Lender's Losses in Fraud Case May Exceed 400% of Loan Amount
In re Teleservices Group, Inc., decided in March 2011 in the United States Bankruptcy Court for the Western District of Michigan, may compel a lender to return payments made on a revolving loan over an extended period of time. The risk results from information known to the lender that raised red flags about whether fraud was involved in the transfers.
The case arises from an equipment fraud, but surprisingly it is not an equipment financier that faces one of the worst losses. Rather it is a bank that provided a $16.6 million line of credit secured by the borrower's accounts receivable, not a transaction typically associated with a risk of equipment fraud. Importantly, the bank took a conservative approach in structuring the financing, with the borrower's cash collections being applied to the line of credit on a daily basis and the borrower's cash needs being funded from the line of credit. Unexpectedly, this prudent lending practice, known as "cash dominion," actually served to multiply the bank's potential loss, which could exceed 400% of the loan amount.
The first red flag came to the bank's attention about a year after closing. A bank employee noticed that most of the borrower's cash collections were infrequent transfers of large amounts from a company named Teleservices (which was not the borrower), instead of frequent transfers of smaller amounts from many different customers. This discovery prompted the bank to ask questions and, when the borrower's explanations were unsatisfactory, to investigate further. In time, a bank investigator discovered that the borrower's principal had been previously convicted of fraud (prior background checks had been foiled with a false social security number) and was then the subject of another law enforcement investigation. The bank investigator informed the bank's credit officers of the investigation but did not inform them of the prior fraud conviction until some time later. The credit was eventually transferred to the bank's special asset group, which asked the borrower to find new financing. Although the borrower never secured a new line of credit, the bank must have been relieved when the original debt was paid in full (with checks from Teleservices).
Ultimately the facts of the fraud came to light:
- The borrower contacted banks and finance companies to arrange for equipment financing;
- Teleservices was a shell company that was controlled by the principal of the borrower but held out as an independent equipment vendor;
- Teleservices sent invoices for nonexistent equipment to the equipment financiers, which advanced funds to Teleservices against the fake invoices;
- Teleservices paid the proceeds to the borrower's lockbox account; and
- The lockbox funds were applied to the borrower's line of credit balance.
Clearly, the equipment financiers had been defrauded and ordinarily would face bleak prospects of recovery. However the trustee in Teleservices' bankruptcy proceeding saw a source of recovery: the bank. The trustee argued that the payments by Teleservices that were applied to the borrower's line of credit were fraudulent transfers and must be returned by the bank. Since the bank would re-advance funds under the line of credit after receiving payment, the aggregate amount received by the bank far exceeded the line of credit, thus dramatically increasing the bank's exposure.
The bankruptcy court found that the payments by Teleservices were indeed fraudulent transfers since Teleservices (a) was insolvent after it made the transfers, and (b) had not received reasonably equivalent value for the transfers. Although the bank could avoid liability if it received the payments in "good faith," the court stated that good faith would be absent if the bank (1) had sufficient information to conclude that fraud was involved in the transfers, or (2) turned a blind eye to information that suggested fraud when an honest person would have investigated further. Applying this standard, the court found that transfers received after the bank had knowledge of the principal's previous fraud conviction were not received in good faith. Further, the court found that the bank had knowledge of the prior conviction when the bank investigator learned of the conviction, not when the credit officers were informed by the investigator. As a result, all payments after the investigator learned of the conviction were at risk.
The bank did, however, receive some good news when the U.S. Supreme Court ruled to limit the power of bankruptcy courts in Stern v. Marshall. Following this June 2011 decision, the bankruptcy court in In re Teleservices Group, Inc. determined that it did not have the authority to order the bank to turn the money over. Rather, the bankruptcy court stated it would submit a report to the U.S. District Court recommending that the order be entered, thus giving the bank an opportunity to convince the U.S. District Court that a judgment should not be entered.
Like many legal rules, the standard announced by the bankruptcy court in In re Teleservices Group, Inc. is not a bright line. Under this standard, lenders should investigate signs of fraud regarding line-of-credit payments, as well as any questionable facts uncovered in an investigation. All aspects of the investigation should be documented so that the lender can demonstrate that it did not "turn a blind eye" when receiving payments. Further, when faced with a possible fraud, a lender should consider any steps that can be taken to limit exposure if it is later found to have had "sufficient information to conclude that fraud was involved in the transfers." Ironically, in the case of In re Teleservices Group, Inc., discontinuing the usually prudent practice of "cash dominion" could have significantly limited the bank's exposure since this would have reduced the total amount of loan payments received by the bank.