In Meoli v. The Huntington National Bank (In re Teleservices Group, Inc.), the U.S. Court of Appeals for the Sixth Circuit examined the elements of “good faith” and “knowledge of the voidability of the transfer avoided” that initial and subsequent transferees must establish when defending against fraudulent transfer claims brought under sections 548 and 550 of the Bankruptcy Code. The Sixth Circuit’s Teleservices opinion may provide helpful guidance to defendants in fraudulent transfer actions.

In Teleservices, the chapter 7 trustee (the “Trustee”) sought to recover as fraudulent certain transfers made by the debtor to Huntington National Bank (“Huntington”). Under section 548(c), an initial transferee is not liable for the transferred property if the transferee took the property in good faith and gave value to the debtor in exchange for such transfer. Under section 550(b)(1), a subsequent transferee is not liable if the transferee took the property for value, in good faith, and “without knowledge of the voidability of the transfer avoided.”

The debtor, Teleservices Group, Inc., was a “paper company” set up by Barton Watson in order to perpetuate a scheme using a second company, Cyberco Holdings (“Cyberco”). Watson, the chairman and chief executive of Cyberco, had previously confessed to two separate bank frauds, served time for fraud-related crime, and had been permanently blacklisted by the National Association of Securities Dealers. Apparently, Watson’s time in jail did little to reform him. Cyberco obtained a series of equipment financing loans, purportedly to purchase computer equipment from Teleservices. Cyberco directed the equipment financing companies to pay Teleservices directly for the equipment. The funds were then transferred from Teleservices to Cyberco’s bank account at Huntington. Teleservices, however, did not have any computer equipment to sell, as Watson claimed. In fact, Teleservices had no assets and no employees, officers, or directors, other than Cyberco executives who assumed false names to conduct Teleservices’s false business.

In addition to maintaining bank accounts at Huntington, Cyberco also had a loan from Huntington, the balance of which would grow to $16 million. Funds transferred from Teleservices were used to pay down this loan in two ways: with payments sent directly from Teleservices to Huntington, and with indirect payments sent from Teleservices to Cyberco’s account at Huntington, which Cyberco then used to repay the loan. As a result of these payments, Huntington conceded that it was both an initial and a subsequent transferee of Teleservices’s funds.

Following an FBI raid of its offices, Cyberco’s creditors commenced an involuntary chapter 7 case against the company. Around the same time, a state-appointed receiver filed Teleservices’s petition, setting the stage for the Trustee’s fraudulent transfer action against Huntington. Following two trials, the bankruptcy court issued a Report and Recommendation summarizing its findings of fact and conclusions of law, recommending, among other findings, that Huntington gained inquiry notice of Cyberco’s fraud on September 25, 2003 and that its good faith ended on April 30, 2004. As a result, all transfers made after April 30, 2004 and for which Huntington was the initial transferee were recoverable, as were all transfers made after September 25, 2003 for which Huntington was a subsequent transferee. The district court adopted the Report and Recommendation, and Huntington appealed.

The Sixth Circuit reversed in part and remanded. It affirmed the bankruptcy court’s conclusion that the Trustee could recover all direct loan repayments, on which Huntington was an initial transferee, as well as those indirect loan repayments, on which Huntington was an indirect transferee, to the extent that such indirect payments occurred after April 30, 2004, the date on which Huntington’s “proven good faith ended.” That date was significant because it was the day on which Huntington’s regional head of security learned that the FBI was investigating Cyberco and of Watson’s record of bank fraud, including his permanent ban by the NASD, but failed to report it to the Huntington employee responsible for managing the bank’s relationship with Cyberco. Before April 30, 2004, several Huntington employees had harbored suspicions of Watson and Teleservices and had even met with Watson to discuss their concerns, but April 30, 2004 marked “a critical breakdown in communication” by the regional head of security, and as a result, “Huntington as a corporate entity could not prove that it continued to receive transfers from Teleservices in good faith.”

The Sixth Circuit rejected Huntington’s argument that the bankruptcy court had committed legal error by “amalgamating Huntington’s employees’ scattered information” and by finding that Huntington’s proven good faith had ended on April 30, 2004, without finding that any of Huntington’s employees’ proven good faith had ended on that date.  Quoting the bankruptcy court, the Sixth Circuit said that a “corporation cannot feign ignorance when it has delegated responsibilities to a group of individuals and an inexcusable breakdown of communication then occurs within the group.”  Huntington’s good faith could end “if employees failed to share information—innocently but critically—with the person whom Huntington charged with managing Huntington’s relationship with Cyberco.” Notably, Huntington’s continued cooperation with the FBI’s investigation “did not cure the corporate bad faith embedded in that breakdown in communication.” Instead, Huntington was responsible for its “weakest link,” the failure of the regional head of security to communicate with the employee responsible for managing the bank’s relationship with Cyberco.

The Sixth Circuit reversed the bankruptcy court’s conclusion that the Trustee could recover those transfers to Huntington as a subsequent transferee that took place after September 25, 2003 because Huntington had “failed to prove lack of knowledge of voidability of the transfers.” The Sixth Circuit disagreed that inquiry notice always suffices for “knowledge of voidability.” Instead, it concluded that Sixth Circuit precedent “invite[s] a holistic factual determination of whether a reasonable person, given the available information, would have been alerted to a transfer’s voidability.” In turn, what “a reasonable person would be alerted to depends not just on whether there was inquiry notice, but also on what investigative avenues existed, whether a reasonable person would have undertaken those avenues given the situation, and what findings the reasonable investigations would have yielded.” The Sixth Circuit remanded the case so that a holistic, factual determination of the date on which Huntington gained knowledge of voidability could be made.

As the Sixth Circuit acknowledged, there is minimal guidance on what constitutes good faith and knowledge of voidability, but in practice, Teleservices does not significantly clarify these elements. With respect to good faith, Teleservices indicates that it is what a transferee and its employees do not do, rather than what they do, that determines good faith. Perhaps most alarmingly, curative steps do not necessarily insulate the transferee from liability for lack of good faith. With respect to knowledge of voidability, Teleservices provides some comfort that inquiry notice will be tailored to the facts and circumstances. Whether subsequent transferees defending against fraudulent transfer claims under section 548 will be able to establish a lack of investigative avenues, or the lack of sufficient findings yielded by such reasonable investigations, remains to be seen.