Texas Law Has Fraudulent Transfer Liability When the Bankruptcy Code Doesn’t

The Fifth Circuit found fraudulent transfer liability under Texas law even though the same facts would give the transferee a complete defense under Section 548(c) of the Bankruptcy Code.

According to the January 9 opinion by Chief Circuit Judge Carl E. Stewart, the so-called futility exception to the good faith defense is not available under Texas law, although a defendant in an identical case under the Bankruptcy Code would have a valid defense under Section 548.

The appeal arose from the $7 billion Ponzi scheme orchestrated by R. Allen Stanford, now serving a 110-year prison sentence. The Securities and Exchange Commission initiated a receivership and tasked the receiver with bringing lawsuits to aid defrauded investors.

Under the Texas Uniform Fraudulent Transfer Act, or TUFTA, the receiver sued an investor who took out $79 million in principal shortly before the fraud was exposed. The district court ruled that the investor was the recipient of a transfer made with actual intent to hinder, delay or defraud. The only issue was the investor’s good faith defense under TUFTA.

The defendant escapes liability under TUFTA by proving it received the property “in good faith and for reasonably equivalent value.” Good faith alone was at issue because repayment of the investor’s principal established reasonably equivalent value.

The district court committed two questions for the jury to decide. First, the jury decided that the defendant was on inquiry notice regarding the question of good faith. The charge to the jury said that inquiry notice was “knowledge of facts . . . that would have excited the suspicions of a reasonable person and led that person to investigate.”

However, the jury also decided that an investigation would have been futile. In the jury charge, a futile investigation was defined as “a diligent inquiry that would not have revealed to a reasonable person that Stanford was running a Ponzi scheme.”

Although the defendant was on inquiry notice and thus ordinarily could not raise the good faith defense, the district court ruled that the defendant was nonetheless entitled to the defense by having proven that an investigation would have been futile.

The receiver appealed, contending that the trial court improperly engrafted a futility exception onto the good faith defense under TUFTA. Siding with the receiver, the Fifth Circuit reversed.

Judge Stewart in substance said that the district court erred by “analyzing bankruptcy good faith rather than TUFTA good faith.”

Judge Stewart explained that Section 548(c) of the Bankruptcy Code “mirrors TUFTA’s good faith defense.” Section 548(c) provides that a transferee who “takes for value and in good faith” may retain the transfer to the extent it gave value to the transferor in return for the transfer. He went on to explain that courts interpreting the Section 548(c) “good faith defense permit transferees to ‘rebut’ a finding of inquiry notice by demonstrating that they conducted a ‘diligent investigation’ into their suspicions.”

If the defendant did not conduct an investigation, Judge Stewart added that “some courts” still permit the defendant “to rebut inquiry notice” by proving that “the fraudulent scheme’s complexity would have rendered any investigations futile.”

Judge Stewart said that the Texas Supreme Court has not ruled on whether “good faith” under TUFTA “requires a diligent investigation or a corresponding futility exception.” He therefore made an “Erie” guess on how the state’s high court would rule were it confronted with the question.

Following a decision by an intermediate appellate court in Texas, Judge Stewart said that “no court has considered extending TUFTA good faith to a transferee on inquiry notice who later shows an investigation would have been futile.” Indeed, he said that the trial court in the case on appeal was “the first to supplement [the Texas intermediate appellate court’s] good faith analysis with interpretations of Bankruptcy Code good faith.”

Judge Stewart said that the Fifth Circuit has previously “declined to rely on Section 548(c) to interpret TUFTA good faith.” Those decisions, he said, are “reinforced by the fact that neither Section 548(c)’s text nor its legislative history defines good faith.”

To the contrary, Judge Stewart said that the Fifth Circuit “has agreed with others that a transferee on inquiry notice ‘must satisfy a “diligent investigation” requirement’ to succeed on a Section 548(c) good faith defense.” He said that courts “also disagree as to whether Section 548(c) permits a futility exception.”

“This lack of conformity,” Judge Stewart said, counsels against relying on Section 548(c) interpretations to construe TUFTA good faith.

In sum, Judge Stewart held, “Regardless of the intricate nature of a fraud or scheme, failing to inquire when on inquiry notice does not indicate good faith.” He therefore declined “to hold that the Supreme Court of Texas would” apply a futility exception to the good faith requirement when no other court had done so.

For some of ABI’s discussions of divergent law in cases involving inquiry notice, click here and here.