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Settlement Funds Voluntarily Transferred Under the Pretext of Fraudulent Inducement are Property of the Estate

In re Dreier LLP, No. 08-15051-SMB, 2016 U.S. Dist. LEXIS 92322 (S.D.N.Y. July 15, 2016)

Debtors Cosmetics Plus Group and its affiliate companies (CPG) filed for Chapter 11 protections in the U.S. Bankruptcy Court for the Southern District of New York. CPG retained the Traub Firm as bankruptcy counsel and subsequently employed the law firm Dreier LLP after Paul Traub and Steven Fox became partners at Dreier LLP. CPG initiated an adversary proceeding against its insurer, AIG, to recover losses sustained due to the terrorist attacks. The parties agreed to settle and the Bankruptcy Judge Beatty approved the settlement agreement between AIG and CPG. Pursuant to the settlement agreement, AIG issued a check for $350,000 to CPG and the funds were deposited into the Dreier LLP attorney trust account. Dreier LLP, in turn transferred the funds to the Traub firm’s account (the Traub Firm Transfer). After sometime, Drier LLP filed for bankruptcy and the Trustee sought the return of the Traub Firm Transfer which the law firm held subject to further direction from the Court. The Traub Firm wired the amount back to the Trustee’s account. CPG filed proofs of claim in the Dreier LLP’s case, alleging that they had a secured claim in the proceeds of the settlement agreement.

The bankruptcy court concluded that CPG did not have a secured interest in the settlement proceeds that were paid to the firm because the firm commingled the proceeds with other money it held in a trust account. Further, the transfer of settlement funds from the Drier account to the Traub account created an express trust and this express trust was created only a few days before the commencement of Dreier’s Chapter 11 case. Thus, the alleged transfer of funds constituted an avoidable preference pursuant to Sec. 547(b). The Court reclassified CPG’s alleged proofs of claim numbers as general unsecured claims and also ruled that the Traub Firm Transfer was a preference under Sec. 547(b).

Upon appeal, CPG alleged that the bankruptcy court erred in finding that the Traub Firm transfer was an avoidable preference as there was a legally enforceable obligation to turn over the settlement agreement funds to CPG because they had an elevated priority interest in the funds held by Dreier LLP. CPG also alleged that the bankruptcy court erred by failing to impose a constructive trust on the settlement agreement proceeds transferred because the alleged transfer was not part of the Dreier estate and Dreier was required to hold these funds in escrow for CPG. The Trustee argued that the alleged transfer of funds provided CPG with the rights superior to the general unsecured creditors and hence, the transfer was an avoidable preference pursuant to Sec. 547(b).

Relying upon the decision of Judge Batts in a separate bankruptcy appeal stemming from the Dreier bankruptcy, the District Court in the case at bar ruled that the settlement funds that were voluntarily transferred into the Dreier account – albeit under the pretext of a fraudulent inducement, become property of the Dreier estate. The District Court agreed with the bankruptcy court that the monies constituting the transfer of funds from Dreier to the Traub Firm account were, in fact, property of the Dreier estate and hence avoidable. The District Court also agreed that the Drier account consisted of commingled funds of various Dreier clients and that the Traub transfer was not traceable.

The District Court concurred that CPG was not entitled to a relaxation of the tracing requirement because CPG was unable to demonstrate that the bankruptcy estate would be unjustly enriched in the absence of a constructive trust and the Debtor estate would not retain any of the funds if the constructive trust failed. The Court added that recognition of a constructive trust under these circumstances would merely prejudice other creditors whose assets had also been misused by the Dreier firm. The Court also stated that the Judge Beatty’s order did not create anything other than an obligation to transfer general Dreier assets (the settlement proceeds having been dissipated long before). It did not create any security or other interest in the transferred Drier account assets that insulated those funds from the claims of other Dreier creditors in the context of the bankruptcy proceeding. The District Court affirmed the Bankruptcy Court’s decision on all aspects and concluded that the alleged transfer was a preference pursuant to Sec. 547 of the Bankruptcy Code.


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