United States: Fourth Circuit Weighs In On Good-Faith Defense To Avoidance Of Fraudulent Transfer

An important defense in litigation brought by a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") to avoid a fraudulent transfer is that the recipient provided value in exchange for the transfer and acted in "good faith." Because the Bankruptcy Code does not define "good faith," courts assessing the viability of a good-faith defense typically examine whether, on the basis of the specific circumstances, a transferee knew or should have known that a transfer was actually or constructively fraudulent. Although most courts agree that this test is an objective one, a ruling recently handed down by the Fourth Circuit Court of Appeals may have introduced an element of subjectivity into the analysis. In Gold v. First Tenn. Bank N.A. (In re Taneja), 2014 BL 47157 (4th Cir. Feb. 21, 2014), a Fourth Circuit panel ruled in a split decision that: (i) the same standard applies in assessing good faith under sections 548(c) and 550(b) of the Bankruptcy Code; and (ii) a transferee bank met its burden of demonstrating good faith without introducing evidence of standard practices in the mortgage warehousing industry.

Good-Faith Defense to Avoidance of Fraudulent Transfers

Section 548(a)(1) of the Bankruptcy Code authorizes a trustee or DIP to avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor within the two years preceding a bankruptcy filing if: (i) the transfer was made, or the obligation was incurred, "with actual intent to hinder, delay, or defraud" any creditor; or (ii) the debtor received "less than a reasonably equivalent value in exchange for such transfer or obligation" and was, among other things, insolvent, undercapitalized, or unable to pay its debts as such debts matured.

Section 548(c) provides a defense to avoidance of a fraudulent transfer for a "good faith" transferee or obligee who gives "value" in exchange for a transfer or obligation:

Except to the extent that a transfer or obligation voidable under this section is voidable under section 544, 545, or 547 of this title [dealing with a trustee's power to avoid, respectively, transfers that are voidable under state law, statutory liens, and preferential transfers], a transferee or obligee of such a transfer or obligation that takes for value and in good faith has a lien on or may retain any interest transferred or may enforce any obligation incurred, as the case may be, to the extent that such transferee or obligee gave value to the debtor in exchange for such transfer or obligation.

Thus, the ability of a transferee or obligee to rely on section 548(c) as a defense depends upon whether: (i) the transferee or obligee takes "for value"; (ii) the transferee or obligee acts in "good faith"; and (iii) the transfer or obligation is not otherwise avoidable. Section 550(b) of the Bankruptcy Code similarly provides that, after avoidance of a transfer, the trustee may not recover the property transferred or its value from any transferee "that takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer avoided."

What Is "Good Faith"?

The Bankruptcy Code defines "value" for purposes of section 548. Section 548(d)(2)(A) states that " 'value' means property, or satisfaction or securing of a present or antecedent debt of the debtor, but does not include an unperformed promise to furnish support to the debtor or to a relative of the debtor."

"Good faith," however, is not defined by the Bankruptcy Code, and courts have sometimes struggled to find a reliable standard to apply in assessing whether it exists under a wide range of circumstances. See generally Jimmy Swaggart Ministries v. Hayes (In re Hannover Corp.), 310 F.3d 796, 800 (5th Cir. 2002) ("[T]here is little agreement among courts as to what conditions ought to allow a transferee [the good-faith] defense. This is not surprising, as the variables are manifold."). For example, in Hayes v. Palm Seedlings Partners-A (In re Agric. Research & Tech. Group, Inc.), 916 F.2d 528 (9th Cir. 1990), the Ninth Circuit explained that the standard is an objective one—namely, in gauging good faith, a court should examine what a transferee knew or should have known, rather than what the transferee actually knew from a subjective standpoint. Accord Brown v. Third Nat'l Bank (In re Sherman), 67 F.3d 1348 (8th Cir. 1995); Leonard v. Coolidge (In re Nat'l Audit Defense Network), 367 B.R. 207 (Bankr. D. Nev. 2007).

Other courts have refined this standard into a two-part analysis, examining: (i) whether the transferee was on inquiry notice of suspicious facts amounting to "red flags"; and (ii) if so, whether the transferee reasonably followed up with due diligence to determine whether a transaction may not have been bona fide. See, e.g., Horton v. O'Cheskey (In re Am. Hous. Found.), 2013 BL 307573 (5th Cir. Nov. 5, 2013); Christian Bros. High School Endowment v. Bayou No Leverage Fund LLC (In re Bayou Group, LLC), 439 B.R. 284 (S.D.N.Y. 2010); Bear Stearns Securities Corp. v. Gredd (In re Manhattan Inv. Fund Ltd.), 397 B.R. 1 (S.D.N.Y. 2007); Soifer v. Bozarth (In re Lydia Cladek, Inc.), 494 B.R. 555 (Bankr. M.D. Fla. 2013). Whether a transferee has acted in good faith is a fact-intensive inquiry that must be determined on a case-by-case basis. See Sherman, 67 F.3d at 1355; Wagner v. Ultima Homes, Inc. (In re Vaughan Co. Realtors), 493 B.R. 597 (Bankr. D.N.M. 2013).

