By: Michael Maffei
St. John's Law Student
American Bankruptcy Institute Law Review Staff
In a good news, bad news decision for prime brokers, the District Court in In re Manhattan Investment Fund v. Gredd
held that a prime broker is an initial transferee of funds held in a customer’s margin account, but recognized a “robust” good faith defense to transferee liability. In this appeal from an award of summary judgment,
[2]
Bear Sterns had receive approximately $141 million to cover margin calls for a hedge fund that, in reality, was a “Ponzi” scheme. In a holding that spells trouble for prime brokers, the Court rejected the argument that a prime broker is a “mere conduit” and lacks “dominion and control” over the funds in a margin account. Applying the Second Circuit’s “nuanced” approach, the Court rejects the narrow view that a party must have unfettered control over funds in order to be an initial transferee.
[3]
Since Bear Sterns could use the margin funds to protect itself against possible losses, it did not qualify as a mere conduit. Further, the discretionary authority given it as prime broker to close out positions, which was standard in the industry, was sufficient “control” to trigger transferee status.
The bankruptcy court rejected Bear Stearns’ good faith defense, finding it to be on inquiry notice due to suspicions regarding the hedge fund
[4]
. However, unlike the bankruptcy court, the district court found that Bear Stearns had acted with the requisite good faith and diligence, to avoid fraudulent transfer liability
[5]
under section 548(c) of the Bankruptcy Code
[6]
, by continually investigating and researching the circumstances of the hedge fund’s activities.
Section 548(c) permits the good faith recipient of a fraudulent transfer to hold a lien on or retain any interest transferred to the extent of value given to the debtor.
[7]
The court rejected Bear Sterns’ argument that actual knowledge was required to defeat the recipient’s good faith. Courts have adopted a two part analysis that focuses on inquiry notice and diligent good faith investigation
[8]
. Both factors involve an objective inquiry, with case law defining the parameters of the test
[9]
.
Although many courts, including the bankruptcy court in this case, apply a fairly strict analysis of the good faith exception, the district court’s more relaxed view of what constitutes sufficient diligence should provide some comfort to prime brokerages who are likely to be prime targets as the current economic situation produces more bankruptcies. Whether Gredd decision is indicative of a trend towards a broader exception remains to be seen.
[2]
In re Manhattan Investment Fund Ltd., v. Bear Stearns, 359 B.R. 510, 527 (Bankr. S.D.N.Y. 2007) (denying Bear Stearns motion for summary judgment while granting trustee’s motion for summary judgment).
[3]
See Christy v. Alexander & Alexander of
[4]
2007 WL 4440360, at *17 (holding, as the bankruptcy court had, that Bear Stearns was on inquiry notice of fraudulent transfer).
[5]
2007 WL 440360, at *19 (holding that proactive steps that Bear Stearns had taken, which they were under no obligation to take, were ample evidence to support finding of good faith and diligence in investigating transfer)
[6]
11 U.S.C. § 548 (2006). ((c) Except to the extent that a transfer or obligation voidable under this section is voidable under section 544, 545, or 547 of this title, a transferee or obligee of such a transfer or obligation that takes for value and in good faith has a lien on or may retain any interest transferred or may enforce any obligation incurred, as the case may be, to the extent that such transferee or obligee gave value to the debtor in exchange for such transfer or obligation).
[8]
See In re Agricultural Research and Technology Group v. Palm Seedlings Partners-A, 916 F.2d 528, 535-536 (9th Cir. 1990) (holding that the transferee was on inquiry notice but had not acted with the requisite diligence to meet its good faith burden).
[9]
See Nat’l W. Life Ins. Co. v. Merrill Lynch, Fenner & Smith, Inc., 89 Fed. Appx. 287, 291 (2nd Cir. 2004) (establishing standard for when inquiry notice will be construed); De Kwiatkowski v. Bear, Stearns & Co., Inc., 306 F.3d 1293, 1310 (2d Cir. 2002) (defining parameters of diligence needed in regards to every transaction); In re World Vision Entm’t, Inc., 275 B.R. 641, 660 (Bankr. M.D. Fla. 2002) (stating that willful ignorance will not suffice to establish good faith claim).
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