On February 21, 2014, the US Court of Appeals for the Fourth Circuit in Gold v. First Tennessee Bank National Ass'n (In re Taneja), affirmed the decision of the district court which emphasized the subjective component of the good faith defense to a fraudulent conveyance action under section 548(c) of the Bankruptcy Code, failing to consider whether a similarly situated, objectively reasonable transferee would have known of the fraud (743 F.3d 423 (4th Cir. 2014)).

Vijay Taneja (Taneja) operated Financial Mortgage, Inc. (FMI), a company that originated home mortgages and sold them to secondary purchasers. These purchasers then aggregated and securitized these mortgages to sell to other investors. In connection with its business, FMI borrowed funds from warehouse lenders. Beginning in 1999, FMI had difficulty in selling its mortgage loans to investors. Therefore, FMI began engaging in fraudulent conduct which included selling the same loan to multiple secondary purchasers and conspiring with other business entities controlled by Taneja to have them serve as intermediaries to conceal the fraud.

In July 2007, after conducting due diligence on FMI and its operations, First Tennessee Bank N.A. (First Tennessee) agreed to provide a line of credit in the amount of $15 million to FMI. The lending agreement required First Tennessee to send funds directly to an insured title agent. After each mortgage loan closed, FMI was required to send certain documents, including the mortgagor's promissory notes, to First Tennessee within two business days. In September 2007, FMI made three payments to First Tennessee, totalling about $1 million, but by October 2007, it owed First Tennessee about $12 million. First Tennessee then ceased making additional advances to FMI due to untimely payments.

Representatives from First Tennessee met with Taneja regarding repayment and expressed concerns regarding the validity of FMI's loans and the possibility of fraudulent practices. They were assured that no fraud existed, and agreed that Taneja would sell other real estate to make payments to First Tennessee. FMI had made 12 payments totalling about $4 million in principal and interest to First Tennessee before April 2008, when First Tennessee learned that the deeds of trust securing the mortgage notes it held had been falsified and were not valid.

Taneja and FMI filed for relief under Chapter 11 of the Bankruptcy Code. A trustee was appointed and sought to avoid and recover the $4 million that FMI repaid to First Tennessee on the grounds that the funds were fraudulently conveyed. First Tennessee argued that because the payments were received from FMI "for value and in good faith," it qualified for the affirmative good-faith defense under section 548(c) of the Bankruptcy Code.

After a three day trial during which First Tennessee relied on the testimony of two of its employees, the bankruptcy court determined that First Tennessee established its good-faith defense and dismissed the trustee's complaint. The district court affirmed the decision, and the trustee appealed to the Fourth Circuit, arguing that:

The Fourth Circuit rejected the trustee's arguments and affirmed the decision of the district court, holding that the bankruptcy court correctly applied the good faith standard and that it did not err in holding that First Tennessee carried its evidentiary burden.

First, the Fourth Circuit explained that section 548(c) of the Bankruptcy Code provides an affirmative defense to transferees subject to fraudulent conveyance actions if the transferee can prove that it accepted the transfers "for value and in good faith." Although the Bankruptcy Code fails to define the term "good faith," the Fourth Circuit applied its interpretation of the term from its recent decision in Goldman v. City Capital Mortgage Corp. (In re Nieves), in which it held that determining "good faith" requires both a subjective and objective analysis of what the transferee knew or should have known, taking into consideration the customary practices of the transferee's industry (see 648 F.3d 232 (4th Cir. 2011)).

Because the trustee did not claim that First Tennessee actually knew about FMI's fraudulent conduct, the Court only considered whether it should have known about the fraudulent conduct. In its analysis, the Fourth Circuit declined to adopt a bright line rule requiring that a transferee asserting the good-faith defense show that each and every action it took was objectively reasonable in light of industry standards. Instead, the Fourth Circuit held that its "inquiry regarding industry standards serves to establish the correct context in which to consider what the transferee knew or should have known." The Court therefore held that the two First Tennessee bank officials had sufficiently proved that the bank had received the funds in good faith since they were able to prove that they did not know nor should they have known of the fraud. In doing so, the Court rejected the trustee's reliance on the objective good-faith standard articulated in Christian Brothers High School Endowment v. Bayou No. Leveraged Fund, LLC (In re Bayou Group) (see 439 B.R. 284 (S.D.N.Y. 2010) and Legal Update, Bayou Group Court Clarifies Good Faith Defense to Fraudulent Conveyance Action).

Next, the Fourth Circuit declined to hold that third-party expert testimony must be presented to establish prevailing industry standards. Instead, it held that the objective component of the good-faith defense may be established by lay or expert testimony, or both, depending on the nature of the evidence at issue. In this case, the testimony of First Tennessee's two lay witnesses was sufficient to show that First Tennessee received the transfers in good faith and that it had no reason to know that they were fraudulent, although the evidence did not address whether a reasonably prudent warehouse lender would have been aware of the fraud.

This decision departs from the objective analysis used by other circuit courts, and introduces an additional element of subjectivity to the "good faith" determination under section 548(c) of the Bankruptcy Code. Under Taneja, the relevant inquiry is whether the transferee acted reasonably, instead of whether a similarly situated, reasonably prudent transferee would have or should have known of the fraud. Practitioners should be aware of this alternative good-faith standard and consider both the objective as well as the subjective aspect of good faith when claiming it as an affirmative defense to a fraudulent transfer action.

Additionally, the Fourth Circuit alleviated the burden on transferees asserting a good-faith defense by accepting lay testimony regarding industry practice instead of requiring the transferee to provide expert evidence. Although the testimony of an expert witness may strengthen a good-faith defense, the Fourth Circuit does not insist on it.

For more information on fraudulent conveyances, see Practice Notes, Fraudulent Conveyances in Bankruptcy: Overview and Fraudulent Conveyances: Issues and Strategies for Lenders and Private Equity Sponsors.