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 Texas Supreme Court, on a certified question from the Fifth Circuit Court of Appeals, determined that a recipient of a fraudulent transfer who was on inquiry notice of the transferor’s fraud must diligently investigate suspicions to prove good faith as part of the good faith and value defense in the Texas Uniform Fraudulent Transfers Act, irrespective of whether the investigation would reveal fraudulent conduct.  Janvey v. GMAG, L.L.C., 2019 WL 6972237 (Tex. Sup. Ct. 2019).

To view the full opinion, click here.

Facts

This opinion is part of the Stanford International Bank, Ltd. (Stanford) Ponzi scheme case.  The federal equity receiver for Stanford, Ralph Janvey (the Receiver), filed a fraudulent transfer complaint against Gary Magness and entities through which Magness invested his funds in Stanford (collectively, Magness).  The district court granted partial summary judgment in favor of the Receiver for the amount of interest or “false profits” (the amount received by Magness in excess of his investments in what turned out to be a Ponzi scheme) that Magness received of $8.5 million, but it left whether the investment itself should be avoided and recovered as a fraudulent transfer to be determined by a jury.  The amounts invested and withdrawn were significant—Magness invested $79 million with Stanford and withdrew $88.2 million (but then repaid $700,000 of that amount), leaving total false profits of $8.5 million ($87.5 million net amount withdrawn less the $79 million invested).

The jury determined that Magness had inquiry notice not just of general fraudulent conduct, but rather inquiry notice of Stanford operating as a Ponzi scheme.  The jury also determined that an investigation by Magness would have been futile.  The district court denied the Receiver’s motion for entry of judgment as a matter of law, holding that Magness satisfied the good faith prong of the affirmative defense of good faith and value under TUFTA.  The Fifth Circuit Court of Appeals reversed, holding that Magness had not proved his good faith affirmative defense (similar to the Bankruptcy Code at 11 U.S.C. § 548(c), the Texas Uniform Fraudulent Transfer Act (TUFTA) at Tex. Bus. & Com. Code § 24.009(a) provides for an affirmative defense if the transferee took the transfer in good faith and for value).  Magness moved for a rehearing by the Fifth Circuit and asked the Fifth Circuit to certify the issue of good faith to the Texas Supreme Court.  The Fifth Circuit vacated the opinion and certified the question regarding whether TUFTA’s good faith affirmative defense may be used by a transferee with inquiry notice of fraudulent conduct when the transferee did not conduct a diligent investigation.

Reasoning

The Texas Supreme Court noted that “TUFTA does not define good faith” but, citing to Black’s Law Dictionary (11th ed. 2019), Gulf Energy, 482 S.W.3d at 569 and Wichita County v. Hart, 917 S.W.2d 779,786 (Tex. 1996), reiterated that “[a] transferee must show that its conduct was honest in fact, reasonable in light of known facts, and free from willful ignorance of fraud.”  The court determined that “a transferee seeking to prove good faith must show that it investigated the suspicious facts diligently.  A transferee who simply accepts a transfer despite knowledge of facts leading it to suspect fraud does not take in good faith.”  However, the court did not determine what constitutes a diligent investigation.

The court stated that “[t]he Fifth Circuit’s certified question presumes, and the jury found, that Magness was on inquiry notice.  We therefore focus our analysis on how a transferee with inquiry notice of fraud can prove good faith.”  The court defined inquiry notice as when the transferee “knows facts that are, or should be, suspicious: red flags that a reasonable person would have investigated prior to engaging in the transfer.”  If a transferee is on inquiry notice, the court stated that “[i]f a transferee has actual knowledge of facts that would lead a reasonable person to suspect the transfer is voidable under TUFTA but does not investigate, the transferee may not achieve good-faith status to avoid TUFTA’s clawback provision—regardless of whether the transferee reasonably could have discovered the fraudulent activity through diligent inquiry.”

The Texas Supreme Court held that “[a] transferee on inquiry notice of fraud cannot shield itself from TUFTA’s clawback provision without diligently investigating its initial suspicions—irrespective of whether a hypothetical investigation would reveal fraudulent conduct.  To hold otherwise rewards willful ignorance and undermines the purpose of TUFTA.  We answer the certified question no.”

Author’s Comment

Although not fully explained in the opinion, the issues in this case relate to whether Magness is an innocent net winner in the Ponzi scheme since the district court previously granted summary judgment on the false profit amount but not the principal investment amount.  To the extent that Magness is an innocent winning investor (has a good faith defense), he would only be liable to repay the amount of false profit withdrawn (less amounts invested) in the Ponzi scheme.  See, e.g., Donell v. Kowell, 533 F.3d 762, 771 (9th Cir. 2008) (“Under the actual fraud theory, the receiver may recover the entire amount paid to the winning investor, including amounts which could be considered “return of principal.”  However, there is a “good faith” defense that permits an innocent winning investor to retain funds up to the amount of the initial outlay.”)

