United States: Fraudulent Transfer: How Can A Warehouse Lender Qualify For The Good Faith Exception?

Last Updated: June 3 2014
Article by Vicki R. Harding

Gold v. First Tennessee Bank Nat'l Ass'n (In re Taneja), 743 F.3d 423 (4th Cir. 2014)

A liquidating trustee under a plan of reorganization sought to recover 12 payments totaling ~$4 million made by the debtor–mortgage broker to a bank that acted as a warehouse lender. The bank successfully asserted an affirmative defense that it was a good faith transferee for value, and the bankruptcy court dismissed the complaint. The district court affirmed, and the trustee appealed to the 4th Circuit. In a 2-to-1 decision, the 4th Circuit affirmed.

The debtors – a mortgage broker (FMI) and its principal (Taneja) – had a legitimate business of originating home mortgages and selling them to secondary investors. In originating loans, the debtors worked with numerous "warehouse lenders," who typically extended lines of credit and advanced funds to FMI for its loan originations. FMI was required to sell the mortgage loans to secondary purchasers within a certain period of time, and after the sale the lines of credit were typically "replenished."

At some point after 1999, the debtors began having difficulties selling the loans. In response, Taneja began engaging in fraudulent conduct, which included selling the same loans to several different purchasers, and conspiring with other affiliates to conceal the fraud. The fraud, which continued during 2007 and 2008, resulted in losses of ~$14 million to warehouse lenders and ~$19 million to secondary purchasers.

FMI began a relationship with First Tennessee Bank as a warehouse lender in 2007. The bank did various due diligence on FMI and Taneja, including analysis of financial statements and tax returns, research in a private database of information on mortgage irregularities, and checking references. The bank agreed to provide a $15 million line of credit (although it made advances for only ~four months).

Under their agreement, the bank sent funds directly to a title insurance agent, and FMI was required to send certain documents to the bank within two business days, including the promissory notes. Although FMI did not always meet the deadline, it did provide original notes for each loan.

After FMI's outstanding balance reached $12 million, the bank suspended further advances and told FMI that it needed to sell its mortgage loans and "clear" the line of credit. FMI responded that the failure to provide timely documentation for sales was caused by the unexpected departure of one of its loan processors, and without documentation, secondary purchasers would not buy the loans. The bank contacted a representative of FMI's chief customer (Wells Fargo) to review outstanding loans. Wells Fargo confirmed that it had not purchased loans because the supporting documentation was not provided.

A couple of months later the bank intended to obtain the files for the unsold mortgage loans in order to sell directly to secondary purchasers. During a meeting in which the debtor's attorney told the bank that "you don't want these loans," the bank asked the attorney whether the loans were valid and whether there was any fraud involved. The attorney assured the bank that there was no problem and the mortgage loans were good. The bank also visited numerous properties, reviewed appraisals for some of them, and confirmed that FMI was listed on the deeds of trust placed on those properties. In another meeting the bank reiterated its inquiry and the attorney continued to affirm that there was not a problem.

However, a couple of months after that the bank learned that the deeds of trust securing notes held by the bank were not valid and had been falsified. Taneja was convicted of conspiracy to engage in money laundering, and he and FMI filed bankruptcy.

The liquidating trustee alleged that 12 payments for ~$4 million were fraudulent conveyances under Section 548 of the Bankruptcy Code. Under Section 548(a)(1)(A), a transfer may be avoided if the debtor "made such transfer... with intent to hinder, delay, or defraud" creditors. However, Section 548(c) provides an exception for a transferee to the extent that it "takes for value and in good faith." The parties did not dispute that the bank gave value, so the only issue was whether the bank met the burden of proving its good faith.

The court reviewed the law and concluded that the bank must meet both a subjective (honesty in fact) and objective (observance of reasonable commercial standards) requirement to establish a good-faith defense. It noted 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." The trustee did not contend that the bank actually knew about the fraudulent conduct. Thus the case turned on whether the bank should have known taking into account industry practices.

During the trial, the bank relied on the testimony of two employees of the bank. Although they were not qualified as expert witnesses, they were permitted to testify about the warehouse lending industry based on their careers and experience.

The trustee argued that "the bank, as a matter of law, was unable to 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 4th Circuit rejected this argument, finding that it went beyond the requirement that a court consider customary practices. The trustee also argued that the testimony should have been provided by a third-party expert, but the court declined to hold that expert testimony was required.

Turning to the trustee's contention that there were a number of red flags so that the bank "should have known" about the fraud, the court again disagreed:

  • Delay in providing collateral documents: The testimony was that untimely delivery "was 'common' and was 'consistent' with the practices of other investors and warehouse lending customers." The court also noted that the bank always received the note.
  • Failure to sell loans in the secondary market: The testimony was that this was an "extraordinary time." This failure was "part of the business" of warehouse lending generally, but was particularly true during 2007 and 2008. Further, it was "common for mortgage bankers intentionally to delay selling their mortgage loans during this time, because they expected only a temporary market decline."
  • FMI, rather than secondary purchasers, directly made payments to the bank: FMI was required to pay regardless of whether it was able to sell loans. So direct payments were not an indication of fraud.
  • Explanation that delays resulted from one of the loan processors leaving unexpectedly: The testimony indicated that secondary purchasers tightened their standards and would not purchase loans with incomplete documentation.
  • Statement by debtor's attorney that loans were valid and executed in arm's length transactions: The bankruptcy court concluded that it was proper to accept the attorney's response. The decline in market value of loans was an industry wide problem.

Consequently, the 4th Circuit concluded that the bankruptcy court did not clearly err in rejecting the trustee's argument that the bank had not established objective good faith, and accordingly, affirmed dismissal of the trustee's action.

A dissenting opinion argued that the bank failed to offer evidence sufficient to support a finding of objective good faith. The bank bore the burden of showing that "its conduct comported with routine practices in its industry and that its response to potential 'red flags' about FMI's fraud comported with that of an objectively reasonable warehouse lender."

While agreeing that expert testimony was not required, the dissenter found that the witnesses testified only in generalities: "After carefully reviewing the record, I cannot even discern what those industry practices are, let alone find evidence that First Tennessee Bank's actions comported with them."

While acknowledging the market turmoil in 2007 and 2008, the court found that of limited relevance. Economic turmoil should not give a business a free pass on proving objective good faith. Thus, the dissenter would have concluded that there was clear error and that the objective good faith finding was unsupported.

The bank itself lost more than $5.6 million. Losing an additional $4 million due to a clawback of payments during the 2 years prior to bankruptcy would have been difficult to swallow. It can come as a surprise to clients that a transfer made to the client may be recoverable as a fraudulent transfer even if the client had nothing to do with the actual or constructive fraud. And, as indicated by the 2-to-1 split, it is difficult to predict with confidence that the recipient of a fraudulent transfer will be able to establish a good faith exception so that it is not required to return the payment.

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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Vicki R. Harding
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