The U.S. Court of Appeals for the Sixth Circuit recently held that a bankruptcy trustee seeking to recover fraudulent transfers could recover direct and indirect loan repayments made after the bank had knowledge of the debtor’s Ponzi scheme, but could not recover deposits not applied to pay back the bank’s debt because the bank was not a “transferee” under the Bankruptcy Code as to ordinary bank deposits.

A copy of the opinion in Meoli v. The Huntington National Bank is available at: Link to Opinion.

The principal of two bankrupt companies orchestrated a Ponzi scheme in which he fabricated invoices documenting phony purchases of computer equipment by one company from the other. The principal borrowed money from several equipment financing companies, and instructed them to send the money directly to the phony seller. The principal would then move the money to the phony buyer’s bank account. The money was then used to pay salaries and the phony buyer’s earlier debts to lenders for earlier such fraudulent “purchases.”

In September 2003, the phony buyer deposited a check with the defendant bank for $2.3 million from the phony seller that bounced. During a meeting in October 2003 between bank employees and the principal, the principal explained that the phony seller was a recently-formed, wholly-owned subsidiary of the phony buyer and, while “not yet operational,” the new company “was already collecting [the buyer’s] receivables before sending them to [the buyer].” This explanation contradicted the principal’s earlier representation that the seller was the buyer’s “supplier of computer equipment,” which if true would mean that the money would have flowed the other way.

The lead bank investigator suspected foul play in part because the phony buyer refused to use the bank’s lockbox service supposedly because the phony buyer’s customers refused to use it.

In January 2004, the bank decided to end its relationship with the two companies due to several “red flags,” such as doubts about the actual amount of the buyer’s receivables and overdrafts that were offset by increasing the loan balance.

Then, in April 2004, while reviewing the buyer’s “receivables aging report,” the bank noticed that the buyer’s customers included many large Fortune 500 companies that would never object to sending their checks to a lockbox. In addition, some of the alleged customers on the report were the buyer’s competitors, not customers.

The bank’s investigator then discovered that the phony buyer was under investigation by the FBI and the principal had committed bank fraud in Michigan and California for which he was incarcerated for three years. The investigator contacted the FBI, but did not reveal this information to the bank.

The bank wanted to contact the phony buyer’s customers directly, but the principal objected and offered to have a “big eight” accounting firm independently audit the buyer, to which the bank agreed. As it turned out, the principal also defrauded the accounting firm “by providing it with fake responses from [the buyer’s] fake customers.”

The phony buyer paid down the debt in the months that followed, making the last payment on Oct. 29, 2004. The FBI then raided the phony buyer’s offices and the principal committed suicide.

A state court appointed a receiver to take control of both companies, who filed bankruptcy for the phony seller. Creditors of the phony buyer then filed an involuntary bankruptcy proceeding against it.

The bankruptcy trustee for the phony seller sought to recover from the bank “all of the direct loan repayments, the indirect loan repayments, and the excess deposits.”

After two trials and several opinions, and applying “the dominion and control test to determine whether [the bank] was a transferee of the loan repayments and excess deposits[,] the bankruptcy court “concluded first that the Trustee could potentially recover $72 million in loan repayments and excess deposits from [the bank]” because the bank was a “’transferee’ under the Bankruptcy Code.” The bankruptcy court reasoned that once the loan payments were received, the bank could do as it pleased with the money. Likewise, the bank could do as it pleased with the excess deposits, “subject only to [the phony buyer’s] right to withdraw them.”

The bankruptcy court then ruled that the bank received the loan repayments and excess deposits in good faith only until April 30, 2004, but not thereafter, reasoning that had the bank’s investigator shared his discovery of the principal’s fraudulent past, the bank could no longer continue believing in good faith that the transfers from the phony seller were the phony buyer’s receivables.

In addition, the bankruptcy court found that the bank’s affirmative defense of good faith stopped applying even earlier, i.e., September 2003, because it had “inquiry notice” of the fraud when the principal lied about the relationship between the two companies and the bank’s own files showed otherwise. Thus, despite that the bank was acting in good faith until April 2004, the fact that it was on “inquiry notice” negated its affirmative defense.

The bankruptcy court awarded $72 million in loan repayments and excess deposits to the trustee and awarded prejudgment interest “on a portion of that amount and under the federal statutory rate for postjudgment interest.”

The trial court affirmed the bankruptcy court, and both the bankruptcy trustee and the bank appealed.

On appeal, the bank argued: (a) that it was not a transferee of the excess deposits because “it never gained dominion and control over those funds, as [it] was merely maintaining those funds, subject to [the phony buyer’s] right to remove those funds at its will”; (b) “the bankruptcy court applied the wrong standard to assess its good faith[,]” which the bank argued continued beyond April 20, 2004; and (c) “Sixth Circuit precedent did not require the bankruptcy court to conclude that its affirmative defense ended earlier, when it gained inquiry notice of [the phony buyer’s] fraud.”

The trustee cross-appealed, arguing that the bankruptcy court applied the wrong test of good faith, and should have found that the bank’s good faith ended prior to April 30, 2004, and also that the bankruptcy court’s award of prejudgment interest was too low.

The Sixth Circuit first found that the trustee could not recover the phony buyer’s “excess deposits (those deposits not applied to pay back debts to [the bank]) under the Bankruptcy Code provision for recovery of avoidable transfers from ‘transferees’ because banks are not ‘transferees’ with respect to ordinary bank deposits.”