The Fifth Circuit certified the question relating to good faith to the Texas Supreme Court in spite of the breadth of existing case law across jurisdictions on this issue.  The Texas Uniform Fraudulent Transfer Act’s (UFTA) good faith defense is similar to the defense under the Bankruptcy Code and other states that adopted the UFTA (the text of the Texas statute states that “[a] transfer or obligation is not voidable under Section 24.005(a)(1) of this code against a person who took in good faith and for a reasonably equivalent value or against any subsequent transferee or obligee.”)

The Texas Supreme Court’s general holding requiring a diligent investigation by a transferee when the transfer is on inquiry notice comports with existing case law in other jurisdictions.  See, e.g., In re Bayou Group, LLC, 439 B.R. 284, 312 (S.D.N.Y. 2010) (“Once a transferee has been put on inquiry notice of either the transferor’s possible insolvency or of the possibly fraudulent purpose of the transfer, the transferee must satisfy a “diligent investigation” requirement.”)  Although the jury instructions cited in the opinion reference a reasonable person standard, the Texas Supreme Court did not discuss an objective versus subjective standard in assessing the transferee’s good faith either as part of inquiry notice or as part of a diligent investigation.  Most courts have used an objective (reasonable person) standard rather than a subjective standard in assessing good faith.  See, e.g., In re Agricultural Research and Technology Group, Inc., 916 F.2d 528, 536 (9th Cir. 1990); In re Dreier LLP, 452 B.R. 391, 447 (Bankr. S.D.N.Y. 2011); In re LLS America, LLC, 520 B.R. 841, 847 (E.D. Wash. 2014), as amended (E.D. Wash. 2015) 2015 WL 163038.  The Texas Supreme Court varied from other cases in that it specifically held that the diligent investigation must take place “irrespective of whether a hypothetical investigation would reveal fraudulent conduct.”  Therefore, regardless of whether an investigation would be futile, the court determined that it is necessary for a transferee who is on inquiry notice of fraudulent conduct.

In this case, it is not clear why a diligent investigation became a focal point of the appeal given that this is a Ponzi scheme case where the transferee had inquiry notice that it was a Ponzi scheme.  The transferee bears the burden of proof in establishing good faith.  See, e.g., In re Cohen, 199 B.R. 709, 718–719 (9th Cir. BAP 1996).  The jury already determined that Magness was on inquiry notice of fraudulent conduct by Stanford, and it has previously been determined that Stanford operated as a Ponzi scheme.  To the extent that Magness conducted a diligent investigation, the investigation should have concluded that Stanford was engaged in fraudulent conduct, was insolvent and was a Ponzi scheme (for which the jury determined Magness was already on inquiry notice).

The Ninth Circuit’s analysis was correct in In re Agricultural Research and Technology Group, Inc. (“Agritech”), 916 F.2d 528, 535–536 (9th Cir. 1990), where the Ninth Circuit stated that the burden of proof is on the transferee and if a diligent inquiry would have discovered the fraudulent purpose, then the transfer is fraudulent.  As the Ninth Circuit stated in Agritech, “[t]hese pronouncements indicate that courts look to what the transferee objectively “knew or should have known” in questions of good faith, rather than examining what the transferee actually knew from a subjective standpoint. Therefore, appellants’ reference to the subjective assertions of good faith in the Grant affidavit are of no moment.  At least one court has held that if the circumstances would place a reasonable person on inquiry of a debtor’s fraudulent purpose, and a diligent inquiry would have discovered the fraudulent purpose, then the transfer is fraudulent.”  See also, Donell v. Kowell, 533 F.3d 762, 771, fn.3 (9th Cir. 2008), citing Agritech as “stating that a Ponzi scheme investor claiming good faith must meet an objective standard, and possibly prove that a diligent inquiry would not have discovered the fraudulent purpose of the transfer, but declining to determine a precise definition of good faith.”

In Ponzi scheme cases, the crux of the good faith defense centers on whether there was actual or inquiry notice using the objective standard.  Given the transferee’s inquiry notice of a Ponzi scheme, and given that a diligent inquiry should have reasonably discovered a fraudulent purpose or Ponzi scheme, the transferee should not be able to meet his burden of proving a good faith defense.

For discussions of other cases dealing with related issues, see:

• 2019-5 Comm. Fin. News. NL 10
• 2018-19 Comm. Fin. News. NL 38
• 2017-7 Comm. Fin. News. NL 13

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 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.  Thomas 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 Thomas Reuters.