Fifth Circuit Blocks Fraudulent Transferee's Good Faith Defense

The district court in Golf Channel had dismissed the receiver's complaint, relying on the defendant's statutory good faith affirmative defense, reasoning that the defendant "looks more like an innocent trade creditor than a salesman perpetrating and extending the [debtor's] Ponzi scheme." In its original 2015 decision, the Fifth Circuit reversed, holding that the Golf Channel case was "different" because the debtor had been "engaged in a Ponzi scheme," but reluctantly vacated that ruling after it received a definitive answer from the Texas Supreme Court on the Texas state law issue — the meaning of "value" in TUFTA. According to the Fifth Circuit, the Texas court interpreted "the concept of 'value' under TUFTA differently than we have understood 'value' under other states' fraudulent transfer laws and under Section 548(c) of the … Code." Significantly, the defendant's good faith in Golf Channel was undisputed, in contrast to the alleged facts in GMAG, where the defendant's good faith was the key issue.

Facts

The defendants in GMAG (collectively, M) had invested in the debtor's Ponzi scheme and had later received $88.2 million in cash from the debtor. After the receiver sued, M returned $8.5 million, representing so-called "fictitious profits" on its original $79 million investment.

M had an "investment committee" monitor its investment in the debtor. When it learned that the SEC was investigating the debtor, M's investment committee resolved to "take back, at minimum, [M's] accumulated interest …." 2019 WL 141107, at 1. According to the receiver, M's later redemptions were "the result of mounting skepticism about" the debtor. Id.

The receiver sued M to recover the redeemed funds, asserting a fraudulent transfer under TUFTA and unjust enrichment. The district court rejected the receiver's unjust enrichment claim before trial, only presenting to the jury the issue of whether M received $79 million as a fraudulent transfer in good faith. According to the jury, M had "inquiry notice that [the debtor] was engaged in a Ponzi scheme, but not actual knowledge." Id. at 2. The court had defined inquiry notice for the jury as "knowledge of facts relating to the transaction at issue that would have excited the suspicions of a reasonable person and led that person to investigate."

Significantly, the jury further found that "an investigation [by M] would have been futile," having been told by the district court that futility existed if "a diligent inquiry would not have revealed to a reasonable person that [the debtor] was running a Ponzi scheme." Id. Rejecting the receiver's argument that "the jury's finding of inquiry notice defeated [M's] TUFTA good faith defense as a matter of law," the district court held that M had "satisfied [its] good faith defense." It relied on the jury's "futility" finding and limited the receiver to the $8.5 million it had already received from M.

The Fifth Circuit

TUFTA's Good Faith Defense

"Recipients of fraudulent transfers can prevent clawback actions by proving they received property 'in good faith and for a reasonably equivalent value' [but …] bear the burden of proving" that good faith defense, said the Fifth Circuit. Id. The Texas Supreme Court has not defined "good faith," but Texas lower courts "have overwhelmingly adopted an objective definition: 'A transferee who takes property with knowledge of such facts as would excite the suspicions of a person of ordinary prudence and put him on inquiry of the fraudulent nature of an alleged transfer does not take the property in good faith and is not a bona fide purchaser.'" Id. at 3, citing Hahn v. Love, 321 S.W. 3d 517, 527 (Tex. App. – Houston [1st Dist.] 2009, pet. denied); and GE Capital Commercial Inc. v. Worthington Nat'l Bank, 754 F.3d 297, 313 (5th Cir. 2014).

No Futility Exception for TUFTA Good Faith Defense

In fraudulent transfer cases based on the Code's good faith provision, §548(c) (transferee "that takes for value and in good faith … may retain any interest transferred … to the extent that such transferee … gave value to the debtor in exchange for such transfer"), a transferee may "rebut" proof of inquiry notice by showing that it "conducted a 'diligent investigation' into [its] suspicions." Id., citing Templeton v. O'Cheskey, 785 F.3d 143, 164 (5th Cir. 2015). Further, courts in Code cases also permit a "transferee on inquiry notice to rebut inquiry notice by proving that the fraudulent scheme's complexity would have rendered any investigation futile." Id., citing Christian Bros. High Sch. Endowment v. Bayou No Leverage Fund, LLC, 439 B.R. 284, 317 (S.D.N.Y. Sep. 17, 2010).

The district court in GMAG applied this "futility exception," reasoning that the Texas Supreme Court "would adopt the diligent investigation requirement" because the Code "may be used to interpret [TUFTA] …." Id., citing Janvey v. Democratic Senatorial Campaign Comm'n, Inc., 712 F.3d 185, 194 (5th Cir. 2013). It found no binding precedent "requiring the conclusion that a transferee on inquiry notice who fails to investigate lacks good faith." Id. The district court still "held that a transferee with inquiry notice must conduct a diligent investigation into the facts that put [it] on inquiry notice to retain TUFTA good faith." Id. In addition, reasoned the lower court, the transferee could "satisfy TUFTA good faith by proving that such an investigation would have been futile." Id. M had retained good faith, said the district court, because the jury found "that an investigation into the [Ponzi] scheme would have been futile despite M's inquiry notice." Id. at 4.

