Accepting Payment From Strangers Can Buy You Strict Liability
by Brandon Lewis
Do not accept payment from someone for services rendered to someone else. This simple rule applies to lawyers and clients alike and has ethical and economic aspects. But whereas informed consent and professional judgment can avoid conflicts of interest, they cannot cure the other danger that this rule prevents: fraudulent transfer liability.
Under the Bankruptcy Code and Texas law, a transfer is fraudulent if it is made for less than reasonably equivalent value and occurs when the transferor is or becomes insolvent as a result, is inadequately capitalized, or should know that it will be unable to service debts. A person (or law firm) who receives money from an insolvent without giving that insolvent reasonably equivalent value in exchange is strictly liable as an “initial transferee.” Therefore, if an insolvent pays you for services you rendered to someone else, your firm may potentially acquire strict liability. Put differently, although your services constitute “value,” you gave that value to your client—not to the person paying you. You gave your payor nothing in exchange, and you could have to disgorge every cent received.
Even if you are not the first to receive the fraudulent transfer but receive proceeds of it later on through someone else, you face liability as a “subsequent transferee.” For example, suppose that an insolvent third party pays your client for services rendered to a customer. And suppose your client pays you with some of those funds. Your client received a fraudulent transfer for which it faces strict liability, and you face potential liability as a subsequent transferee.
These examples are simplistic, but consider your own practice. Do you see every check for every matter, or are they cursorily sent to accounting? What happens when the name on the check does not match the engagement letter? Do your corporate clients have paymaster affiliates that cover your invoices? Have you been told that a payment from a non-client resolves an inter-company receivable? What about settlement payments made by non-parties? Each of these practices carries the potential for strict liability if the payor is insolvent. Moreover, if your client is paid by one of these methods and uses those funds to pay you, your client faces strict liability, and you are a subsequent transferee.
As a subsequent transferee, you can assert the “good faith” affirmative defense. A subsequent transferee defeats liability by proving it received the transfer for value and in good faith. The Bankruptcy Code separately requires you to have received the transfer without knowledge of its voidability. Texas wraps this concept into “good faith.”
Unlike initial transferees, subsequent transferees asserting the “good faith” defense do not have to have provided value to their transferor. They need only have provided value to someone in exchange for the transfer received. But knowing (or refusing to investigate) why a stranger is covering your client’s tab can preclude “good faith.” Under both Texas law and the Bankruptcy Code, having knowledge that would put an ordinary person on inquiry notice of a transferor’s insolvency or other red flags defeats the “good faith” defense.
For those still skeptical, consider the recent opinion inLiquidating Trustee of the App Fuels Creditors Trust v. Bingham Greenebaum Doll LLP, No. 13-8023, 2014 WL 185033 (B.A.P. 6th Cir. Jan. 17, 2014). A client had paid a law firm’s fees with settlement proceeds. The client and the law firm, however, had allowed a non-party to make the settlement payment. Because that non-party happened to be insolvent, the settlement payment was a fraudulent transfer, and the firm was sued as a subsequent transferee. The firm asserted a “good faith” defense and sought summary judgment, but the Sixth Circuit B.A.P. held that three emails sent to the firm—when construed together—put the firm on notice that a company in financial difficulty was making the settlement payment despite no obligation to do so. This knowledge, coupled with the failure to investigate further, was sufficient to require a trial on the merits. Had the client insisted that a party to the settlement make the payment or had the firm refused payment from the settlement proceeds, the result would have been different. Instead, three emails defeated the firm’s summary judgment bid.
How many emails does your firm receive during a representation? Could three be construed together to sink your “good faith” defense? Avoid that risk entirely. Refuse payment from anyone other than those you render services to, and advise your clients to do the same.
Brandon Lewis is a partner at Reid Collins & Tsai LLP. He can be reached at firstname.lastname@example.org.