District Court Reverses Good Faith Test in Bayou III

As a colleague characterized it, the U.S. Bankruptcy Court for the Southern District of New York in Bayou III,[1] set the high water mark for limiting the good-faith defense under § 548(c) in fraudulent transfer proceedings. That high water mark has now been reduced by a reversal by the U.S. District Court filed on Sept. 17, 2010, in a 90-page opinion (Bayou IV). Bayou III was a summary-judgment ruling, finding in favor of the trustee that certain redeeming investors were required to return payments for redemption of principal invested in the Bayou funds.

The courts ruled in both Bayou III and IV that the trustee had made a prima facie case for return of principal. The courts reasoned that because Bayou’s officers, Samuel Israel and Dan Mario, entered criminal guilty pleas admitting the Ponzi scheme, that such admissions constituted intent to hinder, delay and defraud because the redemption payments were necessarily part of the furtherance of the Ponzi scheme. This finding relegates defendants to their § 548(c) defense: They received the payments in good faith and gave reasonably equivalent value. As to principal redemptions, value is not an issue because antecedent consideration (their original investment) constitutes reasonably equivalent value. Thus, whether redemptions of principal must be paid back turns on the defense’s proof of good faith.

Despite the plain-meaning language, beginning in 1990, federal courts began defining good faith—currently undefined in the Bankruptcy Code—as meaning knowledge by the investor-transferee, with a “knew or should have known,” reasonable person standard, and imposing upon investors a duty of inquiry and diligence in inquiry if suspicious circumstances were present. At issue in Bayou III and IV is the triggering definitions for the duty of inquiry and the extent of the required due-diligence in investigation. In Bayou III, the court ruled as a matter of law that the appellant investors in Bayou IV (the appellants) had a duty of inquiry and failed to fulfill that duty, and were thus liable for the return of their redemption payments.

The appellants in Bayou IV sought a reversal because Bayou III’s expanded scope of inquiry departed significantly from the case law, and because it improperly abandoned the reasonable-person benchmark in determining whether they conducted a diligent investigation of their concerns. With a most extensive citation to case law, Bayou IV held that proof of the § 548(c) defense was a two-step inquiry: (1) Did the transferee have information that put it on inquiry notice that the transferor was insolvent or the transfer might be made with a fraudulent purpose, and (2) once on inquiry notice, did the transferee satisfy a diligent investigation requirement? In making both determinations, the court found that the “objective reasonable-investor standard” applies. Furthermore, that standard is not governed by a generic, reasonable person test—applicable equally to the elderly widow and the sophisticated hedge fund—but instead requires “a specific focus on the class or category of transferee.” The test here—with hedge funds as defendants—was whether the alleged “red flag” information would have put a "reasonably prudent institutional hedge fund investor" on inquiry notice of insolvency or a fraudulent purpose.

Bayou III held that the red flag triggering the duty of inquiry need not be specific, but rather that it alerted the defendant of a “potential infirmity in the investment.” As such, Bayou IV held that the bankruptcy court had “significantly expanded the scope of information prior courts have found sufficient to require inquiry.... The phrase is so broad as to be undefinable (sic).” It found that the great weight of authority was that the red flag must suggest insolvency or a fraudulent purpose.

Once a duty of inquiry was found, Bayou III held that the standard is what the transferee objectively knew or should have known. However, it went on to impose some hard-and-fast rules that included subjective views and reactions to the information. Bayou III held that the test was not whether the defendant could, should, did or did not actually discover the fraud, but whether its diligent inquiry set to rest its concerns. Bayou III admitted that the test could almost never be met where the transferor was engaged in fraud because once the investigation encounters evasion or stonewalling, the investor will redeem its funds, without its concerns being allayed. As such, it must return them.

Bayou IV held that such an absolute rule renders the good-faith defense illusory, and the test does not lend itself to the application of rigid or absolute rules. As such, as in the Bayou III case, the court will look at additional subjective factors, rather than the objective factors the court said should be reviewed. In contrast to Bayou III, the court held that a defendant may offer evidence that a diligent investigation would not have led to a discovery of the fraud. It pointed out, for example, that (1) the Westervelt lawsuit[2]—taken as a whole—did not raise the issue of insolvency or fraud; (2) Bayou did not have a contractual duty to disclose the manner in which its net-asset values (NAV's) were calculated; and (3) only one of Bayou’s 325 investors—Altegris—found that Marino, Bayou’s president, was the registered agent for its outside auditors.

