8th Cir. Rules on Bankruptcy Trustee’s Ability to Recover Overdraft Covering Deposits

In a bankruptcy preferential transfer dispute, the U.S. Court of Appeals for the Eighth Circuit recently held that the bankruptcy trustee could recover true overdraft covering deposits, while deposits covering intra-day overdrafts were not recoverable.

A copy of the opinion in Joseph Sarachek v. Luana Savings Bank is available at:  Link to Opinion.

A company filed for bankruptcy and, 90 days before filing, wired funds to its bank to cover overdrafts.  The bankruptcy trustee argued that those funds were avoidable transfers that could be recovered from the bank.

The bankruptcy court agreed as to some of the deposits but not others.  The trustee and the bank cross-appealed to the trial court, which affirmed.  The parties then cross-appealed again to the Eighth Circuit.

The Eighth Circuit noted that, under the Bankruptcy Code, a bankruptcy trustee may “avoid” a debtor’s transfer of a property interest (1) “to or for the benefit of a creditor”; (2) “for or on account of an antecedent debt owed by the debtor before such transfer was made”; (3) “made while the debtor was insolvent”; (4) “made . . . within 90 days before the date of the filing of the petition”; and (5) “that enables [the] creditor to receive more” than it would receive under Chapter 7 if the transfer had not been made. 11 U.S.C. § 547(b).

The trustee has the burden to prove a transfer is avoidable. § 547(g). The trustee may not avoid a transfer if a creditor proves an exception applies. § 547(c), (g).  If a transfer is avoidable, the trustee may recover it from “(1) the initial transferee of such transfer or the entity for whose benefit such transfer was made; or (2) any immediate or mediate transferee of such initial transferee.” § 550(a). The trustee may not recover from a “mere conduit for an avoidable transfer.” In re Reeves, 65 F.3d 670, 676 (8th Cir. 1995).

Here, the Eighth Circuit noted that the bank’s policies recognized two types of overdrafts: “intraday overdrafts,” which occurred when provisional settlement or debiting caused a negative account balance, and “true overdrafts,” which occurred when provisional settlements caused a negative balance that became final at the midnight deadline provided for under Iowa Code 554.4104(1)(j) and 554.4301.

The debtor company had two accounts, one for checking and a second one that was unspecified.  The checking account was always negative during the 90 days prior to the company filing for bankruptcy, but the second account held a balance of approximately $1.4 million.  The bank netted the two accounts so that as long as the second account had a balance higher than the negative checking account balance, the company had a positive balance and was treated as if no overdrafts had occurred. Near the end of the 90-day preference period, the bank transferred the $1.4 million balance to the checking account.

The bankruptcy trustee sought to recover the deposits that covered the intraday and true overdrafts and the $1.4 million balance that the company had transferred to the checking account and disputed whether the accounts had been properly netted.  The bank argued that none of the deposits were recoverable and that the $1.4 million was a protected set-off.

The bankruptcy court had held that the trustee could recover the true overdrafts but not the intraday overdrafts and that, although the set-off was improper, it did not affect the trustee’s recovery. On cross-appeal, the trial court affirmed the bankruptcy court’s ruling except for holding that the bankruptcy court erred in finding the set-off improper, although the trial court agreed that the set-off error did not affect the trustee’s recovery.

The Eighth Circuit affirmed the bankruptcy court’s holding entirely.

The Eighth Circuit noted that, under the Bankruptcy Code, the trustee could not recover the intraday overdraft-covering deposits because intraday overdrafts do not create antecedent debt and the bank “was functioning as a mere conduit” for the intraday overdrafts. See 11 U.S.C. § 547(b)(2); Laws v. United Mo. Bank of Kansas City, N.A., 98 F.3d 1047, 1051 (8th Cir. 1996) (“[R]outine advances against uncollected deposits do not create a ‘debt’ to the bank.”); § 550(a); In re Reeves, 65 F.3d 670, 676 (8th Cir. 1995).

The Appellate Court refused to consider the trustee’s argument that the intraday overdrafts were antecedent debt under 11 U.S.C. § 547 because, unless the 11 U.S.C. § 550 requirement was fulfilled — i.e., that the bank was more than a mere conduit when it received the funds to cover those overdrafts — the funds were not recoverable, an argument the trustee had failed to make.

The Eighth Circuit also affirmed that the trustee could recover the company’s true overdraft-covering deposits from the bank under the Bankruptcy Code because they qualified as debt.

