Texas Supreme Court Says Stanford Investor's Lack Of Good Faith Justifies Clawback Of Principal Investment

Approximately one year ago in January 2019, a federal appeals court found that the Receiver appointed to recover assets for victims of Allen Stanford’s massive $7 billion Ponzi scheme could recover a Stanford investor’s nearly $90 million principal investment -in addition to the ‘false profits’ he received - based on a lower court’s jury finding that the investor was on inquiry notice of Stanford’s Ponzi scheme. After the investor asked for reconsideration of that decision, the U.S. Court of Appeals for the Fifth Circuit (the “Fifth Circuit”) vacated its previous decision and asked the Texas Supreme Court to decide whether the Texas Uniform Fraudulent Transfer Act’s (“TUFTA”) good-faith defense was available to an investor who had inquiry notice of the fraudulent behavior but failed to conduct any subsequent inquiry - even if any such inquiry would not have been able to detect the fraud. The Texas Supreme Court recently answered that question in the negative, finding that the investor “must show at minimum that it investigated its suspicions diligently….[as] an opportunity for the [investor[ to demonstrate its good faith.” As discussed below, the decision is likely to have potentially far-reaching implications.

The Clawback Suit

Investor Gary D. Magness and his related entities (collectively, "Magness) were one of Stanford's largest U.S. investors, purchasing $79 million in Stanford CDs between December 2004 and October 2006 - several years before the scheme's collapse.  Following a July 2008 Bloomberg report that the SEC was investigating Stanford, Magness's investment committee decided at an October 2008 meeting to seek, at a minimum, the accumulated interest owing on Magness's investment.  Magness has maintained that this decision was not due to the Bloomberg report but rather because of his own mounting liquidity issues in the run-up to the financial crisis. 

After Magness's financial advisor approached Stanford's issuing bank for a redemption, Magness ultimately received approximately $88.2 million in cash later that month as purported "loans" repaid by the accrued interest and principal investment.  This amount included approximately $8.5 million in purported profits on Magness's CD investment.  Stanford was charged by the SEC several months later.

Janvey sued Magness to recover all $88.2 million he had received before SIB's collapse.  Magness subsequently returned the $8.5 million he had received in "false profits" following the Court's award of partial summary judgment to the Receiver for those transfers. The case ultimately went to a jury to decide whether Magness had received the returns constituting his principal investment in good faith.  The jury decided that Magness had inquiry notice that Stanford's bank was engaged in a Ponzi scheme, but not actual notice.  Inquiry notice was defined in the jury instructions as:

[K]nowledge of facts relating to the transaction at issue that would have excited the suspicions of a reasonable person and led that person to investigate.

In what would be the focus of appellate efforts, the jury also concluded that any investigation by Magness would have been futile.  The jury instructions defined a futile investigation as when:

a diligent inquiry would not have revealed to a reasonable person that Stanford was running a Ponzi scheme.

Notwithstanding the jury verdict, The Receiver asked the lower court to enter judgment in his favor and argued that the jury's finding of inquiry notice defeated Magness's good faith defense under TUFTA.  The court denied that motion, finding the Receiver was only entitled to recover Magness's $8.5 million in false profits, and the Receiver appealed that Order to the Fifth Circuit. The Fifth Circuit at first reversed the ruling, finding that the Receiver was entitled to recover Magness’s entire principal investment, and then subsequently vacated the order and certified the question to the Texas Supreme Court.

The Texas Supreme Court Opinion

One of the primary defenses for an investor facing a lawsuit to “clawback” any Ponzi transfers under both Texas law and other similar adaptations of the Uniform Fraudulent Transfer Law adopted by a majority of states is to demonstrate both that it “took in good faith and for a reasonably equivalent value.” As for the latter prong, courts have generally held that an investor provides reasonably equivalent value when receiving transfers consisting of their principal investment under the theory that the investor is partially or fully relinquishing potential claims (i.e., for restitution) they might have in receiving the return of their principal. The analysis shifts, however, when the funds at issue are false or fictitious profits, as the investor cannot provide the same reasonably equivalent value when receiving funds that are simply stolen from other investors and repackaged as illusory returns. Courts have similarly denied the use of the defense on public policy grounds.

However, an investor seeking to rely on the defense must demonstrate both good faith and reasonably equivalent value. Thus, a transfer may be recoverable even if an investor provided reasonably equivalent value if that same investor cannot establish the corresponding good faith prong. But, what exactly is good faith? Noting that TUFTA does not provide a definition of good faith, the Texas Supreme Court looked to its “plain or common meaning” in Black’s Law Dictionary:

“[a] state of mind consisting in (1) honesty in belief or purpose, (2) faithfulness to one’s duty or obligation, (3) observance of reasonable commercial standards of fair dealing . . . , or (4) absence of intent to defraud or to seek unconscionable advantage.”

Noting the definition’s reliance on honest conduct, the Court concluded that a “transferee must show that its conduct was honest in fact, reasonable in light of known facts, and free from willful ignorance of fraud.” A transferee like Magness who is on inquiry notice, regardless of whether that inquiry notice consisted of actual or constructive knowledge, must then undertake a diligent investigation - even if that investigation would have been “fruitless.” As the Court observed":

A transferee cannot show good faith in this situation because, irrespective of what a hypothetical investigation could reveal, the facts giving rise to a reasonable suspicion of fraud have not been confronted. Even if the fraud is inherently undiscoverable, the transferee still has actual knowledge of facts at the time of the transfer that would lead a reasonable person to suspect fraud and investigate. If the transferee fails to demonstrate its good faith and avoid willful ignorance by conducting a diligent investigation, it cannot be characterized as acting with honesty in fact.

In short, Magness was on inquiry notice of Stanford’s fraud when he became aware of the SEC’s investigation and his failure to conduct any subsequent investigation of those suspicions prevents him from using his good faith as a defense to the Receiver’s efforts to recover the amount Magness transferred - his entire principal investment and profits - after having inquiry notice.

Implications

As I mentioned in an article last year and based on the assumption that the decision would stand, the Magness decision becomes a potentially potent avenue available to a Receiver if an investor’s fortuitous withdrawl on the eve of the scheme’s collapse comes after learning of suspicious circumstances - even if the investor only withdraws a portion of its investment. While the Texas Supreme Court provides some initial clarity on the use of this strategy, it will inevitably require future court decisions to decide just what circumstances can sufficiently place an investor on inquiry notice and in turn require them to conduct a sufficient investigation to satisfy those concerns. Indeed, such a theoretical blueprint for prescribed conduct seems contrary to how a similarly-situated investor would likely act; an investor who learns of potentially nefarious conduct placing their investment at risk is likely not going to conduct any further investigation before deciding to withdraw their investment and get as far away from the scheme as possible. And if the investor does conduct an investigation and somehow confirms their suspicions that the transfer is a fraud, does that totally obliterate the availability of the good faith defense?

Regardless, the potential for principal distributions to now be within a receiver's grasp upon the existence of a certain event placing any recipients on inquiry notice greatly expands both the potential number of clawback targets as well as the ultimate size of the receiver's possible recoveries.  

A copy of the Texas Supreme Court’s decision is below: