Objective “Knew or Should Have Known” Standard Applies to Good Faith Defense to Actual Fraudulent Transfer Claim

While a defendant who received transfers from an insolvent or fraudulent enterprise in good faith and for reasonably equivalent value may ultimately defeat an actual fraudulent transfer claim, the plaintiff is not required to negate an anticipated good faith defense in the complaint to adequately state a claim. Such a defense is an affirmative defense that defendant has the burden of proving in the course of the litigation. As such, the good faith of the defendant/transferee, even if thoroughly established in a motion to dismiss, cannot serve as the basis for dismissal of a well-pled actual fraudulent transfer claim.

 

Plaintiff Need Not Negate Good Faith Defense in Complaint to Survive Motion to Dismiss Actual Fraudulent Transfer Claim.

Almost all state fraudulent transfer laws that follow UFTA, provide for a good faith affirmative defense to a claim of actual fraudulent transfer. See, e.g., NYDCL § 278(1) (providing an affirmative defense that allows a bona fide purchaser for value who took without knowledge of the fraud to retain the transfer); see also California Civil Code, § 3439.08(a) (“(a) A transfer or obligation is not voidable under paragraph (1) of subdivision (a) of Section 3439.04, against a person that took in good faith and for a reasonably equivalent value given the debtor or against any subsequent transferee or obligee.”); Section 726.109(1), Fla. Stat. (“(1) A transfer or obligation is not voidable under s. 726.105(1)(a) against a person who took in good faith and for a reasonably equivalent value or against any subsequent transferee or obligee.”).

In considering whether a fraudulent transfer claim should be dismissed based on the plaintiff’s failure to negate the anticipated good faith affirmative defense of defendant, the Bankruptcy Court for the Southern District of New York, in In re Bernard L. Madoff Inv. Securities, LLC, 458 B.R. 87, 105 (Bankr. S.D.N.Y. 2011) (“Madoff”), offered the following analysis:

The District Court reasoned that “transferee’s intent … is material under the statute, but, because Section 278 is an affirmative defense, the transferee’s intent should be considered on a full evidentiary record, either at the summary judgment phase or at trial.” Merkin II, 2011 WL 3897970, at *6. Consequently, “[f]or the purposes of a motion to dismiss, the trustee need state with particularity only the circumstances constituting the fraud and allege the requisite actual intent by the transferor to hinder, delay, or defraud creditors.” Id. (emphasis added). Thus, irrespective of whether an actual fraudulent transfer claim is brought under the Code or the NYDCL, a transferee’s good faith “need not be negated by the Trustee in the Complaint” as the Defendants contend. Cohmad, 454 B.R. at 330 (quoting Sec. Inv. Prot. Corp. v. Stratton Oakmont, Inc., 234 B.R. 293, 318 (Bankr. S.D.N.Y. 1999)).

 

Defendant Has Burden of Proof for Good Faith Defense.

In determining the avoidability under California’s Uniform Fraudulent Transfer Act (UFTA) of transfers made in furtherance of a fraudulent scheme, the Ninth Circuit B.A.P., in In re Cohen, 199 B.R. 709, 718-19 (9th Cir. B.A.P. 1996), explained as follows:

The issue of good faith under UFTA § 8(a) is a defensive matter as to which the defendants asserting the existence of good faith have the burden of proof.  UFTA § 8(a), comment (1).  One lacks the good faith that is essential to the UFTA § 8(a) defense to avoidability if possessed of enough knowledge of the actual facts to induce a reasonable person to inquire further about the transaction. UFTA § 8(a), comment (2) (knowing facts rendering transfer voidable “would be inconsistent with the good faith that is required of a protected transferee”). Such inquiry notice suffices on the rationale that some facts suggest the presence of others to which a transferee may not safely turn a blind eye.

Id. (case citations omitted)

 

Defendant, Including a Third Party Lender, Must Meet Objective Standard to Establish Good Faith Defense.

When a defendant asserts a good faith defense, Courts will objectively consider what the defendant knew or should have known when it received the transfer – not what the defendant actually knew. See In re Agricultural Research & Technology Group, Inc., 916 F.2d 528, 535–36 (9th Cir. 1990). (stating that a Ponzi scheme investor claiming good faith must meet an objective standard, and possibly prove that a diligent inquiry would not have discovered the fraudulent purpose of the transfer, but declining to delineate a precise definition of good faith).

