The Court of Appeals for the Seventh Circuit recently issued a decision which may give a trump card to fraudulent transfer defendants seeking to use the “good faith” defense under the Bankruptcy Code’s recovery provision. This defense, set forth in section 550(b)(1), provides that a trustee may not recover a voidable transfer from “a transferee that takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidablity of the transfer avoided[.]” (emphasis added).

The case, In re Equipment Acquisition Resources, Inc., involved former owners of the debtor – which manufactured and refurbished machinery used in the high-technology sector – who received approximately $17 million in transfers from the debtor as a result of a fraudulent scheme. The former owners, the aptly-named Sheldon Player and his wife, Donna Malone, lost $8 million of these funds gambling at the Horseshoe Casino over approximately 2 years.

The casino observed, but did not act on, various suspect activity of the defendants, including Player’s “walking with chips” (leaving a casino with chips rather than cashing them in) and “passing chips” (giving chips to a third party to cash in). The casino ran credit checks on Player and Malone which revealed that they had understated their liabilities on their credit application by over $2 million, but still extended credit to them. In addition, the casino kept one of the debtor’s accounts on file as a “reference account,” and Player and Malone paid some of their gambling debts from a bank account referring to the debtor’s name.

The bankruptcy court-appointed plan administrator sought to recover the transfers made to the casino pursuant to Code section 550 as a subsequent transferee of the fraudulent transfers. In its summary judgment motion, the casino argued that it was insulated from recovery because it acted without knowledge of the fraud of the debtor, and the district court agreed. On appeal, the Seventh Circuit identified the key issues – whether the casino took the transfers “in good faith” and “without knowledge of the voidability of the transfer avoided.”

With respect to whether the casino took the transfers “without knowledge,” the Court looked to its prior decision in Bonded Financial Services, Inc. v. European American Bank, which held that if a reasonable inquiry would not have led to actual knowledge of voidability, a court cannot impute knowledge. Applying this standard, the Court found that unless the casino had some reason to know that it was receiving funds resulting from a fraudulent transfer, it should not be liable. While the trustee pointed to various “red flags” which he claimed should have alerted the casino that it was receiving fraudulent transfers, the Court was unconvinced that any of the signs were sufficient to impose a duty on the casino to investigate the transfers from the debtor to Player and Malone. The Court further noted that even if the casino had investigated, it likely would not have uncovered the fraud.

With respect to whether the casino took the transfers “in good faith,” the Court found that the casino had “no way of knowing the transactions from [the debtor] to Player were voidable, and thus, was not closing its eyes to the creditors’ plight. There is no indication that any alleged lack of diligence was the product of bad faith.”

The decision certainly serves as a hurdle for trustees, creditors’ committees and other plaintiffs seeking to recover fraudulent transfers from subsequent transferees. Plaintiffs invoking section 550 will now need to plead more than the existence of “red flags” to meet the “without knowledge” standard. Given the difficulties many bankruptcy plaintiffs face in pleading fraud with particularity, the heightened pleading standard could prove exceedingly difficult. Equipment Acquisition Resources provides transferees that ignore or otherwise fail to investigate “red flags” before accepting transfers that are ultimately deemed fraudulent with a basis to avoid liability and breathe a sigh of relief.