Texas, like nearly every other state, has adopted its own version of the Uniform Fraudulent Transfer Act (UFTA).[1] The UFTA is aimed at preventing “debtors from transferring their property in bad faith before creditors can reach it.”[2] To that end, the Texas UFTA (TUFTA) renders transfers made “with actual intent to hinder, delay, or defraud any creditor of the debtor” voidable[3]. But a transferee of such a transfer is not liable if they received the transferred property “in good faith and for a reasonably equivalent value.”[4]
The Fifth Circuit recently confronted the good faith defense in Janvey v. GMAG L.L.C..[5] There, the Fifth Circuit vacated its own opinion to certify a question to the Texas Supreme Court, which it asked to decide whether a transferee on inquiry notice who failed to conduct a diligent inquiry may nevertheless assert the good faith defense if such an inquiry would have been futile.[6]
In an opinion that will affect fraudulent transfer plaintiffs, including bank-ruptcy trustees, and defendants across Texas and, perhaps, beyond, the Texas Supreme Court held that no futility exception to the diligent-inquiry requirement exists.[7] As explained below, this holding makes perfect sense given the mutual incompatibility of good faith and willful ignorance.
The SIB Ponzi Scheme, the Receiver’s Clawback Efforts, and the Fifth Circuit Passing the Buck
In 2009, the U.S. Securities and Exchange Commission (SEC) uncovered the SIB International Bank (SIB) Ponzi scheme.[8] For almost 20 years, SIB issued fraudulent certificates of deposit (CDs) with fixed interest rates purportedly based on returns from “a well-diversified portfolio of marketable securities.”[9] But there was no such portfolio, and — as with all Ponzi schemes — existing investors’ “returns” were actually new investors’ fraudulently obtained funds.[10] In October 2008, after Bloomberg reported that the SEC was investigating SIB, one of the scheme’s largest investors (Magness) approached SIB about redeem-ing his outstanding CDs and ultimately “received $88.2 million in cash from SIB….”[11]
The district court appointed a receiver over SIB who sued Magness to recover funds under the TUFTA.[12] After Magness agreed to return $8.5 million to the re-ceiver, ultimately “the only issue presented to the jury [w]as whether Magness received $79 million, already determined to be fraudulent transfers, in good faith.”[13] “The jury determined that Magness had inquiry notice that SIB was en-gaged in a Ponzi scheme, but not actual knowledge[, and] that an investigation would have been futile.”[14] The receiver moved for entry of judgment on the jury’s verdict, on the grounds that the jury’s finding of inquiry notice defeated Mag-ness’s good faith defense as a matter of law.[15] The district court denied the re-ceiver’s motion and held that the receiver was not entitled to recover the addi-tional $79 million under the TUFTA.[16]
On appeal, the receiver argued, among other things, that the jury’s finding of inquiry notice defeated Magness’s TUFTA good faith defense as a matter of law.[17] A three-judge panel of the Fifth Circuit agreed, and reversed the judgment of the district court.[18] Magness then filed a motion for rehearing, which the same pan-el granted.[19] On rehearing, the Fifth Circuit vacated its earlier opinion and certi-fied the following question to the Supreme Court of Texas:
Is the Texas Uniform Fraudulent Transfer Act's “good faith” defense against fraudulent transfer clawbacks, as codified at Tex. Bus. & Com. Code § 24.009(a), available to a transferee who had in-quiry notice of the fraudulent behavior, did not conduct a diligent inquiry, but who would not have been reasonably able to discover that fraudulent activity through diligent inquiry?[20]
“Without comprehensively defining the contours of TUFTA's good-faith defense, [the Texas Supreme Court] answer[ed] the question no.”[21]
The Good Faith Defense and the Inquiry Notice Exception
Ordinarily, a plaintiff can recover property, or its value, from the transferee of an actually fraudulent transfer.[22] However, the transferee is not required to return the property if they can prove that they received the transfer “in good faith and for a reasonably equivalent value.”[23]
But “[a] transferee who takes property with knowledge of such facts as would excite the suspicions of a person of ordinary prudence and put him on in-quiry of the fraudulent nature of an alleged transfer does not take the property in good faith and is not a bona fide purchaser.”[24] Thus, courts consider whether transferees received fraudulent transfers with actual knowledge or inquiry notice of the transferor’s fraudulent intent or insolvency.[25] Accordingly, in most cases, a find-ing that a transferee received a fraudulent transfer with actual knowledge or inquiry notice of the transferor’s fraudulent intent or insolvency defeats a trans-feree’s good faith defense.[26] But the analysis does not end there.
The Exceptions to the Exception: Diligent Investigation and Futility
“Once a transferee has been put on inquiry notice of either the transferor's possible insolvency or of the possibly fraudulent purpose of the transfer, the transferee must satisfy a ‘diligent investigation’ requirement.”[27] Accordingly, courts generally allow transferees asserting the good faith defense to rebut a finding of inquiry notice by demonstrating that they conducted a diligent investi-gation into their suspicions.[28] This result makes sense because the investigation itself shows that the transferee exercised reasonable precautions to guard against aiding or abetting a transferor’s fraud.
Some courts, however, permit defendants an additional avenue to rebut a finding of inquiry notice. These courts allow a transferee on inquiry notice who made no investigation to sustain the good-faith defense if the transferee proves that the fraudulent scheme's complexity would have rendered any investigation futile.[29] As discussed below, this result runs counter to the ordinary meaning of “good faith.”