The Court reasoned that the bank was not a “transferee” of the excess deposits because it “did not gain ‘dominion and control’ over them.” Adopting the Seventh Circuit’s test, the Court explained that “'[t]he minimum requirement of status as a ‘transferee’ is dominion over the money or other asset, the right to put the money to one’s own purposes.’ … We have thus distinguished ‘mere possession’ from ‘ownership,’ so that ‘a party is not considered an initial transferee if it is merely an agent who has no legal authority to stop the principal from doing what he or she likes with the funds at issue.’”

First, the Sixth Circuit noted, the bank “did not gain dominion and control over [the phony buyer’s] excess deposits” because it held the funds on deposit. The Court stated, “[a]s our sister circuits have explained, the account-holder’s right to withdraw the deposits keeps the bank from obtaining dominion and control.”

The Sixth Circuit also noted that it was not enough that the bank “could use the cash as it pleased as long as it had enough liquidity to pay back deposits on demand. As the Eleventh Circuit explained, the depository bank’s obligation to maintain liquidity is ‘sufficiently important’ to defeat any dominion and control that the depository bank might otherwise have exercised over those funds.”

Second, the Court rejected the trustee’s argument that the bank’s security interest in the phony buyer’s deposits gave it dominion and control over the money because the security interest covered only the $16 million loan and not “over $64 million in deposits.” Also, the loan agreements clearly stated that the borrower owned the deposits, despite the bank’s security interest. Thus, “[e]ven though [the bank] was the recipient of a transfer of a security interest, [it] was not a ‘transferee’ of that transfer under the Bankruptcy Code.”

The Court then addressed the bank’s affirmative defense of good faith under section 548(c) and 550(b)(1) of the Bankruptcy Code. The bank conceded it was a “transferee” of the direct and indirect loan repayments.

Under section 548(c) of the Bankruptcy Code, “[a]n initial transferee is not liable for the transferred property if the transferee: (i) took the property ‘in good faith’; and (ii) ‘gave value to the debtor in exchange for such transfer.’ [The bank] is an initial transferee of the direct loan repayments from [the phony seller] which [it] gave directly to [the bank]….”

Under section 550(b)(1) of the Bankruptcy Code, “[a] subsequent transferee is not liable for the transferred property if the transferee took the property: (i) ‘for value,’ (ii) ‘in good faith,’ and (iii) ‘without knowledge of the voidability of the transfer avoided.’ … [The bank] is a subsequent transferee of the indirect loan repayments, which [the phony seller] sent to [the phony buyer], and which [the latter] later gave to [the bank] to pay down its debt….”

Applying these provisions, the Sixth Circuit concluded that the bankruptcy court did not commit error when it found that the bank’s good faith ended on April 30, 2004, and that the trustee could “recover all subsequent loan repayments, which include some of the indirect loan repayments and all the direct loan repayments.” However, the Sixth Circuit held, “[w]ith respect to the earlier indirect loan repayments, the bankruptcy court erred in concluding that our precedents necessarily ended [the bank’s] affirmative defense earlier — on September 25, 2003 — when [the bank] gained inquiry notice of [the phony buyer’s] fraud.”

The Court rejected the trustee’s argument that Sixth Circuit precedent required a finding that the bank was on inquiry notice, reasoning that “[w]hile inquiry notice sometimes suffices to ‘alert’ a reasonable person to voidability … on different facts, and viewing those facts holistically, a reasonable person may not be alerted to a transfer’s voidability even if there was inquiry notice. What a reasonable person would be alerted to depends not just on whether there was inquiry notice, but also on what investigative avenues existed, whether a reasonable person would have undertaken those avenues given the situation, and what findings the reasonable investigations would have yielded.”

The Sixth Circuit also rejected the trustee’s argument that it could “recover the transfers made between the two dates … because the district court applied the wrong test to determine [the bank’s] good faith[,]” finding that given “that courts have ‘struggled’ to define good faith in this context[,]” the trial court applied the right test — i.e., whether the bank “legitimately continued to believe that [the phony seller’s] transfers to [the phony buyer’s] account were merely [the latter’s] receivables that [the phony seller] had collected.”

The Court concluded that the trustee was entitled to recover from the bank “all direct loan repayments, of which [it] is an initial transferee, because [the bank] received them after its proven good faith ended on April 30, 2004.” The trustee could also recover from the bank “those indirect loan repayments, of which [the bank] is a subsequent transferee, that [the bank] received after April 30, 2004, and that [it] received earlier, if the district court concluded on remand that [the bank] gained knowledge of the voidability of the transfers before April 30, 2004.”

Turning to the bankruptcy court’s award of prejudgment interest at the rate set forth in 28 U.S.C. § 1961 rather than the “market interest rate,” the Court found no abuse of discretion because “[t]he bankruptcy court satisfied its duty to consider case-specific factors when it considered whether the statutory rate was fair in light of the type of conservative investment that a fiduciary like the Trustee would have pursued.”

The Court explained, however, that on remand the trial court could “exercise its discretion to choose a different prejudgment interest rate, should it deem appropriate[,]” because “[w]hen the bankruptcy court chose the statutory rate to be the prejudgment interest rate, it did so in the context of a judgment that included about $55 million in [the phony buyer’s] excess deposits. These are funds that [the bank] no longer has: [the phony buyer] withdrew them or the government seized them. But we hold that [the bank] is not liable for those excess deposits. [It] remains liable for the loan repayments only, which are funds that [the bank] received, as [the phony buyer’s] creditor, in satisfaction of [the phony buyer’s] debt to it. Once [the bank] received that money [it] was free to invest that money however it wished. Doing so, [the bank] may have profited more during this litigation than it will be ordered to pay under the statutory rate.”

Accordingly, the trial court’s judgment was reversed in part and the case remanded for further proceedings.