For the second time in the same case, the Fifth Circuit has ruled that the good faith defense to a fraudulent transfer under Texas law requires a defendant with “inquiry notice” to conduct a “diligent inquiry,” even if investigation would have been fruitless.
This time, the conclusion by the court of appeals was buttressed by an opinion from the Texas Supreme Court resolving a previously undecided question under Texas law. The outcome is remarkable because the same defendant would have had a good defense if the suit were under Section 548.
The Stanford Ponzi Scheme
The appeal arose in the wreckage of the $7 billion Ponzi scheme orchestrated by R. Allen Stanford, now serving a 110-year prison sentence.
Appointed by the Securities and Exchange Commission, the Stanford receiver filed suit under the Texas Uniform Fraudulent Transfer Act, or TUFTA, against an investor who took out $79 million in principal shortly before the fraud was exposed, but after news of the SEC investigation was public knowledge. The district court ruled that the investor was the recipient of a transfer made with actual intent to hinder, delay or defraud. To prove a claim under TUFTA, the receiver was required to show that the defendant was not in good faith, because return of principal provided “reasonably equivalent value.”
The jury concluded that the defendant was on inquiry notice regarding good faith. However, the jury decided that an investigation would have been futile. Believing that the defendant passed the good faith defense under Texas law, the district court ruled against the receiver, who appealed.
The First Fifth Circuit Opinion
In January 2019, the Fifth Circuit reversed and found the defendant liable. Janvey v. GMAG LLC, 913 F.3d 452 (5th Cir. Jan. 9, 2019). The appeals court made a so-called Erie guess by presuming that the Texas Supreme Court would not recognize the futility defense. The circuit court noted that the same facts would have given the transferee a complete defense were the suit 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. In May 2019, the panel granted the motion for panel rehearing, vacated the opinion from January, and certified a question, asking the Texas Supreme Court to decide 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 Supreme Court Rules for the Receiver
As it turned out, the guess by the Fifth Circuit was spot on. In an opinion on December 20, the Texas Supreme Court ruled 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.” Janvey v. GMAG, L.L.C., 592 S.W.3d 125, 131 (Tex. 2019).
If a diligent inquiry would not have disclosed fraud, the state high court went on to hold 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.” Id. To read ABI’s report, click here.
The Third Opinion by the Fifth Circuit
The answer to the certified question was not completely dispositive, because the Texas Supreme Court did not say how much of a diligent investigation establishes good faith, nor did the state court say whether the defendant in the Fifth Circuit had performed a diligent investigation.
The defendant conceded it was on inquiry notice. The open questions therefore called on Circuit Judge Carl E. Stewart to scour the trial record and determine whether the jury’s conclusion about lack of good faith was based on sufficient evidence. In Texas, he said, a defendant on inquiry notice “cannot satisfy the good faith defense without first diligently investigating his or her initial suspicions of fraud.”
Reciting the evidence most favorable to the defendants, Judge Stewart concluded that the “record does not show the [defendants] accepted the fraudulent transfers in good faith.” For a second time, he therefore reversed the district court and granted judgment in favor of the trustee.
For the second time in the same case, the Fifth Circuit has ruled that the good faith defense to a fraudulent transfer under Texas law requires a defendant with “inquiry notice” to conduct a “diligent inquiry,” even if investigation would have been fruitless.
This time, the conclusion by the court of appeals was buttressed by an opinion from the Texas Supreme Court resolving a previously undecided question under Texas law. The outcome is remarkable because the same defendant would have had a good defense if the suit were under Section 548.
The Stanford Ponzi Scheme
The appeal arose in the wreckage of the $7 billion Ponzi scheme orchestrated by R. Allen Stanford, now serving a 110-year prison sentence.
Appointed by the Securities and Exchange Commission, the Stanford receiver filed suit under the Texas Uniform Fraudulent Transfer Act, or TUFTA, against an investor who took out $79 million in principal shortly before the fraud was exposed, but after news of the SEC investigation was public knowledge. The district court ruled that the investor was the recipient of a transfer made with actual intent to hinder, delay or defraud. To prove a claim under TUFTA, the receiver was required to show that the defendant was not in good faith, because return of principal provided “reasonably equivalent value.”
The jury concluded that the defendant was on inquiry notice regarding good faith. However, the jury decided that an investigation would have been futile. Believing that the defendant passed the good faith defense under Texas law, the district court ruled against the receiver, who appealed.