Ruling on a $500 million mistake, the Second Circuit reversed the district court, allowed one of the world’s largest banks to recover $500 million that it had mistakenly paid to a group of lenders, and wrote the definitive statement on “inquiry notice” under New York law.
Although the decision does not involve bankruptcy, the opinion on September 8 by Circuit Judge Pierre N. Leval lays out guiding principles for bankruptcy courts to apply, for instance, in deciding whether a creditor was on inquiry notice when the creditor’s good faith or knowledge is in question.
After a bench trial, the district court ruled in favor of the lenders and would have allowed them to retain $500 million of the bank’s money that was sent to them by mistake. Although the appeals court decided that the district court had an erroneous interpretation of governing New York law, the opinion may suggest to some readers that the circuit court set aside some findings of fact without explicitly declaring them to be “clearly erroneous.”
Although the opinion is heavy on the facts and the law, the outcome seems to emanate chiefly from a desire to prevent the lenders from receiving a “huge windfall” from the bank’s “ministerial error,” to use Judge Leval’s words.
The Big ‘Oops’
Judge Leval devoted almost half of his 100-page opinion to laying out the facts. For our purposes, it amounts to this:
Cosmetics maker Revlon Inc. was in financial trouble in August 2020. To stave off bankruptcy successfully for the time being, Revlon was engaged in complex refinancings. At the same time, a $7.8 million interest coupon was coming due on $894 million in bonds.
Payment of the $7.8 million in interest had been delegated to Revlon’s bank’s contractor in India. Although neither the bank nor Revlon intended to pay off the $894 million in principal, the contractor in India didn’t check the correct boxes on the computer screen. As a result, the bank paid both the $7.8 million in interest plus the $894 million in principal. The principal would not have come due for another three years.
The bank discovered the mistake the next morning and immediately notified the lenders, asking them to return the mistaken principal payments.
Some lenders voluntarily returned almost $400 million. Six days after the mistaken payment, the bank sued the remaining lenders in district court in New York, seeking a return of the remaining $500 million. The lenders agreed to a preliminary injunction preventing them from dissipating the $500 million pending the outcome of the litigation.
Although Revlon had the right to prepay the principal, the company did not intend to do so. As Judge Leval said, the bonds were trading on the market at about 25% of face value, so Revlon could have bought the bonds back more cheaply. Paying off the bonds at face value made no sense, neither to Revlon nor to the lenders who received the windfall.
During the pandemic, the district court held a bench trial by video and ruled about six months after the mistaken payment that the lenders were entitled to retain the $500 million under New York law. The bank appealed. Oral argument was held one year ago.
Judge Leval explained in an addendum to his opinion that he and Circuit Judge Robert D. Sack originally intended to certify the New York law question to the New York Court of Appeals, the highest court in New York. After having written the opinion certifying the question, they became “increasingly persuaded” that New York law favored the bank. In addition, they wanted to decide the appeal more quickly because a certified question would delay the ultimate result by one year, Judge Leval said.
Even though the $500 million was tied up by an injunction pending final judgment, the delay was not without effect. Revlon had filed in chapter 11 while the appeal was pending and did not know whether the bank or the lenders held the claim. Also, the credit markets were roiled by the district court’s decision, and loan documents were being redrafted.
Discharge for Value
In the eyes of Judges Leval and Sack, the appeal turned on the applicability (or not) of the discharge-for-value rule set forth in the Restatement (First) of Restitution and the opinion of the New York Court of Appeals in Banque Worms v. BankAmerica International, 570 N.E.2d 189 (N.Y. 1991).
Judge Leval began his legal analysis by stating that the “New York law governing mistaken payments generally calls for restitution of the mistaken payment unless the recipient so significantly changed its position in reliance on the mistake that it would be unjust to require repayment.”
In Banque Worms in 1991, Judge Leval said that the New York high court “endorsed an exception to that traditional rule [of restitution] based on the First Restatement’s discharge-for-value principle.”
Adding emphasis, Judge Leval laid out the exception, quoting from Banque Worms:
When a beneficiary receives money to which it is entitled and has no knowledge that the money was erroneously wired, the beneficiary should not have to wonder whether it may retain the funds; rather, such a beneficiary should be able to consider the transfer of funds as a final and complete transaction, not subject to revocation. 18 570 N.E.2d at 196 (emphases added).