The Fourth Circuit's ruling in Taneja has already been criticized by some commentators and industry professionals for corrupting the objective element of the test for good faith.

In Taneja, the Fourth Circuit examined the meaning of "good faith" as used in section 548(c).

Taneja

Beginning in the 1990s, Vijay K. Taneja ("Taneja") owned and operated Financial Mortgage, Inc. ("FMI"), a business engaged in originating home mortgages and selling the loans to secondary purchasers who aggregated the mortgage loans and securitized them for sale to investors. As part of that business, FMI worked with several financial institutions known as "warehouse lenders." Those lenders advanced funds to FMI under lines of credit so that FMI could originate mortgages. Under those arrangements, FMI was obligated to sell the mortgage loans to secondary purchasers within a certain period of time, after which the lines of credit were replenished.

At some point after 1999, FMI had difficulty selling mortgage loans and, under Taneja's control, began engaging in fraudulent conduct. The fraud included selling the same mortgage loans to several different secondary purchasers and conspiring with other affiliated entities controlled by Taneja to have those entities serve as intermediaries as a way to conceal the fraud. This scheme continued through 2007–08, when the market for mortgage-backed securities began to implode as part of the financial crisis. The fraudulent scheme resulted in losses of nearly $14 million to warehouse lenders, approximately $19 million to secondary purchasers, and unspecified millions to investors.

One of FMI's warehouse lenders was First Tennessee Bank N.A. ("FTB"). In July 2007, FTB agreed to provide FMI with a $15 million line of credit. Before doing so, FTB analyzed financial statements and tax records provided by FMI and Taneja, checked FMI's references, and examined FMI's "quality control plan." The bank also conducted due diligence, using a "private mortgage database" that contained information regarding mortgage irregularities and reports of fraud or suspected fraud. FTB's investigation did not reveal any negative business information regarding either FMI or Taneja.

The lending agreement obligated FTB to send funds directly to an insured title agent. After each mortgage transaction closed, FMI was required to send the loan documentation, including the promissory note, to the bank within two business days.

From September 2007 to March 2008, FMI made payments to FTB aggregating nearly $4 million, but the payments were often untimely. FTB loan officers met with Taneja and other FMI representatives twice during that period. The loan officers later testified that: (a) Taneja claimed that FMI's failure to produce loan documentation in a timely fashion was caused by the unexpected departure of one of its loan processors; (b) FMI's chief secondary purchaser confirmed that it had not bought FMI's outstanding loans due to the lack of supporting documentation; and (c) Taneja's lawyer assured the officers that the mortgages were "good" and represented "arms-length transactions."

In April 2008, FTB learned that the mortgages originated by FMI had been falsified. The bank immediately declared FMI in default under the lending agreement.

In June 2008, Taneja (who was later convicted and imprisoned for the fraud), FMI, and various affiliates filed for chapter 11 protection in the Eastern District of Virginia. A bankruptcy trustee appointed for all of the debtors sued FTB in the bankruptcy court to avoid the $4 million in payments made by FMI to the bank as fraudulent transfers under section 548(a) and to recover the funds under section 550(a). FTB invoked the good-faith defense under section 548(c).

At trial, the bankruptcy court heard the testimony of the FTB officers who had been in charge of the lending relationship with FMI. Although the witnesses had considerable experience in warehouse lending, they were not qualified as experts in the industry. Both testified that during the "market meltdown" of 2007–08, banks spent more time analyzing mortgage loans, such loans were more difficult to sell, and more loans remained outstanding on the bank's warehouse lines of credit than in previous years.

The bankruptcy court, relying on the loan officers' testimony, ruled that FTB had established its good-faith affirmative defense under section 548(c) and dismissed the avoidance proceeding. Among other things, the court found that, although the bank was concerned about FMI's failure to sell its loans quickly in 2007, the bank reasonably thought that the lagging secondary mortgage market, rather than any misconduct, caused the delay. The court concluded that FTB "did not have any information that would [reasonably] have led it to investigate further, and the bank's actions were in accord with the bank's and the industry's usual practices."

A district court affirmed the ruling, and the trustee appealed to the Fourth Circuit.

The Fourth Circuit's Ruling

A three-judge panel of the Fourth Circuit affirmed in a split decision. Both the majority and dissenting opinions discussed whether the bankruptcy court had erred in: (i) misapplying the good-faith standard; and (ii) concluding that FTB presented sufficient objective evidence to prove that it had accepted the payments from FMI in good faith.

The majority explained that the Fourth Circuit recently interpreted the term "good faith" in the context of section 550(b)(1) of the Bankruptcy Code in Goldman v. City Capital Mortg. Corp. (In re Nieves), 648 F.3d 232 (4th Cir. 2011). In Nieves, the Fourth Circuit ruled that the proper focus in evaluating good faith in the context of section 550(b)(1) is determining "what the transferee [actually] knew or should have known" when it accepted the transfer. In addition, the court determined that good faith has components that are both subjective (honesty in fact) and objective (observance of reasonable commercial standards):

Under the subjective prong, a court looks to "the honesty" and "state of mind" of the party acquiring the property. Under the objective prong, a party acts without good faith by failing to abide by routine business practices. We therefore arrive at the conclusion that the objective good-faith standard probes what the transferee knew or should have known taking into consideration the customary practices of the industry in which the transferee operates.

