Kathy Bazoian Phelps
Senior Counsel in Ponzi Scheme Litigation
and Bankruptcy Matters

Kathy is a senior business trial attorney with more than 25 years experience prosecuting and defending claims for clients involved in Ponzi scheme matters and in bankruptcy proceedings. Kathy’s practice includes recovering assets for clients in complex fraud cases on under standard fee and alternative fee arrangements. Kathy also serves as a mediator in bankruptcy matters, in complex business disputes, and in matters requiring an expert on fraud or Ponzi schemes.

Kathy’s Clients in Ponzi Scheme Cases and Bankruptcy Matters
Equity Receivers
Bankruptcy Trustees
High Net Worth Investors
Debtors in Bankruptcy
Secured and Unsecured Creditors

Tuesday, February 25, 2014

Fourth Circuit Finds Good Faith in Ponzi Scheme Transaction

Posted by Kathy Bazoian Phelps

     What “good faith” means when someone accepts payments from a Ponzi scheme perpetrator is not clearly defined anywhere. Good faith becomes relevant when a trustee or receiver sues an investor or other recipient of funds from the Ponzi schemer during the course of the scheme on a fraudulent transfer theory. The transferee’s primary defense is the good faith value defense under Bankruptcy Code section 548(c) or applicable state law.

     The Fourth Circuit recently affirmed a bank’s good faith defense to a trustee’s fraudulent transfer claim in Gold v. First Tennessee Bank, N.A. (In re Taneja), 2014 U.S. App. LEXIS 3279 (4th Cir. Feb. 21, 2014), and in the process, helped move the discussion forward on how to evaluate and prove good faith.

     The importance of proving good faith for defendants in fraudulent transfer litigation is that it is a zero sum game. If they prove it, along with value provided, they win. If they can’t establish good faith and value, and the plaintiff otherwise proves the prima facie case, the defendant loses. The purpose of the good faith defense is to let innocent transferees off the hook; if the recipient didn’t know and could not have known about the fraud, and gave something up in exchange, it is arguably not fair to hold that recipient liable to return innocently obtained property for which it has provided value. In other words, don’t hold liable the innocent, but require those “in the know” to return the money.

     The difficulty for courts in evaluating good faith is where to draw the “in the know” line. If the recipient actually knew of the fraud, the answer is easy – no good faith. But what if the facts are less clear? Does the court consider and how does it weigh:
  • Red flag warnings?
  • What Warren Buffet would have known?
  • What an elderly uneducated homemaker would have known?
  • What someone similarly situated to the transferee would have known?
     And what if the recipient isn’t an investor, but is a well-established financial institution? Does the analysis change? Banks are generally just running a business and are paid fees or loan repayments by Ponzi scheme perpetrators as part of its ordinary business operations. Or were they? 
     That was the question in Taneja. First Tennessee Bank had extended a line of credit to the debtor on which the debtor made some payments. Although the bank ultimately lost more than $5.6 million, the trustee sued the bank to recover payments made on the line of about $4 million. 
     The Fourth Circuit reviewed and affirmed the findings of the Bankruptcy Court, some of which the court recited as follows:
  • The bank did not have any information that would [reasonably] have led it to investigate further, and the bank's actions were in accord with the bank's and the industry's usual practices.
  • The bank did not have any actual knowledge of the fraud Taneja was perpetrating on it and others.
  • The bank did not have any information that would [reasonably] have led it to investigate further.
  • The bank's actions were in accord with the bank's and the industry's usual practices.
     The Court further reviewed the testimony of the bank employees, adopting their explanations of:
  • Why FMI's and Taneja's conduct did not raise indications of fraud despite FMI's failure to sell their mortgage loans in the secondary market in a timely manner.
  • The severe decline in the market for mortgage-backed securities in 2007 and 2008, which provided additional objective evidence of the state of the warehouse lending industry during that period.
  • The bank’s additional investigation into the collateral securing some of FMI's loans and that they did not discover any problems at that time.
     The Court then reviewed the following evidence submitted by the trustee which the trustee argued should have alerted the bank to the fraudulent scheme:
  • FMI's delay in providing collateral documents to the bank in connection with some of FMI's mortgage loans.
  • FMI's failure to sell many of its mortgage loans in the secondary market
  • FMI, rather than secondary purchasers, directly made payments to the bank on certain loans
  • Taneja told that one of FMI's loan processors had left FMI unexpectedly, resulting in delays in FMI's production of its mortgage loan documentation
  • In a meeting between the bank employee and Taneja's attorney, the bank asked whether FMI's unsold loans were fraudulent, and the attorney responded that the loans were valid and executed in "arms-length" transactions.
     The Court was not persuaded by the trustee’s arguments and found that such issues were “common” and “consistent” in this type of business relationship. In analyzing the appropriate standard to apply, the Court reiterated that both the subjective and objective components of the analysis of good faith should be applied, as it previously determined in its decision in Goldman v. City Capital Mortg. Corp. (In re Nieves), 648 F. 3d 232 (4th Cir. 2011). The Court’s standard in that case was:
Under the subjective prong, a court looks to "the honesty" and "state of mind" of the party acquiring the property. Under the objective prong, a party acts without good faith by failing to abide by routine business practices. We therefore arrive at the conclusion that the objective good-faith standard probes what the transferee knew or should have known taking into consideration the customary practices of the industry in which the transferee operates.
     The trustee in Taneja argued on appeal that “the bank, as a matter of law, was unable to prove good faith without showing that ‘each and every act taken and belief held’ by the bank constituted ‘reasonably prudent conduct by a mortgage warehouse lender.’" The Taneja Court, however, declined “to adopt a bright-line rule.”  It stated that it would not require:
that a party asserting a good-faith defense present evidence that his every action concerning the relevant transfers was objectively reasonable in light of industry standards. Instead, our inquiry regarding industry standards serves to establish the correct context in which to consider what the transferee knew or should have known. 
       The Taneja court also declined “to hold that a defendant asserting a good-faith defense must present third-party expert testimony in order to establish prevailing industry standards.
     There was a dissent to the Taneja decision, however, in which Judge Wynn stated, “Importantly, good faith has not just a subjective, but also an objective ‘observance of reasonable commercial standards’ component.” The dissent, while agreeing that the bank could meet its burden as to the objective component without presenting testimony on prevailing industry standards, disagreed that that the bank had met its burden without presenting any third party testimony. The dissent concluded that the employees’ testimony was evidence of their “subjective good faith, not of objective good faith, taking in consideration industry standards.” The dissent concluded that “the issue is whether First Tennessee Bank, which bore the burden of proof, failed to proffer any evidence or elicit any testimony to support a finding that it received transfers from FMI with objective good faith in the face of certain alleged red flags. It did.”
     Overcoming a defendant’s good faith defense is not an easy task, especially in the case of investor-transferees. Ponzi schemes tend to target and trap the elderly, retired, uneducated and unsophisticated. In such instances, the objective standard would be what an elderly unsophisticated investor would know, and not what Warren Buffet would have known. For more sophisticated investors, however, beware. Burying your head in the sand will not likely be tolerated.

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