The Texas Supreme Court Recognized that Willful Ignorance Is Incompatible with Good Faith
The term “good faith” is not defined by the TUFTA and had not previously been interpreted by the Supreme Court of Texas, but, as the Fifth Circuit noted in Janvey I, “[l]ower courts analyzing TUFTA good faith have overwhelmingly adopted an objective definition[.]”[30] Under this approach, a transferee who actually knows facts that would make a reasonable person question whether the transfer is fraudulent cannot demonstrate good faith without first conducting a diligent in-vestigation.[31] This approach to determining whether a transferee received a fraudulent transfer in good faith mirrors the following test for inquiry notice of fraud: A person is on constructive or inquiry notice of a fraud if he “has learned of facts which would cause a reasonable person to inquire further … and is charged with knowledge of all facts such an investigation would have dis-closed.”[32]
In answering the certified question, the Texas Supreme Court “conclude[d] that the meaning of good faith under TUFTA is consistent with these principles.”[33] Accordingly, to prevail on a good faith defense, “[a] transferee must show that its conduct was honest in fact, reasonable in light of known facts, and free from willful ignorance of fraud.”[34] Therefore, the court held that “[a] trans-feree on inquiry notice,” i.e., a transferee with actual knowledge of facts that would make a reasonable person suspect fraud, “must conduct a diligent inves-tigation to prove good faith.”[35]
Conclusion
The Texas Supreme Court answered Janvey correctly. Whether the transfer-ee’s inquiry would result in the transferee having actual knowledge of the trans-feror’s fraudulent intent or insolvency is simply irrelevant to the state of mind of the transferee at the time of the transfer, the foundation is of good faith.[36] As the court aptly observed, “A transferee on inquiry notice of fraud cannot shield itself from TUFTA's clawback provision without diligently investigating its initial suspicions — irrespective of whether a hypothetical investigation would reveal fraudulent conduct. To hold otherwise rewards willful ignorance and undermines the purpose of TUFTA.”[37] At first glance, this result might appear harsh for Ponzi scheme vic-tims who obtained refunds “before the house of cards came tumbling down,”[38] but to hold otherwise would undermine the goal of receivership proceedings aimed at equitably distributing receivership assets to all Ponzi scheme victims — including those who did not receive a refund while on notice of the fraud.
[1] Tex. Bus. & Com. Code § 24.001, et seq.
[2] BMG Music v. Martinez, 74 F.3d 87, 89 (5th Cir. 1996).
[3] Tex. Bus. & Com. Code § 24.005(a)(1) (2017).
[4] Id., § 24.009(a).
[5] 925 F.3d 229 (5th Cir. 2019) (Janvey II).
[6] Id. 235.
[7] Janvey v. GMAG LLC, __ S.W. 3d __, 2019 WL 6972237 (Tex. Dec. 20, 2019).
[8] Id. 231.
[9] Id.
[10] Id.
[11] Id.
[12] Id.
[13] Id. 231–32 (footnote omitted).
[14] Id. 232
[15] Id.
[16] Id.
[17] Id.
[18] See Janvey v. GMAG L.L.C., 913 F.3d 452 (5th Cir. 2019) (Janvey I).
[19] Janvey, 925 F.3d at 230.
[20] Id. at 235.
[21] Janvey, 2019 WL 6972237 at *1.
[22] Tex. Bus. & Com. Code § 24.008(1).
[23] Id. § 24.009(a). See also Flores v. Robinson Roofing & Constr. Co. Inc., 161 S.W.3d 750, 756 (Tex. App.––Fort Worth 2005, pet. denied) (holding that transferees bear the burden of proving good-faith defense).
[24] Hahn v. Love, 321 S.W.3d 517, 527 (Tex. App.––Houston [1st Dist.] 2009, pet. denied). See also GE Capital Commercial Inc. v. Worthington Nat'l Bank, 754 F.3d 297, 313 (5th Cir. 2014).
[25] See, e.g., Citizens Nat'l Bank of Tex. v. NXS Constr. Inc., 387 S.W.3d 74, 85 (Tex. App.––Houston [14th Dist.] 2012, no pet.).
[26] Id.; Janvey I, 913 F.3d at 456.
[27] Templeton v. O'Cheskey (In re Am. Hous. Found.), 785 F.3d 143, 164 (5th Cir. 2015) (quoting Horton v. O'Cheskey (In re Am. Hous. Found.), 544 Fed. Appx 516, 520 (5th Cir. 2013)).
[28] See, e.g., Templeton, 785 F.3d at 164.
[29] See, e.g., Christian Bros. High Sch. Endowment v. Bayou No Leverage Fund LLC, 439 B.R. 284, 317 (S.D.N.Y. Sep. 17, 2010).
[30] Javney I, 913 F.3d at 455.
[31] Hahn, 321 S.W.3d. at 527 (articulating objective standard for inquiry notice).
[32] Jensen v. Snellings, 841 F.2d 600, 607 (5th Cir. 1988) (articulating test for inquiry notice under securities law for deter-mining when statute of limitations commenced).
[33] Janvey 2019 WL 6972237 at *4.
[34] Id(emphasis added).
[35] Id. at *5.
[36] After all, good faith is, fundamentally, “[a] state of mind….” Black’s Law Dictionary 701 (7th ed. 1999).
[37] Janvey 2019 WL 6972237 at *7.
[38] Id. at 29.