As such, Bayou IV generally found that the duty to inquire and the diligence in the inquiry were disputed issues of fact, requiring resolution by a jury, and not by the court on summary judgment. While this opinion clearly and forcefully analyzes in depth the last 20 years of federal case law on good faith, it ignores many more fundamental issues:

• The plain meaning of good faith: conduct that denotes conformity with accepted standards of integrity, trust and good conduct.
• Good faith—in English—is a subjective, not an objective, term.
• Lack of statutory basis: there is no legislative history supporting Bayou III’s or Bayou IV’s views.
• Lack of statutory interpretation: In 1978, Congress wrote out of whole cloth
  §§ 548(c) and 550(a); the first uses the terms value and good faith; the latter uses the terms value, knowledge and good faith. Clearly, Congress knew the difference in its phrases.
• Ignores 420 years of case law since the Statute of Elizabeth,[3] under which the transferee must participate in the fraud to be liable for return of the transfer.
• Ignores the state-law interpretation of the UFCA[4] and the UFTA[5].
• Ignores the differing purpose of fraudulent transfer law (to see that the debtor’s limited funds are used to pay some worthy creditor) from preference law (determining which creditor is more worthy).

The knew or should have known objective definition of good faith derives principally from In re Agric. Research and Tech. Grp. Inc.,[6] and Jobin v. McKay,[7] which, in turn, relies on Agric. Research. As argued in two articles in the ABI Journal,[8] the knew or should have known definition and its objective theory are based on “the emperor has no clothes” case law and a policy bias in favor of redistribution of funds. In Agric. Research, the court posited the law after noting that neither party had briefed the issue. Jobin—which is both a preference and fraudulent-transfer case—clearly confuses the two legal theories when it discusses the policy factors for its decision, which is critical to the case. In addition, the 2010 Duberstein Competition’s briefs thoroughly vetted this issue. The winning brief advanced the traditional narrow interpretation of good faith as just that—integrity in action rather than knowledge or constructive knowledge of fraud.[9]

As noted in Bayou IV, before it begins its discussion in Point IV that the trustee had made a prima facie case, it distinguishes the Second Circuit ruling in In re Sharp Int'l Corp.[10]on the basis that Sharp is based on New York law rather than the Bankruptcy Code, and that the two have different statutory purposes, with the state UFCA code being “legal” rather than “equitable.” Bayou IV recites that the state law’s “purpose is not to provide equal distribution of a debtor’s estate among creditors, but to aid specific creditors who have been defrauded by the transfer of a debtor’s property.” As such, it focuses on “doing equity” rather than even bothering with plain meaning, statutory construction, or the lack of legislative history. This lack of history is even more evident with its further distinction between Sharp and Bayou, in that under the Code—as opposed to state law—good faith is a defense, and thus the burden of proof has shifted. There is no legislative history of the 1978 Code discussing in any respect the shift from an affirmative showing to a defense. It may merely have been a statutory shift to promote “clarity” or “orderliness.” We do not know.

Bayou IV does not explore the basic meaning of good faith. We take it that the issue was not raised by the appellants in the court below. Numerous other defenses were raised and strenuously argued, but lacking a bankruptcy court argument, we surmise that the appellants were able to successfully argue that Bayou III had far overstepped its bounds. Bayou III's and Bayou IV's stretch of the statutory language is nothing short of amazing. How can one derive from the language of § 548(c) that the test for whether the defendant is placed on inquiry notice is based on a standard of a “reasonably prudent institutional hedge fund investor?” Do those words appear somewhere in the statute or legislative history? As is clear, once a court departs from the statute and its decades or centuries of tradition to “do equity,” there are no limits upon the free hands of the courts to do so.

At this point, it appears the case is now remanded for trial. If the case were to go further up on appeal, it may be essential for defendants in the many other Ponzi scheme clawback cases pending around the country to file amicus curie briefs to preclude the Second Circuit from compounding 20 years of error.