The Court applied the Bankruptcy Code’s test for when a debt is incurred (i.e., “the test for when debt is incurred is whether the debtor is legally obligated to pay”) and Iowa state law on overdrafts (i.e., “payment by a bank of an overdraft is considered an unsecured loan . . . and/or an extension of credit to a customer”) to conclude that when the bank allowed provisional check settlements to become final, causing true overdrafts, the bank paid those overdrafts thereby making unsecured loans or extensions of credit to the company that the company was legally obligated to pay.  Thus, the Eighth Circuit held, the true overdrafts were debt.

The Appellate Court rejected the bank’s argument that it was a non-liable “mere conduit” as to the true overdrafts because overdrafts are different than “traditional loans” and thus should keep the true overdraft-covering deposits.

The Court reasoned that the bank was actually an initial transferee under 11 U.S.C. § 550 because it had dominion and control over the funds in question by virtue of the fact that it paid third parties in the amounts of the true overdrafts and, in exchange for doing so, the debtor company owed the bank a debt payable directly to the bank. Moreover, the Eighth Circuit noted, when the bank received the true overdraft-covering deposits, it could use the funds for any purpose.  Thus, the Appellate Court affirmed the trial court’s holding that the trustee could recover the company’s true overdraft-covering deposits.

The Eighth Circuit also affirmed the lower court’s rejection of the bank’s exception-based affirmative defenses.

“A trustee cannot recover an otherwise avoidable transfer if the creditor proves a § 547(c) exception.”  For the first exception, the Eighth Circuit found that the bank failed to show that it took the true overdraft-covering payments in exchange for an agreement to provide anything new or contemporaneous.  The Appellate Court rejected the bank’s evidence of having waived overdraft charges because it did not show the parties’ intent.

For the second exception, the Eighth Circuit affirmed that the debtor company did not incur the true overdrafts, which were debts, in the ordinary course of business.  Because there is “no precise legal test” for this exception, only a requirement to “engage in a peculiarly factual analysis,” the Court examined the “cornerstone of debt inquiry,” whether there is any consistency with other business transactions between the bank and company, and other relevant factors, such as whether any unusual payment methods or atypical pressure to pay were involved.

The Eighth Circuit compared the number of overdrafts the company incurred during the preferential period to a time when the company was financially healthy and found that the number of true overdrafts dramatically increased during the preferential period, and that they were unplanned and discouraged, suggesting that true overdrafts were uncommon and thus inconsistent with the parties’ ordinary course of business.

The third possible exception, transfers creating security interests, was not raised.

Concerning the trustee’s challenge to the bankruptcy court’s calculation of the transfer recoverable from the bank, the Appellate Court affirmed the lower courts’ rulings in favor of the bank on both arguments.

More specifically, the Eighth Circuit affirmed the bankruptcy court’s ruling that the calculation for the amount recoverable would be based on the pre-bankruptcy account balances containing the bank’s posting errors, which resulted in less true overdrafts and thus less recovery for the trustee, instead of the post-bankruptcy corrected balances, which would result in more true overdraft-covering payments being avoidable. The Court explained that it would be inequitable to use the corrected balances because the company did not owe the corrected amounts until after it filed for bankruptcy, so those corrections did not result in debts under § 547.

The Eighth Circuit also affirmed the bankruptcy court’s calculation of the bank’s liability for true overdrafts based on the netting of the two accounts and rejected the lack of a written netting agreement as the netting arrangement was supported by three witness’ testimony and rejected expert testimony that netting accounts did not eliminate the debt of the true overdrafts because the facts found by the bankruptcy court showed that in practice the bank and company had treated the accounts as netted.

The Court declined to consider a third argument because the trustee did not raise it on the first appeal to the district court.

The final issue the Eighth Circuit affirmed was that the bankruptcy court properly ruled that the set-off did not apply to the transfer of funds between the two “netted” accounts. The trustee argued that the debtor company’s transfer of its remaining $1.4 million to its checking account during the preference period was an avoidable transfer, and the bank countered that it was not because the transfer was a valid set-off protected by 11 U.S.C. § 553(a).

The Eighth Circuit agreed with the bankruptcy court that, due to the netting arrangement between the two accounts, the debtor company did not incur a debt to the bank until the balance of the checking account fell below the balance of the second account.

Thus, the lower courts’ holdings were affirmed.

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