Although he devoted dozens of pages in explanation, Judge Leval concluded that the exception did not apply because the lenders were not entitled to the principal payment, and they were on “inquiry notice” about the erroneous payment. He went on to say that inquiry notice was satisfied because the “facts were sufficiently troublesome that a reasonably prudent investor would have made reasonable inquiry, and reasonable inquiry would have revealed that the payment was made in error.”
Judge Leval rejected the lenders’ contention that the inquiry notice standard is subjective. “The test is not,” he said, “whether the recipient of the mistaken payment reasonably believed that the payment was genuine and not the result of mistake.” Citing a 1919 opinion by the New York Court of Appeals, he said it is an objective test, “not dependent on what the actual recipient believed.”
In the 1919 case, the New York high court said that someone is charged “with the knowledge which a proper inquiry would disclose . . . . If a person has knowledge of such facts as would lead a fair and prudent man, using ordinary thoughtfulness and care, to make further accessible inquiries, and he avoids the inquiry, he is chargeable with the knowledge which by ordinary diligence he would have acquired.” Fidelity & Deposit Co. of Maryland v. Queens County Trust Company, 123 N.E.370, 372-73 (N.Y. 1919).
In short, Judge Leval said that both New York law and the Restatement “apply the inquiry notice standard and not a standard of ‘knew or should have known.’” Furthermore, Banque Worms was not controlling, he said, because the transferee in that case had “no reason whatsoever” to suspect there was a mistake.
In the case on appeal, Judge Leval said that the lenders “had no incentive” to investigate. He said they received an “unexpected apparent early repayment of principal from an insolvent debtor” when there were “visible red flags” suggesting that the payment was “a mistake.”
Judge Leval saw several red flags. The lenders had received no notice of prepayment, to which they had a contractual right. Revlon was insolvent with an “apparent inability” to repay almost $1 billion, and repayment at face value made no sense when the bonds were trading at around 25 cents on the dollar.
Judge Leval vacated the district court’s judgment, holding that a creditor under New York law “may not invoke the discharge-for-value rule unless the debt at issue is presently payable.” Otherwise, he said that the lender would have “a huge windfall over and above what they bargained for, while an order of restitution would leave them exactly where they contracted to be.”
Judge Leval’s Addendum
Writing only for himself, Judge Leval explained in an addendum why it took one year to publish the opinion. Of greater significance, he said:
It therefore appears to me that the discharge for value rule has no application to the payment made in this case — an accidental payment made without intent to pay, without intent to discharge a debt or lien, and without mistake as to the transferor’s duties or interests.
Regarding the concurrence in the judgment by Circuit Judge Michael H. Park, Judge Leval said that the “solutions” advanced by Judge Park were not “advanced” by the bank, were not briefed, “and do not reflect the law of New York.”
Concurrence by Judge Park
Judge Park concurred in the result, but on different grounds. He agreed with the majority that the district court “clearly erred” in finding “insufficient red flags.” He also agreed that the district court misinterpreted Banque Worms.
In his 30-page concurrence, Judge Park argued that the discharge-for-value defense did not apply because the lenders had “no present entitlement” to payment of the principal.
Ruling on a $500 million mistake, the Second Circuit reversed the district court, allowed one of the world’s largest banks to recover $500 million that it had mistakenly paid to a group of lenders, and wrote the definitive statement on “inquiry notice” under New York law.
Although the decision does not involve bankruptcy, the opinion on September 8 by Circuit Judge Pierre N. Leval lays out guiding principles for bankruptcy courts to apply, for instance, in deciding whether a creditor was on inquiry notice when the creditor’s good faith or knowledge is in question.
After a bench trial, the district court ruled in favor of the lenders and would have allowed them to retain $500 million of the bank’s money that was sent to them by mistake. Although the appeals court decided that the district court had an erroneous interpretation of governing New York law, the opinion may suggest to some readers that the circuit court set aside some findings of fact without explicitly declaring them to be “clearly erroneous.”
Although the opinion is heavy on the facts and the law, the outcome seems to emanate chiefly from a desire to prevent the lenders from receiving a “huge windfall” from the bank’s “ministerial error,” to use Judge Leval’s words.