freeze Orders"), several Bank of America accounts held by the Debtors ("Frozen Accounts") were frozen. The amount of funds frozen in the Frozen Accounts pursuant to the Freeze Orders was no less than $426,030.53 (the "Funds").
On January 15, 2013, Debtors and Defendants entered into a stipulation, and the district court entered an order approving the stipulation that day (the "First Agreement Order"). The First Agreement states, in pertinent part:
On February 12, 2013, the Funds were removed from the Frozen Accounts and deposited into an account held by the Debtors' attorney, Barry Rothman ("Rothman"), which the Plaintiff describes as a "client trust account" and the Defendants describe as an "attorney escrow account" (the "Account").
On July 16, 2013, the Debtors and Defendants entered into a second written agreement that resolved the District Court Action (the "Second Agreement"). On July 19, 2013, pursuant to the Second Agreement, the Funds were transferred out of the Account into an account maintained by the Defendants' counsel, Geoffrey Potter ("Potter").
On July 22, 2013, the Debtors commenced the instant bankruptcy by filing a Chapter 7 voluntary petition.
On July 14, 2014, the Trustee filed an adversary complaint ("Adversary Complaint") against Defendants to avoid and recover preferential transfers pursuant to 11 U.S.C. §§ 547 and 550. Specifically, Trustee seeks to avoid and recover the transfer of the Funds from the Account to the Defendants' counsel on July 19, 2013.
On June 18, 2015, Trustee filed a motion for summary judgment. On June 19, 2015, Defendants filed a motion for summary judgment against Trustee.
Trustee asserts that when Debtors transferred the Funds out of the Account to Defendants' counsel on July 19, 2013, pursuant to the Second Agreement, a transfer of the Debtors' interest in the Funds occurred. Trustee alleges that he may avoid the transfer pursuant to 11 U.S.C. § 547(b).
Conversely, Defendants assert that no transfer of the Debtors' interest in the Funds occurred within ninety days of the Petition Date because when the Debtors transferred the Funds into the Account on February 12, 2013, the transfer was into an "escrow account" created pursuant to the terms of the First Agreement. Defendants assert that under applicable law, for purposes of determining when a transfer of a debtor's interest in escrowed funds occurs, the applicable date is the date that the funds are deposited into escrow. Here, the Funds were deposited into the account in question on February 12, 2013.
In the alternative, Defendants assert that when the Funds were deposited into the Account, they were held in custodia legis. Defendants argue that when property is held in custodia legis, a transfer of interest in said property is deemed to occur on the date that the property is deposited into custodia legis.
For the reasons set forth below, the Court finds that no genuine issue of material fact exists, and that Plaintiff is not entitled to avoid the transfer of Debtors' interest in the Funds that occurred pursuant to the Second Agreement.
As a preliminary matter, the Court does not address the choice of law arguments briefed by the parties. As the material language of the First Agreement Order is unambiguous and the only remaining law to apply is federal bankruptcy law. Similarly, the Court's conclusions rest upon the undisputed facts agreed to by the parties [Dkt. #22 and #42] and, therefore, the Court declines to address the parties' evidentiary objections.
When seeking summary judgment, the moving party has the burden of establishing (1) the absence of a genuine issue of material fact and (2) they are entitled to judgment as a matter of law. Celotex Corp. v. Catrett, 477 U.S. 317, 323 (1986). A fact is material if it "might affect the outcome of the suit under the governing law." Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248 (1986).
Here, the dispute regarding whether the Account was an "escrow account" or a "trust account" (or neither) is immaterial, as discussed below, since the plain language of the First Agreement Order dictates Debtors' property rights in the Account, and, therefore, resort to these labels is unnecessary. The operative legal question is whether the Funds would have been property of the estate if Debtors had filed bankruptcy ninety days earlier, at which time the Funds were held in the Account. If the Funds would not have become property of the estate if Debtors filed bankruptcy while the Funds were held in the First Account, then it necessarily follows that no transfer of property of the estate occurred.
