The following is a case update written by Corey R. Weber, a partner at Brutzkus Gubner Rozansky Seror Weber LLP, analyzing a recent decision of interest:
The Fifth Circuit held in a published opinion that the defendant in a fraudulent transfer case failed to prove a good faith defense under the Texas Uniform Fraudulent Transfers Act where the record at trial showed that the defendants were on inquiry notice of a Ponzi scheme but that the defendant did not engage in a diligent investigation. Janvey v. GMAG, L.L.C., 2020 WL 5948919 (5th Cir. 10/8/20).
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Stanford International Bank (SIB) issued fraudulent certificates of deposit with interest rates higher than those offered by commercial banks. However, SIB was a Ponzi scheme, and the interest paid to investors was from the funds of other investors. Defendant and appellee Gary Magness and his entities (the Magness Parties) were some of the largest investors in SIB, having purchased $79 million in SIB certificates of deposit. In 2008, SIB loaned Magness $88.2 million based on his accumulated interest from the investments.
The court-appointed receiver (the Receiver) filed a lawsuit against the Magness Parties including fraudulent transfer claims under the Texas Uniform Fraudulent Transfers Act (TUFTA) and unjust enrichment claims. The Receiver obtained partial summary judgment as to amounts received in excess of investments and the Magness Parties paid that amount. After cross-motions for partial summary judgment narrowed the issues, a jury trial then proceeded only as to the issue of whether the Magness Parties received the remaining amount of fraudulent transfers in good faith. The jury determined that the Magness Parties had inquiry notice, but not actual notice, that SIB was a Ponzi scheme. The Receiver moved for entry of judgment in his favor given that the Magness Parties were on inquiry notice and renewed a motion for judgment as a matter of law. The district court denied the motion and held that the Magness Parties proved their good faith defense. The district court entered judgment in favor of the Magness Parties, except as to a prior determination that $8.5 million out of the $88.2 million constituted fraudulent transfers without an applicable defense.
The Receiver appealed and the Fifth Circuit issued a published opinion reversing the judgment and entering judgment in favor of the Receiver. Janvey v. GMAG, L.L.C., 913 F.3d 452 (5th Cir. 2019). The Magness Parties filed petitions for panel rehearing and rehearing en banc. The Fifth Circuit vacated its opinion and certified to the Texas Supreme Court the question of whether good faith under TUFTA includes a diligent investigation requirement or a futility exception. The Texas Supreme Court held that a transferee on inquiry notice cannot prove a good faith defense without diligent investigation. Janvey v. GMAG, LLC, 592 S.W.3d 125, 133 (Tex. 2019).
Following the Texas Supreme Court’s determination, the Fifth Circuit again reversed the district court’s judgment and rendered judgment in favor of the Receiver.
Citing to Flores v. Robinson Roofing & Constr. Co., 161 S.W.3d 750, 756 (Tex. App.—Fort Worth 2005), the Fifth Circuit noted that the transferee of a fraudulent transfer bears the burden of proving the affirmative defense of good faith under TUFTA. The Magness Parties argued that the evidence showed that they “reasonably” investigated SIB. The Fifth Circuit stated that the question is whether the Magness Parties “diligently” investigated their suspicions that SIB was a Ponzi scheme during the period for which the jury found them to be on inquiry notice. The Fifth Circuit found that there were “merely inquiries” as to the investments rather than a diligent investigation.
The Magness Parties further argued that a retrial was necessary for a jury to determine whether an investigation would have been futile instead of whether the Magness Parties diligently investigated whether SIB was a Ponzi scheme, and that the record was sufficient for a reasonable jury to conclude that their investigation was diligent. However, the Fifth Circuit found that the record showed no investigation as to suspicions of fraud and did not support the conclusion of a diligent investigation. The Fifth Circuit therefore stated that “[t]he Magness Parties have therefore not shown that there is an evidentiary basis for a reasonable jury to find that they diligently investigated their initial suspicions of SIB’s fraud while on inquiry notice” and found that any issues with regard to the jury instructions constituted harmless error.
