By Daniel A. Lowenthal


At the motion to dismiss stage, courts usually won't consider affirmative defenses. This issue arose recently in a preferential transfer case, where a defendant sought to dismiss a complaint by arguing it was a mere conduit, not an initial transferee. But the court ruled against the defendant, explaining why it would not adjudicate a mere conduit defense on a motion to dismiss. Official Comm. of Unsecured Creditors of Pack Liquidating, LLC v. Kepler Grp., LLC, Adv. Proc. No. 23-50536 (In re Pack Liquidating, LLC), Case No. 22-10797, 2024 Bankr. LEXIS 2444 (Bankr. D. Del. Oct. 4, 2024).

Before their bankruptcy filings, the debtors sold consumer products online. The defendant in the preference action was an e-marketing services provider and an alleged agent of the debtors. In the debtors' Chapter 11 cases, the unsecured creditors' committee (Committee) sued the defendant to recover $389,000 transferred from the debtors. The complaint alleged that the defendant was the initial transferee of the funds. The complaint asserted a preferential transfer claim under Bankruptcy Code section 547 and a constructive fraudulent transfer claim under Bankruptcy Code section 548. The complaint also sought recovery from the defendant under Bankruptcy Code section 550.

The defendant licensed and installed advertising campaigns for the debtors that the defendant obtained from a third-party service provider. The service provider would bill the defendant for its services, then the defendant would invoice the debtors that amount plus a fee for its own work. The defendant would pay the service provider when the debtors paid the defendant.

The defendant moved to dismiss to complaint. When analyzing a motion to dismiss, the court explained, "courts should separate the factual and legal elements of a claim, accepting only the well-pleaded facts as true while disregarding any legal conclusions. And … courts should determine whether the facts alleged, assuming them to be true, give rise to a plausible claim for relief." 2024 Bankr. LEXIS 2444, at *16. A complaint must set forth a "short plain statement of the claim showing that the pleader is entitled to relief." Fed.R.Civ.P. 8(a)(2). In addition, "[Fed.R.Civ.P.] 9 requires particularly when a plaintiff alleges fraud or mistake, but intent and knowledge may be alleged generally." 2024 Bankr. LEXIS 2444, at *15.

The defendant's motion to dismiss argued that it was a mere conduit of the funds transferred from the debtor and to the service provider. "To be a 'mere conduit,' a defendant must establish that it lacked dominion and control over the transfer because the payment simply passed through its hands and it had no power to redirect the funds to its own use." In re Lenox Healthcare, Inc., 343 B.R. 96, 103 (Bankr. D. Del. 2006) (internal quotations and citations omitted). "Where the defendant is 'not under any contractual or other obligation to use [transferred funds] for the benefit of [third parties],' but rather may use the funds freely, it is not a 'mere conduit.'" Id. at 104 (quoting In re 360networks (USA) Inc., 338 B.R. 194, 202 (Bankr. S.D.N.Y. 2005)).

Although courts typically don't consider the mere conduit affirmative defense on a motion to dismiss, there is an exception: when the allegations in a complaint demonstrate the existence of the mere conduit defense, the court will analyze its applicability. But in Pack Liquidating, the court concluded the complaint and documents the defendant submitted with its motion to dismiss did not support application of the exception.

The defendant argued in favor of the mere conduit defense based on the sequence of payments made from the debtors to the defendant to the service provider. The defendant asserted that its obligation to pay the service provider: 1) arose only when the debtors paid the defendant; and 2) depended on the amount the defendant received from the debtors.

The Committee argued that the motion to dismiss should be denied because "fact-intensive" discovery was needed. At issue would be the defendant's "dominion and control" over the transferred funds: whether the funds were placed in the defendant's operating account and were commingled with other funds; whether the funds the defendant received from the debtor were the same funds the defendant used to pay the service provider; and whether the defendant had discretion over when and how much to pay the service provider.

Given that: 1) the factual record that needed to be developed; and 2) that the complaint did not allege facts that gave rise to the mere conduit defense, the court refused to dismiss the complaint based on the assertion of the defense.

An additional point addressed in the court's decision, which was unrelated to the mere conduit defense, is worth a brief mention. As noted above, the Committee also asserted a constructive fraudulent transfer claim pursuant to Bankruptcy Code section 548. The defendant moved to dismiss this claim on the grounds that the complaint: 1) didn't plead that the debtors failed to receive reasonably equivalent value for the alleged transfer; and 2) didn't show that the debtors were insolvent at the time of the transfer.

The court rejected both arguments. First, if the evidence produced later in discovery were to demonstrate the transfer was on account of an antecedent debt — a key element of a preference claim — then the constructive fraud claim would fail. As the court noted, "satisfaction of a viable debt would constitute reasonably equivalent value." 2024 Bankr. LEXIS 2444, at *24. Thus, the court ruled, the constructive fraudulent claim was sufficiently pled in the alternative to the preference claim.

Second, the court noted that the complaint alleged insolvency, and that the debtors lacked sufficient liquidity and were incurring debts beyond their ability to pay. The court also observed that the complaint referenced statements from the debtors' first day declaration filed in the bankruptcy cases that set forth facts about the debtors' alleged insolvency. The court ruled that reference to this material in the complaint was sufficient to defeat the defendant's arguments about the insolvency prong of the claim.

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Daniel A. Lowenthal is the Chair of the Business Reorganization and Creditors' Rights practice at Patterson Belknap Webb & Tyler LLP in New York. He recently served as counsel to the court-appointed Examiner in the Chapter 11 cases of FTX Trading Ltd. and its affiliates. A regular speaker on bankruptcy law topics, Mr. Lowenthal has presented for the American Bankruptcy Institute, the Practising Law Institute, INSOL International, INSOL Europe, and the Association of Corporate Counsel. A member of the Board of Editors of The Bankruptcy Strategist, he can be reached at [email protected].

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