Defendants assert that the transfers of the Funds to the Account placed the funds in custodia legis. Pursuant to 11 U.S.C. § 547(e)(1)(B), a transfer of personal property "is perfected when a creditor on a simple contract cannot acquire a judicial lien that is superior to the interest of the transferee." Under California and New York law, a creditor on a simple contract cannot acquire a lien on personal property held in custodia legis superior to the interest of a particular transferee who is the beneficiary of the property held in custodia legis. Credit Bureau of San Diego v. Getty, 61 Cal.App.2d Supp. 823, 832 (1943)(holding that funds held in custodia legis were incapable of being reached by garnishment or levy on the part of the depositor's creditors); Clarkson Co. Ltd., Shaheen, 716 F.2d 126, 129 (2nd Cir. 1983)(applying New York law and holding that in the absence of express statutory authority, in general, property or funds in custodia legis are not subject to either attachment or garnishment).
Here, Defendants assert that when the Funds were transferred into the Account pursuant to the First Agreement Order, they were maintained in custodia legis because Rothman was acting as an officer of the court. In custodia legis is defined as "in the custody of the law." BLACK'S LAW DICTIONARY 10
Based on the foregoing, the Court finds that when the Funds were deposited into the Account pursuant to the First Agreement, the Funds were not being held in custodia legis.
11 U.S.C. § 541(a)(1) states:
Defendants argue that the Account can be characterized as an escrow account, and that the formation of the account divested Debtors of any legally cognizable interest in the Funds. Trustee argues that the Account can be characterized as a trust account, and that the formation of the account did not divest Debtors of all interest in the funds. The cases cited by the parties generally suggest that property held in escrow does not become property of the estate, while an interest in a trust is property of the estate.
As a preliminary matter, as noted in section I, supra, the First Agreement Order used the words "attorney escrow" and "attorney trust" interchangeably. A search of "escrow account" and "trust account" in BLACK'S LAW DICTIONARY redirects the reader to "impound account" and "client trust account," respectively. "Impound account" is defined as: "An account of accumulated funds held by a lender for payment of taxes, insurance, or other periodic debts against real property." "Client trust account" is defined as: "A bank account, usually interest-bearing, in which a lawyer deposits money belonging to a client (e.g., money received from a client's debtor, from the settlement of a client's case, or from the client for later use in a business transaction)." This is in accord with the general tendency to refer to an arrangement whereby an attorney holds funds on behalf of a client as a "trust account." See, e.g., California Rule of Professional Conduct 4-100 Preserving Identity of Funds and Property of a Client (requiring attorneys to deposit funds received or held for the benefit of clients in a trust account).
Nevertheless, this usage is not universal. Notably, the one state that appears to predominantly refer to these arrangements as "attorney escrow accounts" is New York
The tendency for funds held in escrow accounts to be excluded from a bankruptcy estate, and the tendency for funds held in trust accounts to be classified as property of the estate, are simply a reflection of the fact that the former is typically used to characterize arrangements in which a debtor has been divested of control of the funds, and the latter is predominantly used to characterize arrangements in which a debtor retains some form of oversight or control. See, e.g., Dzikowski v. NASD Regulation, Inc., 247 B.R. 867, 869-70 (S.D. Fla. 2000) (control of escrow determinative regarding question whether funds become property of estate); In re Royal Bus. School, Inc., 157 B.R. 932, 942 (Bankr. E.D.N.Y. 1993) ("Trustee has no immediate possessory interest in the Key Account within the meaning of the concept of property of the estate so as to entitle him to an order directing the turnover of any portion of the funds."); see generally In re All Chemical Isotope Enrichment, Inc., 127 B.R. 829, 837-38 (Bankr. E.D. Tenn. 1991) (listing factors to consider when determining if escrow funds are property of the estate). Likewise, distinguishing between those situations is the critical test in the case of trust accounts. Compare In re Cutter, 398 B.R. 6, 19 (B.A.P. 9
Here, while the Account divested Debtors of some interest in the Funds, the establishment of the Account did not divest Debtors of all interest in the Funds. See generally In re Schwarzkopf, 626 F.3d 1032, 1039 (9
In delineating the boundaries of the interest that Debtors held in the Funds in the Account, a review of how bankruptcy courts have addressed similar situations is appropriate. In re B&B Plastics, Inc., 2005 WL 3198656 (Bankr. S.D. Fla. 2005) involved a debtor that was sued for patent infringement in federal district court. Prior to the filing of the district court case, the debtor deposited a sum into its "attorney trust account," which was to be used to cover future payments or liability to the plaintiff. Id. at *1. The debtor made some attempt to deposit the funds in the court registry, but it appears that debtor did not follow through. Id. The district court instructed debtor's attorney to transfer the funds from his "escrow" account (the attorney trust account) to an interest bearing "escrow" account, but the attorney did not do so. Id. at *2. Shortly before debtor filed bankruptcy, the federal district court entered judgment against the debtor. Id. The federal court plaintiff was unable, however, to recover against its judgment before the debtor filed bankruptcy. Id. After debtor filed bankruptcy, its attorney turned the funds over to the trustee. Id. at *3. The bankruptcy court was tasked with determining whether the property held in the attorney trust account constituted property of the estate.
