In a much-followed case given the recent publicity surrounding collapsed Ponzi schemes, the U.S. District Court for the Southern District of New York on September 17, 2010 reversed a decision of the Bankruptcy Court from the Southern District of New York that had broadened the scope of those facts and circumstances that may trigger inquiry notice under the "good faith" defense to a fraudulent conveyance claim. In re Bayou Group, LLC, 2010 U.S. Dist. LEXIS 99590 (S.D.N.Y. September 17, 2010).

The U.S. Bankruptcy Code generally provides that fraudulent transfers, such as those to a redeeming investor in a Ponzi scheme scenario, made within two years of the collapse of a fund may be clawed back by the bankruptcy trustee unless the redeeming investor shows that the transfer was received (1) for value and (2) in good faith. An investor who prevails in establishing this affirmative defense may avoid rescission to the extent of its principal investment. While the Bankruptcy Code does not define "good faith," the jurisprudence generally has settled upon a two-prong inquiry: first, whether the transferee was on "inquiry notice," and second, if the transferee was on inquiry notice, whether it satisfied a "diligent investigation" requirement.

The Bayou decisions involve certain of the investors in sham hedge funds managed by Bayou Management, LLC that had redeemed their investments within two years of the funds' 2005 collapse. In the recently overturned decision, the Bankruptcy Court found, as a matter of law, that certain red flags suggested an "infirmity in Bayou or the integrity of its management," and that such red flag evidence was sufficient to trigger inquiry notice among certain of the redeeming investors. The red flags noted by the Bankruptcy Court included (1) notice of a complaint filed against the Bayou funds and the management company by a former Bayou employee alleging, among other claims, the former employee's perception of possible violations of SEC rules and regulations and large withdrawals from the trading account for which no explanation was provided, but which complaint did not include reference to "fraud" or "insolvency"; (2) Bayou's delay in providing NAV calculations, inconsistent statements about who was responsible for preparing the NAVs, and Bayou's ultimate disclosure that it was the management company, and not an offshore administrator, that was calculating the NAVs; and (3) certain unfavorable information regarding the Bayou funds and one of its founders contained in two background reports. Once the Bankruptcy Court determined that these transferees were on inquiry notice, it held they then had a duty to conduct a diligent investigation. The Bankruptcy Court found that, as a matter of law, these redeeming investors failed to conduct a diligent investigation and thus granted summary judgment in favor of the debtors.

In its reversal, the District Court found that the Bankruptcy Court had "significantly expanded" the scope of information that prior courts found sufficient to constitute inquiry notice. Rejecting the "infirmity" standard espoused by the Bankruptcy Court as "so broad as to be undefinable," the District Court opined that such a standard could cover a "host of sins." The District Court instead endorsed a narrower standard, in line with what the District Court characterized as the vast weight of authority, focused on whether the transferee had information that the transferor was insolvent or that the transfer might be made with a fraudulent purpose. Under this standard, the District Court found the issue of whether the investors had been on inquiry notice was a fact-specific question for the jury and not one that could be decided, as a matter of law, by the Court.

While the District Court acknowledged that it is an objective, reasonable person standard that applies to both the inquiry notice and diligent investigation prongs of the good faith defense analysis, it is worth noting that the District Court adopted the less common view that the standard requires a focus on the class or category of the transferee (here, an institutional hedge fund investor) rather than a generic reasonable person.

Because the District Court determined that the question of inquiry notice should proceed to a jury, and thus that summary judgment had been granted inappropriately by the Bankruptcy Court, its discussion of the diligent investigation requirement was brief. The District Court did, however, explicitly reject the Bankruptcy Court's opinion that a so-called "futility argument"—an argument that no diligent investigation could have uncovered the fraud or insolvency—was fatal to the diligent investigation requirement and thus the good faith defense. Since the District Court framed the diligent investigation test as "whether a diligent inquiry would have discovered the insolvency or the fraudulent purpose of transfer," it held that a court would be required to consider whether a diligent investigation would have been futile, and that relevant factual determinations must be resolved by a jury.