In a case that has significant implications for all lenders, the United States Bankruptcy Court for the Western District of Michigan ruled that a bank that turned a "blind eye" to red flags in the lending relationship has potential liability for $50 million in fraudulent transfers even though the credit facility did not exceed $16.5 million. The case, In Re Teleservices Group, Inc. (W.D. Michigan, Adv. No. 07-80037, March 17, 2011), is a stark reminder of the possible consequences to a bank that turns a "blind eye" to red flags in a lending relationship.

The case involved a fraudulent scheme by two affiliated companies, Teleservices and Cyberco, to defraud equipment finance companies by obtaining financing for equipment acquisitions that never occurred. Cyberco would obtain the equipment loans and instruct the lender to pay Teleservices who was supposed to be the vendor. The equipment lenders would pay Teleservices, which turned out to be nothing more than a shell entity set up by Cyberco to participate in the scam, and funnel the loan proceeds to Cyberco.

Cyberco had a revolving line of credit with the defendant bank, which was secured by a blanket lien on all of the Cyberco assets. Payments on the line of credit were supposed to come through a lockbox from Cyberco's receivable collections. Cyberco soon began bypassing the lockbox by depositing large payments from Teleservices. The bank first became suspicious when a $2.3 million check from Teleservices bounced causing Cyberco to be overdrawn. The bank initially suspected that Cyberco was engaged in kiting and asked the bank's security department to do a background check. However, the check kiting concern was allayed when Teleservices started wiring the funds to Cyberco's account with the defendant bank and Cyberco explained to the bank that Teleservices was a related party that handled accounts receivable collections for Cyberco. The bank did not enforce the lockbox requirement and continued to accept millions of dollars in payments from Teleservices into Cyberco's depository account which the bank swept and applied to pay down the loan. These payments permitted Cyberco to make additional draws on the line of credit.

While the bank continued to distrust Cyberco and went the extra mile to try to confirm its suspicions, bank management was unable to discover any wrongdoing by Cyberco. For example, the bank required a receivables audit be performed by a large public accounting firm. Cyberco passed the receivables audit with flying colors by giving the accounting firm fake customer audit responses which were created by Cyberco executives for non-existent customers. Even though the loan officers had nothing concrete, their suspicions were sufficient enough that the bank asked Cyberco to find a new lender.

However, the bank's downfall had already occurred according to the judge. The bank's security officer performed a background check and discovered that Cyberco's owner was a convicted felon and had previously confessed to a civil judgment for bank fraud. The security officer did not convey this information to the loan officers because his only concern was the possible check kiting and that issue was resolved. A workout officer later found out about the owner's background after there was an exit plan in place and the workout officer did not think there was any need to alter the bank's plan. Ultimately, Cyberco paid the loan in full and the bank breathed a sigh of relief.

Teleservices and Cyberco wound up in bankruptcy after their scheme was discovered. The Teleservices bankruptcy trustee filed a fraudulent transfer lawsuit against the bank looking to recover not only the money transferred by Teleservices to pay off the loan but also to recover in excess of $50 million transferred into Cyberco's depository account which were swept by the bank and re-loaned to Cyberco. In other words, this was not the typical case where the trustee seeks to recover only the funds used to pay the loan. This trustee was seeking to recover the funds of Teleservices that flowed through the depository account.

Boiling the case down, as a subsequent transferee of the funds from Teleservices, the bank was left with one defense under section 550(b) of the Bankruptcy Code based upon the bank's receipt of the funds in good faith and without any knowledge of the fraudulent nature of the transaction. Recently, these types of "good faith" defenses have been analyzed by courts under an objective standard which determines if the bank's conduct falls within the realm of reasonableness when compared to the standards which are acceptable in the industry. If this standard were used by the Bankruptcy Court, the bank may have been successful with its defense because the bank went above and beyond what many financial institutions would do in a similar situation involving a customer that that was paying its debt and not in default.

The Bankruptcy Court rejected the bank's assertion that its good faith should be measured under an objective standard and adopted a subjective approach to good faith. Under this subjective approach, the Bankruptcy Court would not find good faith unless the bank made an honest effort to respond to any suspicions. In this case, the judge concluded that the failure of the security officer to relay the complete findings of the background check to the loan officers was a procedural error that prevented the bank from claiming good faith. The Bankruptcy Court concluded that the bank turned a "blind eye" to the information. The end result is that the bank would be on the hook for any funds which were deposited into Cyberco's account by Teleservices after the security officer discovered the criminal record of Cyberco's owner.

Although the bank's decision makers believed that they were acting prudently and conservatively in dealing with their suspicions, several key points stand out which should serve as lessons to lenders. First, lenders should be leery of any borrower that bypasses a lockbox. Second, if a third party pays a borrower's loan, the lender should keep in mind that payments from the third party may end up being avoidable in a subsequent bankruptcy by the third party.  A lender should employ due diligence on the payments before it lends the money back out to the borrower or otherwise changes the lender's position. Third, if a lender sees red flags in a lending relationship, it should address those red flags even if the borrower is not in default and is making payments. Fourth, the borrower's depository account under a revolving loan arrangement may be a potential source of lender liability that could dwarf the lender's exposure on the loan. A lender should be comfortable with the types of transactions that are flowing through the depository account. If the lender is not comfortable with the transactions, it could be a sign that there is more at risk than the loan balance. In closing, Teleservices serves as a reminder to lenders that if they are in a position to discover fraud, they may be exposed to substantial fraudulent transfer liability by turning a "blind eye" to red flags in the lending relationship.