In the course of its analysis, the bankruptcy court stated that "funds that are deposited into an escrow account by a debtor, for the benefit of others, cannot be characterized as property of the estate." Id. at *4 (quoting In re Scanlon, 239 F.3d 1195, 1198 (11
Id. at *8 (citations and quotations omitted). In distinguishing Scanlon from its situation, the bankruptcy court in B&B Plastics noted two important differences: (1) the account in Scanlon was set up after litigation began, pursuant to agency order, while in its own case, the account was unilaterally created prior to litigation; and (2) the account in Scanlon was specifically created to compensate victims of wrongdoing, while the disbursement directives in B&B Plastics were less clear. The matter before this Court represents a middle ground — resembling Scanlon on the former factor, and resembling B&B Plastics on the latter. The Court in Scanlon rested its conclusion on the following:
In re Scanlon, 239 F.3d 1195, 1198-99. The critical observation in the above excerpt is the restriction on the Scanlon debtor's use of the funds, and thus his, and the bankruptcy estate's, interest in the funds. While appearing to lack the degree of disbursement specificity present in Scanlon, this case similarly presents a situation in which Defendants were divested of any meaningful oversight or unilateral control over the Funds.
11 U.S.C. § 541(a) governs the creation of a bankruptcy estate. That provision, as well as the other various subsections of § 541, restricts the bankruptcy estate's assumption of the debtor's interests to the interests that are held by the debtor. "To the extent that such an [equitable or legal] interest is limited in the hands of the debtor, it is equally limited in the hands of the estate except to the extent that defenses which are personal against the debtor are not effective against the estate." 124 Cong. Rec. H. 11096 (daily ed. Sept. 28, 1978). While the Funds were held in the Account, Debtors did not have the legal authority to utilize or direct the Funds. To allow Trustee the right to utilize or direct the Funds would be to allow the bankruptcy estate a greater interest in the Funds than Debtors possessed, in contravention of the Code.
Ultimately, Debtors had no meaningful ability to exert control over the Funds while the Funds were in the First Account. This limited interest in the Funds while in the Account is not the level of interest in property contemplated by the preference statute under § 547 or contemplated by the policies prohibiting debtors from preferring one creditor over another (intentionally or otherwise). Here, the simple fact is that, within the preference period and prior to the time of the transfer, the Funds were not realistically available to pay Debtors' other creditors. Because Debtors' interest in the Funds would not have afforded Trustee the ability to utilize or direct the Funds, the consensual release of the Funds from the Account to the Defendants was not a transfer that deprived the bankruptcy estate of value to be distributed to creditors, and, therefore, it cannot be avoided under the "diminution of estate" doctrine. In re Superior Stamp & Coin Co., 223 F.3d 1004, 1007 (9
The Trustee's motion for summary judgment is DENIED, and the Defendants' motion for summary judgment is GRANTED.
