Restructuring

Contributed by Christopher Hopkins
Section 548(c) of the Bankruptcy Code provides transferees subject to fraudulent conveyance actions with an affirmative defense if they received the transfer for value and in good faith.  As with any affirmative defense, the transferee bears the burden of proof.  In cases where the trustee attempts to avoid a debtor’s repayment of a monetary obligation—such as a repayment of a loan or a return of an investor’s cash investment—the “for value” component is rarely at issue because the property transferred—cash—has a readily ascertainable value.  But the question of what constitutes “good faith” under section 548(c) is not so easily determined.  Complicating matters, the Fourth Circuit’s recent decision in In re Taneja, adds to the uncertainty by departing, at least in part, from the good-faith standard applied in other circuits. 
“Good Faith” Pre-Taneja
Neither the Bankruptcy Code nor its legislative history provides the parameters for determining the “good faith” required of transferee’s raising an affirmative defense under section 548(c).  Instead, courts have constructed the applicable framework for assessing whether a transferee received the transfer in good faith.  As a general matter, courts will ask whether the transferee knew or reasonably should have known that the transfer was made either (i) when the transferor was insolvent or (ii) with a fraudulent purpose.  If the transferee can prove that it did not know and that it should not have reasonably known of the transfer’s fraudulent purpose, then its burden of proof is met.
In cases where the trustee alleges that the transferee “should have known” of a transferor’s fraudulent purpose, the analysis consists of two components.  Initially, courts will consider whether the transferee knew or reasonably should have known of certain facts—often referred to as “red flags”—that would have alerted a reasonably prudent transferee to the fraud.  If the court determines that there were sufficient red flags surrounding the transfer to provide such “inquiry notice” of potential fraud, the transferee can still avail itself of section 548(c)’s affirmative defense by showing that a reasonably diligent inquiry would not have discovered the fraud.  Both the inquiry notice and diligent inquiry components are objective tests.  Accordingly, the court considers what a similarly situated, reasonably prudent transferee either should have known, or, if there are sufficient red flags such that a transferee would have inquiry notice of the potential fraud, should have discovered after a reasonably diligent inquiry.
The Good Faith Standard in In re Taneja
The Fourth Circuit’s split decision in Taneja introduces a measure of subjectivity into the standard of “good faith” required by section 548(c).  In Taneja, the court held that the appropriate standard of good faith in the section 548(c) context is whether the “transferee actually was aware or should have been aware, at the time of the transfers and in accordance with routine business practices, that the transferor-debtor intended to hinder, delay, or defraud any entity to which the debtor was or became . . . indebted.”  At first glance, this good-faith standard seems to comport with the generally accepted standard discussed above.  It is in the application of this standard, however, that the Fourth Circuit appears to break new ground.
The transfers at issue in Taneja involved certain payments Financial Mortgage, Inc., a mortgage originator, made to First Tennessee National Bank, N.A., one of FMI’s mortgage warehouse lenders.  Leading up the financial crisis of 2007–08, FMI was engaged in a fraudulent scheme that had started as early as 1999.  As the financial crisis deepened, FMI’s operations crumbled.  By the time the dust settled, First Tennessee had suffered nearly $5.6 million in losses.  FMI filed for bankruptcy protection in June 2008, and a trustee was appointed to oversee the estate.  Shortly thereafter, the trustee sought to avoid certain payments First Tennessee received from FMI as fraudulent transfers under section 548(a) of the Bankruptcy Code.  In response, First Tennessee raised an affirmative defense under section 548(c).
During a three-day trial before the United States Bankruptcy Court for the Eastern District of Virginia, First Tennessee relied on the testimony of two of its employees to establish that it had received the transfers in good faith.  Neither witness provided expert testimony.  Based on the witnesses’ testimony, the bankruptcy court concluded that First Tennessee had proved that it acted with the requisite good faith when it accepted the transfers from FMI.  Accordingly, because the trustee conceded that the transfers were received for value, the court held that the transfers could not be avoided under section 548(a).  The United States District Court for the Eastern District of Virginia affirmed the bankruptcy court’s decision, and the trustee appealed.
On appeal, the trustee argued that (i) the bankruptcy court had misapplied the objective good-faith standard required by section 548(c), and (ii) First Tennessee failed to present sufficient evidence to prove it accepted the payments in good faith. The Fourth Circuit rejected these arguments and affirmed the district court’s decision.  The court held that First Tennessee’s two lay witnesses had adequately demonstrated that the bank had received the transfers in good faith and without knowledge that should have alerted First Tennessee that the transfers were fraudulent.  Notably, First Tennessee’s evidence did not seem to address whether a reasonably prudent warehouse lender would have been alerted to the fraud.  The dissent noted that if the Fourth Circuit was truly applying an objective good-faith test, the proper inquiry should have been whether the facts would have alerted a reasonably prudent warehouse lender to the fraud.  Although First Tennessee’s witnesses may have been able to explain why FMI’s conduct did not raise suspicions of fraud at First Tennessee, the dissent stated that a truly objective inquiry would have required First Tennessee to present evidence showing that its conduct followed routine industry practices and that its response to the various “red flags” at FMI would not have alerted a reasonably prudent mortgage warehouse lender to the fraud.
Conclusion
Taneja introduces a measure of subjectivity into the court’s analysis of a transferee’s good faith under section 548(c) of the Bankruptcy Code.  By focusing on whether First Tennessee acted reasonably, instead of whether a reasonably prudent warehouse lender would have been alerted to the fraud, the Fourth Circuit departed from the objective analysis typically applied in the section 548(c) context.  Further, it alleviated First Tennessee’s burden of presenting expert evidence concerning the warehouse lending industry.  Whether other circuits will introduce a subjective analysis when assessing good faith in the section 548(c) context remains to be seen.