July/August 2016

Lenders Beware: Failure to Investigate Suspicious Facts Can Void Your Security

If a deal seems suspicious in the early stages, the lender is required to go the extra mile to confirm that the borrower is being 100% honest. Michael Molinaro explains that the court expects a lender to check for fraud before a transfer of collateral is made. Failure to investigate can prove expensive.



Michael Molinaro, Partner, Ackerman LLP

Michael Molinaro, Partner, Ackerman LLP


The 7th U.S. Circuit Court of Appeals recently held that a lender is obligated to conduct a diligent investigation when it becomes aware of suspicious facts relating to an existing loan transaction. In Sentinel Management Group, Inc.,1 the 7th Circuit found that a loan officer’s puzzlement was enough to place the lender on inquiry notice, which required the lender to investigate the collateral the borrower had used to secure the loan. The lender’s failure to conduct such investigation caused disastrous consequences.

Background

In Sentinel, a bank lender closed a $500 million loan collateralized by securities. After reviewing a collateral report, a loan officer sent an email to other employees inquiring whether the borrower really could have as much collateral as was listed on the collateral report. The loan officer received a nonresponsive answer to his question and then made no further inquiry.

Subsequently, the borrower filed a Chapter 11 case, and a bankruptcy trustee was appointed. The trustee discovered that the borrower had pledged certain securities to the bank that were owned by the borrower’s customers, not the borrower. The trustee sued the lender, seeking to void the security interest granted to the lender as a fraudulent transfer. As a defense, the lender claimed a good faith transferee in connection with the loan transaction and the pledge of collateral.

Fraudulent Transfers

Under the Bankruptcy Code, two types of transfers can be invalidated as fraudulent transfers. The first are transfers made with actual intent to hinder, delay or defraud creditors. The second involves transfers in which the transferor:

  1. Received less than a “reasonably equivalent value” in exchange for the transfer and became “insolvent” as a result of the transfer or the transferor was engaged, or
  2. Was about to engage in business or a transaction for which its remaining property was an “unreasonably small capital,” or
  3. Intended to, or believed that it would, incur debts which, when mature, would be beyond its ability to pay.

Since actual intent is difficult to establish, courts often consider circumstantial evidence, such as the existence of “badges of fraud,” to show actual fraudulent intent.2

Even if there is no fraudulent intent, a transfer may be invalidated as constructively fraudulent if the transferor did not receive reasonably equivalent value and was left with insufficient assets because of the transfer.3 The Bankruptcy Code defines value as “property, or satisfaction or securing of a present or antecedent debt of the debtor, but does not include an unperformed promise to furnish support to the debtor or to a relative of the debtor.”4

When analyzing the lack of reasonably equivalent value component, the focus is on the economic benefit received and retained by the transferor in exchange for the property transferred.5 The courts generally collapse all the steps in a transaction in order to determine whether a transferor’s assets were depleted after giving effect to the entire transaction.6 Loan proceeds that pass through a borrower to selling shareholders do not constitute reasonably equivalent value.7 However, the court will consider indirect economic benefits received by the transferor to the extent that such indirect benefits conferred a realizable commercial value on the transferor.8

Good Faith Defense
Section 550(a) of the Bankruptcy Code permits a trustee to recover any transfer invalidated to an “initial transferee” or to “any immediate or mediate transferee of such initial transferee.” However, §550(b)(1) provides a defense to the transferee. The trustee may not recover from “a transferee that takes value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer avoided (emphasis added).”

Therefore, this “good faith” defense applies if the transferee is an immediate or mediate transferee under §550(a)(2), took the transfers for value, took the transfers “in good faith” and took the transfers “without knowledge of the voidability of the transfer avoided.”9

The 7th Circuit’s Decision

The 7th Circuit rejected the lender’s good faith defense, finding that the lender was on inquiry notice and that there was something suspicious relating to its collateral. The 7th Circuit stated that inquiry notice is “knowledge that would lead a reasonable, law-abiding person to inquire further” or, in other words, knowledge that “would make him…suspicious enough to conduct a diligent search for possible dirt.” Since the lender failed to conduct a diligent investigation after being on inquiry notice, the 7th Circuit found that the lender’s security interest was void and $300 million of collateral was wiped out. However, in a small victory for the lender, the 7th Circuit refused to equitably subordinate the bank’s unsecured claim to all other creditors, concluding that inquiry notice was not tantamount to a fraud and thus did not constitute the inequitable conduct needed for subordination.

Implications

State law generally imposes no duty on a banking institution to investigate transactions with its customers.10 For example, under Florida law, a bank “has the right to assume that individuals who have the legal authority to handle the entity’s accounts do not misuse the entity’s funds.”11 Accordingly, a “bank is responsible only for making sure that the employee, at the time of the withdrawal, has the authority to make withdrawals on the behalf of the account holder entity.”12

However, in the context of a loan transaction, the circumstances are much different. Sentinel illustrates that a lender should not ignore or turn a blind eye when it becomes aware of suspicious facts and other warning signs in connection with a loan transaction. A prudent lender should conduct a diligent investigation in order to mitigate the risk of additional problems or potential liability.

Footnotes

  1. 809 F.3d 958 (7th Cir. 2016)
  2. See, e.g., CLC Creditors’ Trust v. Howard Savings Bank, 396 B.R. 730, 746 (Bankr. N.D. Ill. 2008).
  3. See, e.g., Boyer v. Crown Stock Distribution, Inc., 587 F. 3d 787, 792 (7th Cir. 2009).
  4. §548(d)(2)(A)
  5. See e.g., In re PSN USA, Inc., 615 Fed. Appx. 925, ___ (11th Cir. 2015).
  6. Wieboldt Stores, Inc. v. Schottenstein, 94 B.R. 488, 502 (N.D. Ill. 1988).
  7. See e.g., In re O’Day Corp., 126 B.R. 370, 394-395 (Bankr. D. Mass. 1991).
  8. See, e.g., In re Northern Merchandise, Inc., 371 F.3d 1056, 1059-59 (9th Cir. 2004); Mellon Bank, N.A. v. Metro Commc’ns, Inc., 945 F.2d 635, 647 (3d Cir. 1991)
  9. Id. See, e.g., CLC Creditors’ Trust, 396 B.R. at 744-745.
  10. Lawrence v. Bank of America, N.A., 455 Fed.Appx. 904, 907 (11th Cir. 2012), citing Home Fed. Sav. & Loan Ass’n of Hollywood v. Emile, 216 So.2d 443, 446 (Fla. 1968)).
  11. Home Fed. Sav. & Loan Ass’n of Hollywood v. Emile, 216 So.2d 443, 446 (Fla. 1968))
  12. Id. Plaintiff failed to state a claim against a bank for failure to detect accountholder’s Ponzi scheme.