Id. at 239–40 (citation omitted). In Taneja, the majority concluded that the good-faith standard adopted in Nieves should apply in determining good faith under section 548(c).

The trustee did not allege that FTB had actual knowledge of FMI's fraudulent conduct at the time of the transfers. Thus, under Nieves, the Taneja panel's inquiry concerned whether the bank should have known about the fraud in keeping with customary practices in the industry.

The majority rejected the trustee's argument that FTB could not prove good faith without showing that "each and every act taken and belief held" by the bank constituted "reasonably prudent conduct by a mortgage warehouse lender." The majority also rejected the trustee's contention that such evidence should have been presented in the form of third-party expert testimony.

"We decline," the majority wrote, "to adopt a bright-line rule requiring that a party asserting a good-faith defense present evidence that his every action concerning the relevant transfers was objectively reasonable in light of industry standards." Rather, the court emphasized, "our inquiry regarding industry standards serves to establish the correct context in which to consider what the transferee knew or should have known."

The majority was similarly loath to adopt an "inflexible rule" that expert testimony must be presented in every case to prove good faith. Such a rule, the court wrote, "unreasonably would restrict the presentation of a defense that ordinarily is based on the facts and circumstances of each case and on a particular witness' knowledge of the significance of such evidence."

Having laid the groundwork regarding the appropriate standard and the nature of the evidence necessary to satisfy it, the majority ruled that: (i) the bankruptcy court applied the correct legal standard in evaluating whether FTB proved its good-faith defense; and (ii) the bankruptcy court did not err in concluding that, on the basis of testimony by FTB's officers regarding their experience in mortgage warehousing and their efforts to investigate Taneja, FMI, and the circumstances surrounding FMI's failure to timely submit mortgage loan documentation, FTB should not necessarily have known of FMI's fraudulent conduct. According to the majority, "[W]hen considered as a whole, the circumstances relied on by the trustee indicated only that FMI had financial difficulties, which was not uncommon in the warehouse lending industry during 2007 and 2008."

Dissenting Opinion

Fourth Circuit Judge James A. Wynn, Jr., dissented. In his opinion, Judge Wynn explained that good faith has not just a subjective component, but also an objective "observance of reasonable commercial standards" element. FTB, the judge wrote, "failed to proffer any evidence to support a finding that it received transfers from FMI with objective good faith in the face of several alleged red flags."

Judge Wynn agreed with the majority's conclusion that FTB could meet its burden as to the objective element of the test without presenting expert testimony on prevailing industry standards. However, he argued that FTB failed to elicit such testimony from its (nonexpert) witnesses, relying instead on "generalities from those witnesses such as having read the Wall Street Journal and having worked in the industry for many years." Such generalities, Judge Wynn posited, constitute evidence of commercially reasonable standards in the warehouse lending industry that is inadequate to satisfy the objective component of the good-faith defense. Moreover, he questioned whether FTB's response to the red flags raised by FMI's conduct comported "with that of a reasonable warehouse lender."

Finally, Judge Wynn discounted FMI's reliance on what it portrayed as a reasonable response in the face of the turmoil in the economy and the mortgage industry during the financial crisis, rather than demonstrating how, in the face of red flags, its conduct comported with industry practices and standards. According to the judge:

If economic turmoil gives businesses a free pass on needing to prove objective good faith, even businesses falling far short of industry standards but rather "wil[l]ful[ly] ignoran[t] in the face of facts which cried out for investigation[,]" In re Nieves, 648 F.3d at 241, could succeed with a good faith defense so long as their implosion coincided with an economic downturn. This is not, and should not be, the law.

Outlook

The Fourth Circuit's ruling in Taneja has already been criticized by some commentators and industry professionals for corrupting the objective element of the test for good faith. Under existing case law, if a DIP or trustee claims that a transferee "should have known" of a transferor's fraud, a two-part analysis is required. First, the court must examine whether red flags existed that should have alerted a reasonably prudent transferee to potential fraud. If the court concludes that the transferee had "inquiry notice" due to the existence of red flags, the transferee can still establish a good-faith defense under section 548(c) if it can demonstrate that a reasonably diligent inquiry would not have revealed the fraud. Both the inquiry notice and diligent inquiry elements are objective tests.

Taneja muddies the waters by injecting an element of subjectivity into this analysis. The Fourth Circuit majority did not require FTB to demonstrate that a reasonably prudent warehouse lender would not have been alerted to the fraud. Instead, the majority ruled that the bank's nonexpert witnesses adequately demonstrated that FTB received the transfers in good faith and without knowledge that should have alerted the bank that the transfers were fraudulent. As noted in the dissent, an objective inquiry would have required FTB to present evidence demonstrating that its conduct followed routine industry standards and that its response to the red flags (e.g., late payments, inadequate loan documentation) would not have alerted a reasonably prudent mortgage warehouse lender to FMI's fraud.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Mark G. Douglas
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