Texas Law: Transferees With Inquiry Notice Have No Good Faith Defense

According to the Fifth Circuit, both "Texas lower courts and federal district courts considering TUFTA good faith rely on Hahn to hold that transferees [with] actual knowledge or inquiry notice of fraud cannot claim TUFTA's good faith defense." Id. at 4. No court "has … extend[ed] TUFTA good faith to a transferee on inquiry notice who later shows an investigation would have been futile." Id. In the Fifth Circuit's view, the district court in GMAG mistakenly supplemented applicable Texas law's "good faith analysis with interpretations of … Code good faith" cases under Code §548(c). Id. The Fifth Circuit may have "relied on §548 to interpret various TUFTA provisions because TUFTA is based on UFTA, which itself is based on §548," but the court has "previously declined to rely on §548(c) to interpret TUFTA good faith." Id.

First, "neither §548(c) text nor its legislative history defines good faith." Id. at 5, citing Jimmy Swaggart Ministries v. Hayes, 310 F.3d 796, 800 (5th Cir. 2002). Courts have disagreed "as to what conditions … allow a transferee this defense." Id. Courts have also disagreed on whether a transferee on inquiry notice, "must satisfy a 'diligent investigation' requirement"; and "the case law is not clear" as to the nature of the investigation requirement and "whether §548(c) permits a futility exception." Id., citing Bayou, 439 B.R. at 312 (recognizing futility exception) and Zayed v. Buysse, 2012 W.L. 12893882, at 22-23 (D. Minn. Sept. 27, 2012) (rejecting futility exception). Because of this "lack of conformity," the Fifth Circuit declined to rely on Code "interpretations to construe TUFTA good faith." Id. Instead, the court held that "failing to inquire when on inquiry notice does not indicate good faith." Id.

"No prior court considering TUFTA good faith has applied a futility exception" in the good faith context. Id. For that reason, the Fifth Circuit declined "to hold that the [Texas] Supreme Court … would do so." At most, a transferee might "offer up evidence of undertaken investigations to prove a reasonable person's suspicions would not have been aroused when the transfer was received." Id. But the complexity of the scheme "does not excuse a finding of inquiry notice and does not warrant the application of TUFTA good faith." Id.

Analysis

GMAG is another example of the Fifth Circuit's construing two virtually identical statues differently, depending on the applicability of federal or state law. Had the GMAG claims been asserted under the Code, M would have been able to assert a futility defense. Unless the Texas Supreme Court reverses Texas lower courts, no futility exception is available to a fraudulent transferee on inquiry notice of the debtor's fraud when TUFTA applies in the Fifth Circuit.

Other courts take a more pragmatic approach than the Fifth Circuit's GMAG decision. The "language of [Code] §548 and the relevant portions of [the Uniform Fraudulent Transfer Act] are quite similar …. Because this language is nearly identical, the holding of [a case decided under Code §548] logically applies to [a case governed by the Uniform Fraudulent Transfer Act]." Kojima v. Grandote Int'l LLC (In re Grandote Country Club Co., Ltd.), 252 F.3d 1146, 1152 (10th Cir. 2001); In re Image Worldwide, Ltd., 139 F.3d 574, 577 (7th Cir. 1998) (bankruptcy case construing UFTA and relying on §548 cases); In re Int'l Mgmt. Assocs., LLC, 563 B.R. 393, 401-02 (Bankr. N.D. Ga. 2017) (federal courts generally conclude that decisions involving UFTA are persuasive authority in §548 cases and vice versa); Walro v. Hartfield, No. 12-90007-JJG-7, 2017 WL 2772335 (S.D. Ind. June 27, 2017) (using federal bankruptcy law to define a UFTA term that was derived from the Bankruptcy Code); In re Polaroid Corp., 472 B.R. 22, 43, 52 (Bankr. D. Minn. 2012), aff'd, 779 F.3d 857 (8th Cir. 2015) ("In the Eighth Circuit, corollary provisions in the federal and state law that address intentionally fraudulent transfers receive the same construction and application … Harmonizing the construction of cognate legislation is as appropriate for the defense as it is for the main remedy."); In re IFS Financial Corp., 417 B.R. 419, 446 (Bankr. S.D. Tex. 2009) (TUFTA fraudulent transfer suit; defendant "received … transfers in good faith"; "… had no reason to question the legitimacy … of the investments prior to receipt of the disputed transfers"; defendant "inquired about the [transferor's] operations [and] found … explanation very persuasive."), aff'd, 669 F.3d 255 (5th Cir. 2012); In re World Vision Entertainment, Inc., 275 B.R. 641, 600 (Bankr. M.D. Fla. 2002) ("The defendants did not perform the minimal due diligence steps needed to demonstrate that they acted in good faith"; claims brought under UFTA and Code). As noted by the leading bankruptcy treatise, "[t]he UFTA [was] … drafted after [Code] Section 548 … by the same individuals." 5 Collier, Bankruptcy §548.09 [5] (16th ed. 2018).

George Bernard Shaw quipped long ago: "England and America are two countries divided by a common language." For the sake of avoiding needless litigation, the Fifth Circuit and the Texas Courts should reconcile their differences in construing virtually identical statutes. The issue here is substantive, not a matter of regional speech patterns.

*****

Michael L. Cook is of counsel, at Schulte Roth & Zabel LLP in New York and a member of this newsletter's Board of Editors.