Citibank’s balance sheet is likely breathing a sigh of relief. A Second Circuit panel held that the bank may finally recoup nearly $500 million in funds that it inadvertently wired to lenders almost two years ago. US Circuit Judge Pierre N. Leval, writing for the Court, vacated the district court’s decision in favor of the lenders and noted that allowing the lenders to keep the inadvertently wired funds would be a “huge windfall.”
The common-sense Second Circuit decision arose out of an administrative error of massive proportions. Citibank, which was acting as the cosmetic company Revlon Inc.’s loan agent, intended to wire approximately $8 million in interest payments to Revlon’s lenders. Instead, Citibank accidentally wired almost $900 million in principal to creditors behind a 2016 syndicated term loan issued to Revlon that would not mature for three years. The next day, Citibank advised the lenders of its mistake and asked that the money wired in error be returned. About $400 million was returned, but the remaining creditors refused to return the nearly $500 million in outstanding funds and Citibank filed suit.
The United States District Court for the Southern District of New York held that Citibank could not recover these funds. The court found that New York’s “discharge-for-value” rule applied. The discharge-for-value rule, which is unique to New York law, permits creditors to retain erroneously wired funds if the creditors are “entitled” to the money on a debt and have no knowledge that a mistake has been made. (Read our analysis of the district court decision here.) Naturally, Citibank appealed.
The Second Circuit disagreed with the district court and held that the discharge-for-value rule did not apply because the defendant-creditors certainly had “knowledge” that the payment was in error. Although it was undisputed that that knowledge included “notice,” the parties disagreed about what constituted “notice” in this context. The Second Circuit clarified that the objective inquiry notice standard applied: if “a prudent person, who faced some likelihood of avoidable loss if the receipt of funds proved illusory, would have seen fit in light of the warning signs to make reasonable inquiry in the interest of avoiding that risk of loss.” Applying that test, the Second Circuit held: “[i]In our view, the Defendants are not shielded from Citibank’s claims for restitution under the discharge-for-value rule because they were on inquiry notice that the unexpected and surprising apparent repayment of the full principal amount of their loans was attributable to mistake.”
Judge Leval noted that while there were some valid reasons for the lenders to believe the transfers were genuine—for example, the amounts sent matched “to the penny” what each was owed—there were several “red warning flags” that put the lenders on inquiry notice of Citibank’s mistake such that “a reasonably prudent investor, to whom the red flag information was available, would have made a simple inquiry to avoid a loss.” Judge Leval did not believe that “[t]hose red flags [could be] explained away by the unlikelihood that a mistaken payment would have matched the amount of the outstanding debt.”
Judge Leval found especially compelling that the lenders and Citibank had put in place a 2016 Loan Agreement that required Citibank to give the defendants prior notice if Revlon undertook to prepay the principal of the loan, but no prior notice was given. “The absence of prior notice from Citibank raised a substantial red flag supporting suspicion. Why would Citibank, the Lenders’ agent, have failed to perform its contractually required obligation to give the Lenders prior notice of Revlon’s huge prepayment?”
Judge Leval also considered the financial distress that Revlon was experiencing at the time. “A hypothetical prudent investor, who suddenly received an unannounced prepayment of the principal of the loan would have been astonished, in light of Revlon’s apparent deep insolvency, that it could find the resources to make a payment of nearly $1 billion.” Judge Leval further noted that “[i]f Revlon wished to retire the [debt] prematurely”, it could have done so “far more cheaply” by buying up discounted portions of the loan on the open market rather than paying off the full amount at face value.
Ultimately, the Second Circuit found that “Notwithstanding factors that tended to support genuineness, the factors supporting doubt were sufficiently troublesome to prompt a prudent investor at least to make a telephone call to Citibank. That is all that was needed to satisfy inquiry notice.”
The panel held that the discharge-for-value rule did not apply for a second reason: Revlon's loan was not due to mature until September 7, 2023. Thus, the lenders’ entitlement to repayment had not yet accrued.
US Circuit Judge Michael H. Park filed a separate concurrence. Also sitting on the panel was US Circuit Judge Robert D. Sack.
The Second Circuit vacated the district court’s order and remanded the case to the district court for further proceedings consistent with its opinion. The defendant debtholders still have the opportunity to request rehearing before the Second Circuit panel that heard their appeal or before the full Second Circuit. As such, the appeal is not yet fully resolved. The defendant debtholders can also petition the Supreme Court to hear the case.
As advised in our prior legal alert on these proceedings, financial institutions can protect themselves from unnecessary litigation by including in loan documents provisions governing mistaken payments that afford lenders the right to unilaterally declare payments as having been inadvertently made and subject to return. Debtors should also consider provisions that account for the event of an errant pre-payment, such as the obligation to provide advance notice of prepayment, as noted in the Court’s decision. We will continue to monitor and report on the proceedings.