What You Do Won’t Help (But What You Can’t Do Might): The Sixth Circuit Considers Defenses to Fraudulent Transfers

In Meoli v. The Huntington National Bank (In re Teleservices Group Inc.),[1] the U.S. Court of Appeals for the Sixth Circuit examined the elements of “good faith” and “knowledge of the voidability of the transfer avoided” that initial and subsequent transferees must establish when defending against fraudulent transfer claims brought under §§ 548 and 550 of the Bankruptcy Code.[2]

The debtor, Teleservices Group Inc., was a “paper company” set up by Barton Watson in order to conduct a Ponzi scheme using a second company, Cyberco Holdings. Watson, the chairman and chief executive of Cyberco, had previously confessed to two separate bank frauds, served time in jail for fraud-related crime, and had been permanently banned by the National Association of Securities Dealers (NASD). Apparently, Watson’s criminal sentence did little to reform him. Cyberco obtained a series of equipment-financing loans, purportedly to purchase computer equipment from Teleservices. Cyberco directed the equipment-financing companies to pay Teleservices directly for the equipment. The funds were then transferred from Teleservices to Cyberco’s bank account at Huntington National Bank. Teleservices, however, did not have any computer equipment to sell. In fact, Teleservices had no assets and no employees, officers or directors, other than Cyberco executives who assumed false names to conduct Teleservices’ fraudulent business.

The chapter 7 panel trustee sought to recover as fraudulent certain transfers made by Teleservices to Huntington. Funds transferred from Teleservices were used to pay down a Cyberco loan. The payments were made in two ways: direct payments from Teleservices to Huntington, and indirect payments sent by Teleservices to Cyberco’s account at Huntington, which Cyberco then used to repay the loan. As a result of these payments, Huntington conceded that it was both an initial and a subsequent transferee of Teleservices’ funds.

Following an FBI raid of its offices, Cyberco’s creditors commenced an involuntary chapter 7 case. At around the same time, a state-appointed receiver filed Teleservices’s petition, setting the stage for the panel trustee’s fraudulent-transfer action against Huntington. After two trials, the bankruptcy court issued its Report and Recommendation, concluding, among other findings, that Huntington gained inquiry notice of Cyberco’s fraud on Sept. 25, 2003, and that its good faith ended on April 30, 2004. As a result, all direct transfers to Huntington made after April 30, 2004, were recoverable, as were all indirect transfers made after Sept. 25, 2003. The district court adopted the Report and Recommendation, and Huntington appealed.

The Sixth Circuit reversed in part and remanded. It affirmed the lower court’s conclusion that the panel trustee could recover all direct and indirect loan repayments that occurred after April 30, 2004, the date on which Huntington’s “proven good faith ended.” However, the Sixth Circuit reversed the bankruptcy court’s conclusion that the panel trustee could recover those transfers to Huntington as a subsequent transferee that took place after Sept. 25, 2003.

Good Faith

April 30, 2004, was significant because it was the day on which Huntington’s regional head of security, Larry Rodriguez, learned that the FBI was investigating Cyberco and of Watson’s record of bank fraud, including his permanent ban by the NASD, but failed to report it to the Huntington employee responsible for managing the bank’s relationship with Cyberco, John Kalb. Before April 30, 2004, several Huntington employees had harbored suspicions of Watson and Teleservices and had taken steps to investigate the relationship between Cyberco and Teleservices. In fact, in January 2004, Huntington asked Cyberco to find a new bank, although the Meoli opinion does not explain why Cyberco did not leave Huntington. After April 30, 2004, however, “Huntington as a corporate entity could not prove that it continued to receive transfers from Teleservices in good faith.”[3]

The Sixth Circuit rejected Huntington’s argument that the bankruptcy court had committed legal error by finding that Huntington’s proven good faith had ended on April 30, 2004, without finding that any of Huntington’s employees’ proven good faith had ended on that date. Quoting the bankruptcy court, the Sixth Circuit said that a “corporation cannot feign ignorance when it has delegated responsibilities to a group of individuals and an inexcusable breakdown of communication that[?] occurs within the group.”[4] The failure of a single employee, Rodriguez, negated the responsible actions of other Huntington employees, because Huntington could not avoid “responsibility for Rodriguez withholding from Kalb information that would have truly put Kalb to the test.”[5] Whether Rodriguez’s failure was an “innocent miscommunication” was irrelevant, and Huntington’s continued cooperation with the FBI’s investigation “did not cure the corporate bad faith embedded in that breakdown in communication.”[6]

Ultimately, Huntington was liable for what it did not do (ensure communication of critical information among the employees charged with acting on that information), rather than for what it did (conduct its own investigations of Teleservices and assist the FBI’s investigation). Though not apparent from the Sixth Circuit opinion, one of the bankruptcy court’s findings was that this communication failure resulted because Rodriguez did not understand his role: to inform Kalb, who was responsible for managing Huntington’s relationship with Teleservices. Because Rodriguez “chose to replace Kalb as the decision-maker — i.e., to decide for himself whether Watson’s past was important to the loan’s administration,” Huntington could not establish its good faith.[7]

Knowledge of Voidability

The Sixth Circuit reversed the lower court’s conclusion that the panel trustee could recover those transfers to Huntington as a subsequent transferee that took place after Sept. 25, 2003, when a check from Teleservices bounced. The lower court determined that the bounced check gave Huntington inquiry notice of fraud. However, the Sixth Circuit disagreed that inquiry notice always suffices for knowledge of voidability. Instead, it concluded that Sixth Circuit precedent “invite[s] a holistic factual determination of whether a reasonable person, given the available information, would have been alerted to a transfer’s voidability.”[8] In turn, what “a reasonable person would be alerted to depends not just on whether there was inquiry notice, but also on what investigative avenues existed, whether a reasonable person would have undertaken those avenues given the situation, and what findings the reasonable investigations would have yielded.”[9] The Sixth Circuit remanded the case so that a holistic, factual determination of the date on which Huntington gained knowledge of voidability could be made.

On the one hand, Teleservices provides some comfort that the notice required for purposes of § 550(b)(1) will be tailored to the facts and circumstances; mere inquiry notice will not always suffice. On the other hand, Teleservices necessarily requires defendants to establish negative facts: that a reasonable person would not have pursued the available investigative avenues and that such investigations, if undertaken, would not have yielded adequate findings. Such negatives are difficult to prove and highly subjective. To the extent that Teleservices relieves indirect transferee defendants by broadening the inquiry of “knowledge of voidability,” that relief may prove to be illusory.