It is often said that fools and their money are soon parted. In this regard, the former owners of a debtor who used the debtor’s funds to gamble at the Horseshoe Casino (the “Casino”), ultimately losing over $8 million dollars, could aptly be considered fools. However, equally culpable may be the creditors who failed to adequately monitor the debtor and prevent its wayward former owners from using millions of dollars to gamble at the Casino.  In In re Equipment Acquisition Resources, Inc., the Seventh Circuit found that the United States District Court for the Northern District of Illinois correctly applied the “good faith” defense under section 550(b)(1) of the Bankruptcy Code after it determined that (i) the Casino accepted the transfers without knowledge of the debtor’s fraudulent activities and (ii) the Casino could not have uncovered the fraud even if it had conducted a reasonable inquiry.  Consequently, the plan administrator could not recover payments made by the debtor’s former owners to cover gambling debts at the Casino.  

Background

In Equipment Acquisition Resources, Inc., the debtor manufactured and refurbished machinery used in the high-technology industry. However, from at least 2005 to 2009, the debtor engaged in a scheme involving its financing of equipment to defraud its creditors. As a result of this scheme, the former owners received approximately $17 million dollars in fraudulent transfers from the debtor which they used for their personal benefit. In particular, the former owners indulged their penchant for gambling at the Casino where, for up to 50 hours a week, the former owners wagered and lost over $8 million dollars.

The Casino also observed the former owners engaging in other suspicious behavior. For example, one of the former owners was known to “walk with chips” and “pass chips.” Walking with chips is the practice of leaving a casino with chips rather than cashing them in. Passing chips is the practice of giving chips to a third party to cash in. While neither practice was illegal, they were indicative of “structuring” transactions to avoid triggering the $10,000 reporting requirement, a federal crime.  Other red flags included false statements made on a credit application and credit checks by the Casino which uncovered an understated indebtedness of over $2 million dollars. Despite these omissions, the Casino still continued to extend credit to the former owners.

The Casino also had clues that the former owners’ gambling funds were derived from the debtor. For example, the Casino kept a debtor bank account on file as a reference account. In addition, one of the former owners’ personal checking account listed the debtor’s corporate address. Moreover, a portion of the gambling debts were paid from a bank account in the name of one of the former owners doing business as the debtor. The Casino had identified this account as a business account, but still accepted and deposited the tendered checks. After the debtor’s fraud was uncovered, the plan administrator filed an adversary proceeding to avoid and recover $8,248,000 in transfers to the Casino pursuant to sections 544, 548, and 550 of the Bankruptcy Code.

Section 550(b)(1) and the “Good Faith” Defense

As an initial matter, the Seventh Circuit established that to recover the transfers to the Casino, the plan administrator was required to prove that such transfers were voidable under sections 544 or 548 and recoverable under section 550 of the Bankruptcy Code. After acknowledging that transfers are generally voidable if they “were made with intent to hinder, delay, or defraud creditors or if the debtor was under financial distress at the time of the transfer,” the Seventh Circuit analyzed whether the transfers were recoverable under section 550.

Specifically, the Seventh Circuit reviewed the District Court’s decision granting the Casino’s summary judgment motion under the “good faith” defense. Pursuant to section 550(b)(1) the Seventh Circuit noted that the “good faith” defense would apply if the transferee: (1) is an immediate or mediate transferee under section 550(a)(2); (2) took the transfers for value; (3) took the transfers “in good faith” and (4) took the transfers “without knowledge of the voidability of the transfer avoided.”  After finding that the first two elements were not in dispute, the Seventh Circuit addressed whether the Casino took the transfers “in good faith” and “without knowledge of the voidability of the transfer avoided.”

The Casino Accepted the Transfers in “Good Faith” and “Without Knowledge”

Relying upon its prior opinion in Bonded Financial Services, Inc. v. European American Bank, the Seventh Circuit determined that section 550(b)(1) codified an imputed knowledge or inquiry notice standard, noting that “if a reasonable inquiry would not have led to actual knowledge of voidability, the court cannot impute knowledge.”  Applying this standard to the facts at hand, the Seventh Circuit first addressed whether the “without knowledge” requirement applied to (i) the entire flow of funds beginning from the debtor to the former owners and then from the former owners to the Casino or (ii) only the first transfer from the debtor to the former owners.

Based upon its analysis of the applicable statutes and the prior opinion, the Seventh Circuit concluded that the “without knowledge” requirement applied only to the first transfer from the debtor to the former owners and not the second transfer from the former owners to the Casino. Consequently, under this standard, the Seventh Circuit determined there was no dispute that the Casino lacked actual knowledge that the transfers from the debtor to its former owners were voidable (i.e., the Casino had no actual knowledge that the transfers arose from fraud at the debtor or that the debtor was under financial distress).

Dismissing the plan administrator’s assertions that the Casino had ignored numerous red flags surrounding the former owners’ activities, the Seventh Circuit found that a reasonable inquiry by the Casino would not have uncovered the fraud at the debtor or the debtor’s financial distress. In reaching this conclusion, the Seventh Circuit stated that the underlying economic policy of section 550 of the Bankruptcy Code was to “efficiently allocate monitoring costs between creditors and transferees,” and, thus, “it makes sense to provide a defense to liability for subsequent transferees who act without knowledge of the fraudulent transfer from the debtor.”

The Seventh Circuit also considered and dismissed the plan administrator’s argument that the Casino did not act in good faith. The Seventh Circuit did not find evidence that the Casino lacked good faith and rejected the plan administrator’s assertion that the Casino failed to act in good faith because it extended credit despite the clear warning signs from the former owners’ suspicious behavior.  The Seventh Circuit concluded that the Casino had “no way of knowing” that the transfers from the debtor to the former owners were voidable, and, thus, the Casino was not “closing its eyes to the creditors.”

Conclusion

While it may be surprising at first glance that the Casino prevailed given its awareness of numerous red flags, the Seventh Circuit’s opinion illustrates that outcomes in fraudulent transfer actions are far from certain. As the Seventh Circuit stated in its opinion, there are competing interests between a debtor’s creditors and a subsequent transferee.  Specifically, while section 550 of the Bankruptcy Code protects creditors from last-minute diminutions in the debtor’s assets, the statute also provides a “good faith” defense to a subsequent transferee “who gave value for the money and was in no position to monitor the debtor.”

This case also serves as a useful reminder to creditors that relying solely upon the fraudulent transfer statutes to protect their interests is not enough. Creditors should also implement comprehensive monitoring programs to detect fraud and establish financial controls to prevent the unexpected dissipation of the debtor’s assets.  Conversely, a potential transferee, particularly one in a high-risk business such as a casino, should carefully screen its largest customers and be on alert for suspicious transactions which may be subject to a fraudulent transfer action in a subsequent bankruptcy proceeding.

Perhaps it should come as no surprise that the Casino ultimately prevailed. After all, as the devil succinctly observed about the vicissitudes of life in the Woody Allen film, Deconstructing Harry, “It’s like Vegas. You’re up, you’re down, but in the end the house always wins. Doesn’t mean you didn’t have fun.