District Court Tries to Make Sense of the Good Faith Defense under Section 548(c)

Print This Post Print This Post

In Christian Bros. High School Endowment v. Bayou No Leverage Fund, LLC (In re Bayou Group, LLC), No. 09 Civ. 02577, 2010 WL 3839277 (S.D.N.Y. Sept. 17, 2010), Judge Gardephe of the District Court for the Southern District of New York partially reversed a bankruptcy court’s opinion that denied defendant-investors the right to assert an affirmative defense of “good faith” to a fraudulent transfer claim under section 548(c) of the Bankruptcy Code as a matter of law.

 The Bayou debtors are hedge funds that were operated as a Ponzi scheme by their managers.  To avoid detection of fraudulent activity, the managers honored payments to investors who exercised a contractual right to redeem their investments.  The defendants in the Bayou action are investors who received such redemption payments from the debtors prior to the debtors’  bankruptcy filing.  The Bayou debtors commenced adversary proceedings against these investors to recover the redemption payments as fraudulent transfers under section 548 of the Bankruptcy Code.  The investors, however, claimed that they were “good faith transferees”  under section 548(c) and, therefore, not liable for any fraudulent transfers made by the debtors.

Section 548(c) provides that, after a debtor has made a prima facie case of actual or constructive fraud, a transferee can defend against recovery of the transfer by proving the alleged transfer was taken for value and in “good faith.”  The Bankruptcy Code does not define “good faith.”  As a result, courts generally apply a two-prong test to evaluate the “good faith” defense.  Under the first prong, a court analyzes whether, from an objective standpoint, a transferee had information to trigger notice that the transferor was insolvent or that the transfer might be made with a fraudulent purpose.  A court must consider the standards, norms, practices, sophistication, and experience generally possessed by participants in the transferee’s industry or class.  Once a transferee is on inquiry notice, the second prong requires an objective analysis of whether a “diligent investigation” would have discovered the fraudulent purpose of the transfer.

In Bayou, the bankruptcy court had denied the appellants’ “good faith” defense as a matter of law.  The bankruptcy court had held that the investors possessed enough alleged information suggesting “some potential infirmity” such that they should have conducted an investigation of their investment, the debtors, or the debtors’ management.  The alleged red-flag information consisted of (1) allegations made in a lawsuit filed against the debtors by a former principal of the debtors; (2) the debtors’ delay in providing net asset values to investors and statements by management relating thereto; and/or (3) negative information about a former principal in two background investigations.  The bankruptcy court also denied as a matter of law the investors’ argument that no amount of diligent investigation would have uncovered the fraud.

The district court rejected the bankruptcy court’s reasoning that information suggesting “some potential infirmity” in the investment, the debtors, or the debtors’ management triggers inquiry notice.  The district court stated, for example, that knowledge of a potential infirmity in the debtors was too broad of a standard and could include information such as a poor business model, incompetent management, or poor marketing.  Instead, the proper inquiry is whether the alleged red-flag information would have put a reasonably prudent institutional hedge fund investor on inquiry notice that the debtors were insolvent or that the debtors had a fraudulent purpose in making the redemption payments to the appellants.

The district court also rejected the bankruptcy court’s application of the “diligent inquiry” prong and held that, in cases where an alleged fraud is not discovered by a transferee prior to receiving the transfer, a transferee is entitled to offer evidence and to argue to the court that no diligent investigation would have disclosed the transferor’s insolvency or fraudulent purpose.  If the transferee can show that a diligent investigation would not have led to discovery of the fraud, it may prevail on this prong.  As a result, the district court concluded that the appellants could assert their “good faith” defense at trial.

This opinion is a must read for any party currently or potentially involved in fraudulent transfer litigation because it provides a thorough analysis of fraudulent transfer law and the good faith defense.  While this opinion does not provide any specific information that may trigger a transferee to conduct a diligent investigation, parties may take comfort that the affirmative defense of good faith under section 548(c) remains a viable defense to recovery of a fraudulent transfer.