The following is a case update prepared by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, analyzing a recent decision of interest:
The Fifth Circuit has held that when a transferee is on inquiry notice of fraudulent behavior on the part of the transferor, the “good faith” defense under the UFTA is destroyed, even if an inquiry by the transferee would have been futile since the transferor’s scheme was so complex. [Janvey vs. GMAG, LLC, 2019 Westlaw 141107 (5th Cir.).]
Facts: A bank conducted an elaborate Ponzi scheme, involving fraudulent certificates of deposit. One of the largest investors in the bank ultimately received $88 million from the scheme. Following the bank’s collapse, its receiver brought a fraudulent transfer action against the investor under the Texas version of the Uniform Fraudulent Transfer Act. The investor defended on the ground that he received the money in good faith.
Following a jury trial, the jury found that the investor was on inquiry notice that the bank was engaged in the Ponzi scheme but had no actual knowledge of the fraud. Although the investor conducted no investigation, the jury found that any investigation would have been futile, given the complexity of the scheme.
Reasoning: The Fifth Circuit reversed the jury verdict, holding that the potential futility of a hypothetical investigation is no defense when the transferee is on inquiry notice of the fraud. The court noted that under Texas law, the issue is one of first impression. The court declined to follow the bankruptcy cases decided under 11 U.S.C.A. §548, some of which had adopted the “futility” theory to mitigate the effect of inquiry notice. The court did hold, however, that a transferee seeking to establish a good faith defense might introduce evidence that an investigation was undertaken:
Transferees seeking to retain fraudulent transfers might offer up evidence of undertaken investigations to prove a reasonable person’s suspicions would not have been aroused when the transfer was received . . . . But the fact that a fraud or scheme is later determined to be too complex for discovery does not excuse a finding of inquiry notice and does not warrant the application of [the] good faith [defense].
Author’s Comment: This is a very confusing holding. Look again at the first sentence in that paragraph: “Transferees seeking to retain fraudulent transfers might offer up evidence of undertaken investigations to prove a reasonable person’s suspicions would not have been aroused when the transfer was received . . . . “
If the transferee shows that an investigation was undertaken, doesn’t that necessarily constitute an admission that the transferee’s suspicions were aroused, thus putting the transferee on inquiry notice? Why else would the transferee have conducted an investigation – just for fun? Worse yet, if the fact of inquiry notice has thus been established, isn’t the result of the investigation immaterial, since there is now no “futility” exception to the duty of inquiry?
The rule adopted by the court would put an alert transferee into a terrible Catch-22 dilemma: if there are hints that fraud is afoot, and the transferee fails to investigate, then the transferee risks the loss of the “good faith” defense. But if the transferee does investigate and finds nothing wrong (because the scheme is so diabolically clever), then the inquiring transferee (1) has admitted the existence of inquiry notice but (2) has thereby lost the right to defend on the ground that the investigation was futile.
I hope that other courts will see that the Fifth Circuit’s holding is illogical and will refuse to follow it. I think there is little or no hope of certiorari in this case, since it was decided under state law. Note that the transferee, an individual, lost nearly $80 million as the result of this ruling.
For discussions of cases dealing with related issues, see:
- 2018-31 Comm. Fin. News. NL 61, Outside Counsel’s Emails to Bank Warning of Fraudulent Transfer Risk Destroyed Bank’s “Good Faith Transferee” Defense.
- 2018-19 Comm. Fin. News. NL 38, Recipient of Funds Looted From Victim’s Investment Account Was On Inquiry Notice That Investment Advisor Was Engaged in Questionable Behavior.
- 2016-03 Comm. Fin. News. NL 6, Bank’s Suspicions That Borrower May Have Misused Collateral Are Enough to Destroy Bank’s “Good Faith” Defense to Fraudulent Transfer Claim But Are Not Grounds for Equitable Subordination.
- 2015-05 Comm. Fin. News. NL 9, Lender Financing Assets Assigned To Special Purpose Entity May Be on Inquiry Notice of Misconduct by Assignor Because Assignor’s Financial Statements List Unsecured “Related-Party” Loans.
- 2013-42 Comm. Fin. News. NL 87, Mortgage Lender Cannot Invoke Good Faith Defense to Fraudulent Transfer Liability Because Lender Knew or Should Have Known That Distressed Debtors Had Recently Transferred Property to Corporation Without Consideration.
- 2009 Comm. Fin. News. 85, When Subsidiaries Incur Debt to Pay off Parent’s Obligations, Lenders’ Liens on Subsidiaries Assets Are Fraudulent Transfers; Lenders Did Not Act in Good Faith Because They Failed to Investigate Subsidiaries’ Solvency; Lenders Are Liable for More Than $600 Million.
- 2007 Comm. Fin. News. 03, Brokerage That Receives Money from Ponzi Scheme Is Liable as “Initial Transferee” of Fraudulent Transfer Because It Had “Dominion and Control” over Funds; “Good-Faith” Defense Is Unavailable Because Brokerage Should Have Investigated Factual Inconsistencies.
- 2002 Comm. Fin. News. 38, Following Leveraged Buyout (LBO), Selling Shareholder Is Liable As Fraudulent Transferee; “Good Faith” Defense Is Unavailable Due to Inquiry Notice of Circumstances Surrounding LBO.
These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.