Under section 548(c) of the Bankruptcy Code, a “good faith” transferee may retain any interest received in an otherwise avoidable fraudulent transfer under the Bankruptcy Code “to the extent that such transferee … gave value to the debtor in exchange for such transfer.” To successfully utilize this affirmative defense, a transferee must demonstrate that it (i) gave value to the debtor and (ii) took the transferred property in “good faith.”
While the Bankruptcy Code defines “value,” it does not define good faith, leaving the courts to determine what constitutes good faith without any Congressional guidance. In response, courts have not crafted a precise definition for good faith. Instead, they have generally considered whether a transferee knew or should have known of a transferor’s financial distress at the time of the transfer to determine whether the transferee was acting in “good faith.” Most recently, the United States Court of Appeals for the Fourth Circuit elaborated on this good faith standard. See Gold v. First Tennessee Bank N.A. (In re Taneja), No. 13-1059 (4th Cir. Feb. 21, 2014).
The Debtor’s Fraudulent Operations
Vijay Taneja, through Financial Mortgage, Inc., originated home mortgages and sold them to secondary purchasers, who thereafter aggregated the mortgages and sold them, via securitizations, to other investors. In connection with its operations, FMI sought to borrow funds from “warehouse lenders,” including First Tennessee Bank N.A.
Prior to lending funds to FMI, First Tennessee conducted due diligence of FMI and its affairs. First Tennessee’s investigation did not reveal any negative information regarding Taneja or FMI and First Tennessee agreed to extend a $15 million line of credit to FMI.
In accordance with its agreement with First Tennessee, FMI was required to provide certain documents, including the mortgagor’s promissory notes, to First Tennessee within 2 days of the mortgage loan closing. On several occasions, FMI failed to timely provide the documents. Approximately 4 months after First Tennessee extended the line of credit, First Tennessee ceased making advances to FMI, apparently because of concerns regarding FMI’s untimely payment.
Over the course of the ensuing months, First Tennessee expressed some concern regarding FMI’s operations and the collateral package. Taneja and his counsel purportedly reassured First Tennessee that the FMI’s mortgage loans were “good.” In addition, FMI made several principal and interest payments totaling approximately $4 million to First Tennessee. Unbeknownst to First Tennessee at the time, Taneja and FMI were engaged in a pattern of fraudulent conduct, which including selling the same mortgage loans to different secondary purchasers and having certain affiliates of Taneja serve as intermediaries in an effort to conceal the fraud. The fraud was ultimately discovered and led to Taneja’s conviction for conspiracy to engage in money laundering.
The Trustee’s Fraudulent Transfer Action
In June 2008, Taneja and FMI filed voluntary Chapter 11 petitions with the Bankruptcy Court for the Eastern District of Virginia and a trustee was ultimately appointed. That trustee filed a complaint seeking to recover the $4 million paid to First Tennessee as a fraudulent transfer. After a three day trial, the bankruptcy court dismissed the complaint finding that First Tennessee was a good faith transferee that gave value to the debtor. The district court affirmed the dismissal. The trustee thereafter appealed to the Fourth Circuit.
Fourth Circuit’s Rationale
On appeal, the trustee challenged the good faith finding, asserting that the bankruptcy court misapplied the objective good faith standard and erred in concluding that First Tennessee had carried its evidentiary burden.
The Fourth Circuit concluded that “good faith” as contemplated by section 548(c) requires a court “to consider 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.” Thus, the good faith “test” has both a subjective and objective component.
Here, it was clear that First Tennessee did not know of FMI’s fraudulent conduct. Thus, the court had to determine whether First Tennessee should have known of the fraudulent conduct subject to the “customary practices of [First Tennessee’s] industry.” The trustee argued that First Tennessee was required to demonstrate, by expert testimony, that every act it took was “reasonably prudent conduct by a mortgage warehouse lender.” The Fourth Circuit disagreed, concluding that a court need not examine every act by a transferee. “Instead, our inquiry regarding industry standards serves to establish the correct context in which to consider what the transferee knew or should have known.” In coming to this conclusion, the Fourth Circuit noted that it may be at odds with the decision from the Southern District of New York in Christian Brothers High School Endowment v. Bayou No. Leverage Fund, LLC (In re Bayou Group), 439 B.R. 284 (S.D.N.Y. 2010).
According to the Fourth Circuit, the objective component of good faith may be established by expert or lay testimony. Moreover, it could be, as was the case here, satisfied by testimony of the employees of the transferee. Ultimately, the Fourth Circuit deferred to the bankruptcy court’s rulings finding that the evidence provided, including the employee’s testimony regarding their discussions with Taneja and industry practices, supported the court’s conclusions. Indeed, “when considered as a whole, the circumstances relied on by the trustee indicated only that FMI had financial difficulties, which was not uncommon in the warehouse lending industry during 2007 and 2008.”
Circuit Judge James A. Wynn, Jr. agreed that deference to the bankruptcy court’s findings is generally appropriate and that the objective component of the good faith defense could by satisfied without expert testimony. He, however, dissented because he found that First Tennessee had not satisfied its burden to provide “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.”
The Fourth Circuits’ decision highlights the factual intensity of a good faith determination. Indeed, while one jurist may conclude that certain facts support a finding of good faith, another might not. Although not necessary, a fraudulent transfer defendant may bolster its good faith defense by engaging an expert to testify on industry practices.