Answering a certified question from the Fifth Circuit, the Texas Supreme Court held that a defendant in a fraudulent transfer suit who is on inquiry notice, but does not investigate, is not entitled to the good faith defense even if inquiry would have been futile.
In his December 20 opinion for the Texas high court, Justice J. Brett Busby said that holding “otherwise rewards willful ignorance and undermines the purpose of” the Texas Uniform Fraudulent Transfer Act, or TUFTA.
“The ruling will have a significant effect on fraudulent transfer litigation not only in Texas, but in other jurisdictions around the country,” Eric D. Madden, a partner with Reid Collins & Tsai LLP of Dallas, told ABI. Madden submitted an amicus brief in the Texas Supreme Court on behalf of the National Association of Bankruptcy Trustees.
The Stanford Ponzi Scheme
The question arose in the $7 billion Ponzi scheme perpetrated by R. Allen Stanford, now serving a 110-year prison sentence. The Securities and Exchange Commission obtained the appointment of a receiver, who brought lawsuits to aid defrauded investors.
Under TUFTA, the receiver sued an investor who took out $79 million in principal shortly before the fraud was exposed, but after news of the SEC investigation had become public. 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.
Under TUFTA, the defendant would have no liability if it could prove that it received the transfer “in good faith and for reasonably equivalent value.” Good faith was the only issue, because repayment of the investor’s principal established reasonably equivalent value.
The parties agreed that the defendant conducted no investigation. The jury was therefore left to decide two questions. First, the jury concluded that the defendant was on inquiry notice regarding the question of good faith. On the second question, however, the jury decided that an investigation would have been futile. A futile investigation was defined in the jury charge as “a diligent inquiry that would not have revealed to a reasonable person that Stanford was running a Ponzi scheme.”
The district court ruled that the defendant was entitled to the good faith defense under TUFTA by having proven that an investigation would have been futile. The receiver appealed.
The First Fifth Circuit Opinion
In January, a three-judge panel of the Fifth Circuit reversed the district court and found the defendant liable. Janvey v. GMAG LLC, 913 F.3d 452 (5th Cir. Jan. 9, 2019).
The opinion by Chief Circuit Judge Carl E. Stewart made a so-called Erie guess by presuming that the Texas Supreme Court would not recognize the futility defense. Ironically, Judge Stewart said that the same facts would have given the transferee a complete defense were the defendant able to raise the seemingly identical good faith defense under Section 548(c) of the Bankruptcy Code.
The defendant who received the fraudulent transfer filed a motion for panel rehearing and rehearing en banc.
The Fifth Circuit’s Certified Question
In a per curiam opinion in May, the panel granted the motion for panel rehearing and vacated the opinion from January.
In a certified question, the panel asked the Texas Supreme Court to rule on whether a defendant on inquiry notice who did not conduct an inquiry is nonetheless entitled to the good faith defense if inquiry would have been futile. Janvey v. GMAG LLC, 925 F.3d 229 (5th Cir. May 24, 2019).
To read ABI’s reports on the first and second Fifth Circuit opinions, click here and here.
The Texas Court Is Tough on Recipients of Fraudulent Transfers
The Texas Supreme Court summarized the question and the answer like this: “May a transferee on inquiry notice of a fraudulent transfer satisfy TUFTA’s good-faith defense without conducting a diligent investigation? We conclude that the answer is no . . . regardless of whether the transferee reasonably could have discovered the fraudulent activity through diligent inquiry.”
The opinion seems based in significant part on policy perceived to underlie TUFTA. For example, Justice Busby said that the uniform act “was created to ensure defrauded creditors attain similar remedies.” He also said that “choosing to remain willfully ignorant of any information an investigation might reveal is incompatible with good faith.”
In general, Texas law doesn’t seem to cut much slack for recipients of fraudulent transfers who have reason to suspect fraud was afoot.
Although TUFTA does not define good faith, Texas courts have ruled that a “transferee must show that its conduct was honest in fact, reasonable in light of known facts, and free from willful ignorance of fraud,” Justice Busby said.
Because the jury decided that the defendant was on inquiry notice, Justice Busby said that his court was tasked with deciding “how a transferee with inquiry notice of fraud can prove good faith.” Citing Black’s Law Dictionary, he defined inquiry notice as “‘[n]otice attributed to a person when the information would lead an ordinarily prudent person to investigate the matter further.’”
If a diligent inquiry would have uncovered facts showing fraudulent intent, Justice Busby said that “Texas common law imputes knowledge of those additional facts to the transferee as well.” Furthermore, a transferee is infected with knowledge “so long as it reasonably could have been discovered at the time of the transfer.”
Focusing on the certified question, Justice Busby said that “a transferee seeking to prove good faith must show that it investigated the suspicious facts diligently. A transferee who simply accepts a transfer despite knowledge of facts leading it to suspect fraud does not take in good faith.”
But what if a diligent inquiry would not have disclosed fraud? Justice Busby found the answer embedded in the notion of good faith.
Justice Busby said that “choosing to remain willfully ignorant of any information an investigation might reveal is incompatible with good faith . . . . If the transferee fails to demonstrate its good faith and avoid willful ignorance by conducting a diligent investigation, it cannot be characterized as acting with honesty in fact.”
Concluding the opinion, Justice Busby held that 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.”
Answering a certified question from the Fifth Circuit, the Texas Supreme Court held that a defendant in a fraudulent transfer suit who is on inquiry notice, but does not investigate, is not entitled to the good faith defense even if inquiry would have been futile.
In his December 20 opinion for the Texas high court, Justice J. Brett Busby said that holding “otherwise rewards willful ignorance and undermines the purpose of” the Texas Uniform Fraudulent Transfer Act, or TUFTA.
“The ruling will have a significant effect on fraudulent transfer litigation not only in Texas, but in other jurisdictions around the country,” Eric D. Madden, a partner with Reid Collins & Tsai LLP of Dallas, told ABI. Madden submitted an amicus brief in the Texas Supreme Court on behalf of the National Association of Bankruptcy Trustees.
The Stanford Ponzi Scheme
The question arose in the $7 billion Ponzi scheme perpetrated by R. Allen Stanford, now serving a 110-year prison sentence. The Securities and Exchange Commission obtained the appointment of a receiver, who brought lawsuits to aid defrauded investors.
Under TUFTA, the receiver sued an investor who took out $79 million in principal shortly before the fraud was exposed, but after news of the SEC investigation had become public. 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.