Answering “no” to a certified question from the Fifth Circuit, the Supreme Court of Texas held that a transferee on inquiry notice of fraud cannot shield itself from clawback without diligently investigating its initial suspicions – irrespective of whether a hypothetical investigation would reveal fraudulent conduct. Janvey v. GMAG, L.L.C., No. 19-0452, 2019 WL 6972237 (Tex. Dec. 20, 2019).
Background and Certified Question
As part of the litigation stemming from Stanford International Bank’s Ponzi scheme, exposed by the SEC in 2009, the current case before the Fifth Circuit involves the Bank’s Receiver’s attempt to clawback funds from one of the Bank’s largest investors under the Texas Uniform Fraudulent Transfer Act (TUFTA). In short, creditors may invoke TUFTA to “clawback” fraudulent transfers from their debtors to third-party transferees. Yet even if a transfer is fraudulent, the transferee may shield itself from clawback if it proves as an affirmative defense that it acted in good faith and the transfer was for a reasonably equivalent value. The investor-transferee in this case asserts a good faith defense even though he failed to investigate his suspicions of fraud, arguing that any investigation would have been futile.
The Fifth Circuit initially held that the investor-transferee could not enjoy a good faith defense against clawback since he failed to investigate his suspicions of fraud, regardless of whether such investigation would have been futile. See Janvey v. GMAG, L.L.C., 913 F.3d 452 (5th Cir. 2019). Subsequently, however, the investor filed a petition for rehearing which the Fifth Circuit granted, agreeing to certify the following question to the Supreme Court of Texas: “Is [TUFTA’s] ‘good faith’ defense against fraudulent transfer clawbacks…, available to a transferee who had inquiry notice of the fraudulent behavior, did not conduct a diligent inquiry, but who would not have been reasonably able to discover that fraudulent activity through diligent inquiry?” See Janvey v. GMAG, L.L.C., 925 F.3d 229 (5th Cir. 2019).
Inquiry notice is “[n]otice attributed to a person when the information would lead an ordinarily prudent person to investigate the matter further.” See Inquiry Notice, BLACK’S LAW DICTIONARY (11th ed. 2019). As the Supreme Court of Texas explained, a person is on inquiry notice when they are “aware of facts that would have prompted a reasonable person to investigate.” In other words, “[a] transferee on inquiry notice knows facts that are, or should be, suspicious: red flags that a reasonable person would have investigated prior to engaging in the transfer.” Actual knowledge of suspicious facts shifts a transferee’s status from taking in good faith to being on inquiry notice of fraud.
Transferee on Inquiry Notice Must Investigate. Period
In answering the certified question, the Supreme Court of Texas was required to consider how a transferee can prove good faith when it has actual knowledge of facts raising a suspicion that the transfer is voidable under TUFTA but refrains from conducting an investigation. The Court concluded that a transferee cannot show good faith in this situation because, irrespective of what a hypothetical investigation could reveal, the facts giving rise to a reasonable suspicion of fraud have not been confronted. As the Court explained, “[e]ven if the fraud is inherently undiscoverable, the transferee still has actual knowledge of facts at the time of the transfer that would lead a reasonable person to suspect fraud and investigate. If the transferee fails to demonstrate its good faith and avoid willful ignorance by conducting a diligent investigation, it cannot be characterized as acting with honesty in fact.” Therefore, “a transferee seeking to prove good faith must show that it investigated the suspicious facts diligently. A transferee who simply accepts a transfer despite knowledge of facts leading it to suspect fraud does not take in good faith.”
The Court’s conclusion is rooted in the concept of good faith, which Texas courts held “requires conduct that is honest in fact and is free of both improper motive and willful ignorance of the facts at hand.” R.R. Comm’n of Tex. v. Gulf Energy Expl. Corp., 482 S.W.3d 559, 568 (Tex. 2016). Therefore, a transferee wishing to take advantage of the good faith defense must show it conducted a diligent investigation.
While the decision is under Texas law and is likely to be followed by the Fifth Circuit, TUFTA’s concept of good faith as a defense to a fraudulent transfer is also contained in the Bankruptcy Code. As such, one can expect it to be featured prominently in cases litigated under the Bankruptcy Code as well. Thus, transferees should diligently investigate any suspicions of fraud regardless of the expected success of such inquiry. Otherwise, they may be precluded from asserting a good faith defense should the transfer be subject to a clawback down the road.