The Fifth Circuit also determined that not having a second jury trial did not violate the Magness Parties’ Seventh Amendment and due process rights. In making that determination, the Fifth Circuit stated that the inquiry is if there is a right to a new trial on whether the defendants “diligently investigated their initial suspicions of SIB’s Ponzi scheme while on inquiry notice—when the record indicates that no reasonable jury could find for the Parties on that issue” and that “[t]he Seventh Amendment does not require us to remand for a new trial when the verdict cannot be sustained on the trial record.” Therefore, the Fifth Circuit found that the Magness Parties “have had an opportunity to establish the affirmative defense available to them—good faith—and so we would not violate the Parties’ due-process rights in foregoing a second jury trial.” Finally, the Fifth Circuit found that the existing record showing inquiry notice and lack of a diligent investigation constituted grounds for judgment in favor of the Receiver. The Fifth Circuit therefore reversed the district court’s judgment and rendered judgment in favor of the Receiver.
This opinion is the latest chapter in the Janvey v. GMAG, LLC case. Based on the determination of lack of a diligent investigation following inquiry notice, the Fifth Circuit correctly determined that the Magness Parties failed to establish their affirmative defense of good faith (TUFTA, similar to 11 U.S.C. § 548(c), requires the defendant to prove as an affirmative defense that they took the transfer for value and in good faith). However, an issue raised in a prior Commercial Finance Newsletter article, 2020-2 Comm. Fin. NL 4, is why the Texas Supreme Court and the Fifth Circuit did not find that inquiry notice of a Ponzi scheme alone defeats a good faith defense. See, e.g., In re Agricultural Research and Technology Group, Inc., 916 F.2d 528, 535-536 (9th Cir. 1990) (where the Ninth Circuit held that good faith is determined by an objective standard as to what the transferee knew or should have known). Since SIB operated as a Ponzi scheme, a diligent investigation presumably would have determined that SIB was a Ponzi scheme. An issue remaining is noted in footnote 1 in the opinion where the Fifth Circuit stated that “we leave for another day the discussion of what actions a party must take to show that they diligently investigated fraud for the purposes of a TUFTA good faith defense.” What the court determines to constitute a diligent investigation is likely to be outcome determinative of the good faith defense in the Fifth Circuit. For instance, if a diligent investigation just requires that the defendant request and review financial statements and have phone calls or meetings with the company regarding the information provided, the financial statements and information provided may well have been manipulated in a Ponzi scheme case. To the extent that a more intensive investigation is required, it should show fraud or improprieties by the company operating as a Ponzi scheme.
An interesting facet of the opinion is the Fifth Circuit’s determination that the Magness Parties did not have a right to a new jury trial. The Fifth Circuit held that “[t]he Seventh Amendment does not require us to remand for a new trial when the verdict cannot be sustained on the trial record.” This serves as what may be construed as a limitation to the right to a jury trial on fraudulent transfer claims based on the initial trial record. See Executive Benefits Ins. Agency v. Arkison, 573 U.S. 25, 30 at fn. 3 (2014) (citing to Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989) as to the right to a jury trial). There are other limitations to a jury trial on fraudulent transfer claims. To the extent that the defendant files a proof of claim in a bankruptcy case, there is no right to a jury trial given that “by filing a claim against a bankruptcy estate the creditor triggers the process of ‘allowance and disallowance of claims,’ thereby subjecting himself to the bankruptcy court’s equitable power.” Langenkamp v. Culp, 498 U.S. 42, 44 (1990).
These materials were written by Corey R. Weber, a partner at Brutzkus Gubner Rozansky Seror Weber LLP, a member of the ad hoc group and the Immediate Past Chair of the CLA Business Law Section, with editorial contributions by the Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal, Ret.), also a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.