The District Court for the Central District of California has applied this objective standard to third party lenders that received liens (the alleged fraudulent transfers) in exchange for loans made to a debtor perpetuating a fraudulent scheme. See Securities and Exchange Commission v. Capital Cove Bancorp LLC, 2015 WL 9701154 *6 (C.D. Cal. 2015). The District Court followed the Ninth Circuit B.A.P.’s holding in Cohen, reasoning that “[o]ne lacks the good faith that is essential to the [UVTA] if possessed of enough knowledge of the actual facts to induce a reasonable person to inquire further about the transaction.” Id. (quoting In re Cohen, 199 B.R. at 719). The District Court also followed the Ninth Circuit’s holding in Agricultural Research, explaining that “[s]uch inquiry notice suffices on the rationale that some facts suggest the presence of others to which a transferee may not safely turn a blind eye.” Id. (quoting In re Agricultural Research, 916 F.2d at 535–36). Therefore, courts should “look to what the [creditor] objectively ‘knew or should have known’ in questions of good faith, rather than examining what the [creditor] actually knew from a subjective standpoint.” Id.

The Capital Cove Court ultimately found that “[t]he evidence provides some objective basis that [lenders] ‘possessed [] enough knowledge … to induce a reasonable person to inquire further about the transaction.’”  Id. at *7-8. Accordingly, the Court concluded that there was a bona fide dispute concerning the voidability of the liens granted to lenders under UVTA.  See id.

Similarly, the Bankruptcy Court for the Middle District of Florida, in In re World Vision Entertainment, Inc., 275 B.R. 641, 659 (Bankr. M.D. Fla. 2002), applied the objective standard to the defendant’s good faith defense to the plaintiff’s actual fraudulent transfer claims brought under Section 548 of the Bankruptcy Code and Florida’s UFTA. In particular, the Court applied the objective inquiry notice standard to the defendants who were brokers earning commissions for selling securities for a fraudulent debtor, framing the determination to be made as follows:

[T]he issue is whether these brokers act in good faith if they make no or little effort to verify the legitimacy of the debt instruments they market. Stated differently, can a broker simply rely on promises made by a dishonest and fraudulent debtor and still act in good faith?

Id. The World Vision Court, citing to several other Courts that have adopted the “knew or should have known” standard, including the Ninth Circuit, offered the following explanation for its employment of the objective standard:

Good faith is judged using an objective standard. [(citations omitted)]. . . A party can rebut the § 548(c) good faith defense by showing that the recipients of the avoidable transfer had knowledge or notice of the debtor’s financial difficulties or fraudulent purpose.  “[C]ourts look to what the transferee objectively ‘knew or should have known’ rather than examining what the transferee actually knew from a subjective standpoint.” In re Agricultural Research & Technology Group, Inc., 916 F.2d 528, 535–36 (9th Cir. 1990). “[I]f the circumstances would place a reasonable person on inquiry of a debtor’s fraudulent purpose, and diligent inquiry would have discovered the fraudulent purpose, then the transfer is fraudulent.” Id. at 536 (citing In re Polar Chips Int’l., Inc., 18 B.R. 480 (Bankr. S.D. Fla. 1982)). “[A] transferee does not act in good faith when he has sufficient knowledge to place him on inquiry notice of the debtor’s possible insolvency.” In re Sherman, 67 F.3d 1348, 1355 (8th Cir.1995). Further, “a transferee may not remain willfully ignorant of facts which would cause it to be on notice of a debtor’s fraudulent purpose,” Model Imperial, 250 B.R. at 798, and then “put on ‘blinders’ prior to entering into transactions with the debtor and claim the benefit of 548(c).” In re Cannon, 230 B.R. 546, 592 (Bankr. W.D. Tenn. 1999) (rev’d on other grounds, 277 F.3d 838 (6th Cir. 2002)).

Accordingly, the Court held that that brokers selling debt instruments and earning commissions could not simply rely on the false promises of the fraudulent debtor but, rather, were on inquiry notice of the fraud and, thus, could not establish their good faith defense.

World Vision is instructive in the receivership context because it involved third party transferees who provided services that assisted to perpetuate a fraud without inquiring as to the legitimacy of the debtor’s operations. Most Ponzi schemes and other fraudulent enterprises that are placed in receivership in the context of government enforcement actions or otherwise typically rely upon the services of third party brokers and vendors to facilitate and prolong the fraud.