Fraudulent Transfer’s Good Faith Defense: A Futility Exception to Investigation?

By: Donald L Swanson

Court Ruling:  A transferee on inquiry notice of fraud must diligently investigate its suspicions, before a good faith defense is available, even if an investigation would have revealed nothing.

This ruling is from Janey, Receiver v. Magness, Case No. 19-0452 in the Texas Supreme Court (decided December 20, 2019), which Court is answering a certified question of state law from the U.S. Fifth Circuit Court of Appeals.

Certified Question

—Background for the Question

Texas’s Uniform Fraudulent Transfer Act (UFTA) is designed to protect creditors from being defrauded by unscrupulous debtors: aggrieved creditors may “claw back” a fraudulent transfer from the transferee.

Yet, even if a transfer is fraudulent, the transferee might escape claw back by proving “good faith.”

—The Certification

The U.S. Court of Appeals for the Fifth Circuit asked for guidance from the Texas Supreme Court on what constitutes “good faith” under the UFTA.

—The Question

Specifically, the Fifth Circuit wants to know what Texas law requires on this question:

• whether a transferee on inquiry notice of fraudulent intent can achieve good faith status without investigating its suspicions, even when an investigation would have revealed nothing.

Background

—Facts

Stanford International Bank, Ltd., ran a Ponzi scheme with over $7 billion in investments. It sold fraudulent certificates of deposit and issued “returns” to old investors with money from new investors. It deceived over 18,000 investors.

Gary Magness was one of the largest investors, with $79 million of fraudulent CDs.  He withdrew his investments after news of an SEC investigation became public.

—Fraudulent Transfer Lawsuit and Appeals

Later, a Receiver sued to recover Magness’s withdrawal of investments as a fraudulent transfer, under UFTA.  The suit happened in the U.S. District Court for the Northern District of Texas.

Magness claimed a good-faith defense.  After trial, a jury found that, (i) Magness had inquiry notice of the Ponzi scheme, but (ii) an investigation would have been futile.

The district court held that Magness had established a good-faith defense and denied the Receiver’s claim.  The Receiver appealed to the Fifth Circuit, contending that the jury’s finding of inquiry notice defeated Magness’s good faith defense.

The Fifth Circuit reversed, finding that Magness failed to establish a good-faith defense, by failing to investigate, and that a “futility exception” does not exist.

—Certification and Answer

Then, Magness urged the Fifth Circuit to certify the good-faith question to the Texas Supreme Court, instead of relying on its Erie guess. The Fifth Circuit agreed, vacated its opinion and certified the question identified above to the Texas Supreme Court.

The Answer:  The Texas Supreme Court ruled that a transferee on inquiry notice must investigate the suspicious circumstances before a good-faith defense can be available.

Good Faith Defined

The “good faith” defense includes concepts of inquiry notice, honesty in fact, and lack of willful ignorance.  But the UFTA does not define good faith.  So, the Texas Supreme Court looks to other sources and describes the “good faith” defense like this:

• “A transferee must show that its conduct was honest in fact, reasonable in light of known facts, and free from willful ignorance of fraud.”

Types of Notice

The certified question focuses on how a transferee with inquiry notice of fraud can prove good faith.  Here are types of notices, as identified and described by the Texas Supreme Court, and how each relates to good faith.

—Inquiry Notice

Inquiry notice exists when, at the time of the transfer, a person is aware of facts that would have prompted a reasonable person to investigate the possibility of fraud.  A transferee on inquiry notice cannot prove good faith without conducting a diligent investigation—regardless of what that investigation would reveal.

—Actual Knowledge

Actual knowledge means knowledge of suspicious information that shifts a transferee’s status away from “good faith” and toward being on inquiry notice of fraud.

—Constructive Notice

Constructive knowledge is what someone using reasonable care or diligence should have known and is therefore attributed by law to that person.  A transferee can be charged with constructive knowledge in hindsight, if the information could have been discovered at the time of the transfer.

—Jury Findings on Notice

The jury found that Magness was on inquiry notice because he had actual knowledge of facts that would have excited the suspicions of a reasonable person and led that person to investigate.

Investigation Required

A transferee seeking to prove good faith must show that it diligently investigated the suspicious facts. A transferee who simply accepts a transfer, despite knowledge of facts leading it to suspect fraud, does not take in good faith.

—Magnuss’s Argument 

Magness points out that the jury also found that a diligent inquiry would not have revealed that Stanford was running a Ponzi scheme.  And he argues that, since any investigation would have been fruitless, (i) knowledge of the Bank’s fraudulent intent cannot be imputed to him, and (ii) he, therefore, took in good faith.

–Court’s Response

Here is how the Texas Supreme Court responds.

• It agrees with Magness’s premise but rejects his conclusion. A transferee’s lack of constructive knowledge of debtor’s fraudulent intent does not, by itself, determine good faith. That’s because, (i) Magness had actual knowledge of facts that raised a suspicion of fraud, and (ii) choosing to remain willfully ignorant, without investigating, is incompatible with good faith.  He did not confront the suspicious facts, and a willfully ignorant transferee cannot demonstrate honesty in fact.
• It is not asked to define what level of investigation will satisfy good faith requirements and expresses no view on that issue. It concludes only that a transferee on inquiry notice must investigate, to have any opportunity for a good faith status.
• The fact that an investigation might have been fruitless (i.e., would not have revealed any fraud) is irrelevant because a transferee on inquiry notice of fraud must diligently  investigate its initial suspicions, irrespective of whether a hypothetical investigation would reveal fraudulent conduct.  To hold otherwise would reward willful ignorance and undermine the purpose of The UFTA.

Conclusion 

Janey, Receiver v. Magness presents a fascinating question of state law under Texas’s Uniform Fraudulent Transfer Act.  Similar questions will arise in other states and under the Bankruptcy Code’s fraudulent transfer provision of § 548. 

It will be interesting to see whether other state and federal courts follow suit.

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