Fri 09/09/2022 06:00 AM
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The U.S. Court of Appeals for the Second Circuit on Thursday, Sept. 8, handed a significant victory to Citibank in the long-running saga over the bank’s August 2020 mistaken payment of nearly $1 billion to lenders under Revlon’s 2016 term loan. The decision is a blow for investment firm defendants in the litigation, who decided to retain a collective $500 million of the funds (other non-defendant lenders decided to return funds they received). The circuit court overturned the district court decision of Judge Jesse Furman, which held that the lender defendants could keep the funds under the so-called “discharge-for-value” rule established by a New York Court of Appeals decision, Banque Worms v. BankAmerica International.

In an opinion written by Judge Pierre Leval and joined by Judge Robert Sack, the Second Circuit observes that the discharge-for-value rule only protects a lender’s right to retain a mistaken repayment of a loan “that was due and payable,” and even then only if the lender “made no misrepresentation and did not have notice of the transferor’s mistake.” The opinion concludes that the Citibank dispute “does not fall within the scope” of this rule “because the Defendants had notice of the mistake and because the lenders were not entitled to repayment at the time” (emphasis added). Thus, the defendants did not have a right to retain the mistaken payment.

Judge Michael Park, the other judge on the three-judge panel that heard the case, issued a written concurrence. Judge Park writes, “Put simply, you don’t get to keep money sent to you by mistake unless you’re entitled to it anyway,” criticizing the panel for taking as long as it did to render a decision.

The panel heard oral argument on the appeals almost one year ago, on Sept. 29, 2021. At the time, the panel considered certifying the question to the New York Court of Appeals. In explaining the time taken to produce the opinion, Judge Leval explains that he and Judge Sack “originally determined to certify the question” and wrote a draft opinion to the effect but altered course in the face of “at least a year’s further delay” and after becoming “increasingly persuaded” that New York law favors Citibank.

Background

Citibank, as administrative agent for the lenders of a $1.8 billion syndicated seven-year loan to Revlon, brought a lawsuit seeking to clawback transfers made in August 2020 to the loan managers for lenders of the majority of the loan. Citibank had intended to transmit payment of accrued interest on the loan, but made a “ministerial error” which, as the Second Circuit explains, “caused the unwitting transfer by wire of Citibank’s funds in the full amount of Revlon’s outstanding principal balance, three years before Revlon’s loan repayment was due, and, at a time when, because Revlon was understood to be deeply insolvent, loan participations were trading at 20% to 30% of the face amount.”

Citibank discovered the error the next day, and demanded a portion of the funds representing the principal be returned. The defendants refused, prompting the agent to bring an action for restitution. The district court ruled in favor of the defendants, and Citibank appealed.

The defendants in the case are Brigade Capital Management, HPS Investment Partners, Symphony Asset Management, Bardin Hill Loan Management, Greywolf Loan Management, Zais Group, Allstate Investment Management, Medalist Partners Corporate Finance, Tall Tree Investment Management and New Generation Advisors.

Main Opinion

The issue on appeal before the Second Circuit is whether, under New York law, the recipients of an accidental, unintended payment were required, under the circumstances, to return the payment. The court first examines the Banque Worms exception to the “traditional rule” of New York law for mistaken payments, which “generally calls for restitution of the mistaken payment unless the recipient so significantly changed its position in reliance on the mistake that it would be unjust to require repayment.” The opinion states that the court in Banque Worms “endorsed an exception” to the traditional rule, relying on the First Restatement of Restitution’s discharge-for-value principle.

The Second Circuit looks to the Banque Worms court’s explanation for the discharge-for-value rule, which is quoted by the opinion as: “[w]hen a beneficiary receives money to which it is entitled and has no knowledge that the money was erroneously wired, the beneficiary should not have to wonder whether it may retain the funds; rather, such a beneficiary should be able to consider the transfer of funds as a final and complete transaction, not subject to revocation.”

Although the Second Circuit lauds the district court’s “impressive and scholarly handling of the case,” it nevertheless disagrees with “some” of the lower court’s conclusions. The circuit court concludes that Citibank is entitled to prevail under the New York rule expressed in Banque Worms. Specifically, the Second Circuit finds that under New York law, the defendants had constructive notice of Citibank’s mistake, and the defendants were not entitled to the money at the time Citibank paid it.

Defendants Were on Notice of Citi’s Mistake

In the majority opinion, Judge Leval writes that the discharge-for-value rule does not “shield” the beneficiary of a mistaken transfer from restitution if the beneficiary is on inquiry notice. The court states that, based on the facts available to the defendants on the Aug. 11 transfer date, “that standard of inquiry notice was satisfied.” “The facts were sufficiently troublesome that a reasonably prudent investor would have made reasonable inquiry, and reasonable inquiry would have revealed that the payment was made in error,” the opinion says.

The opinion observes that the parties disagree as to how the standard of constructive notice is understood in New York law. The defendants argue that constructive notice is evaluated by asking “what the transferee ‘knew or should have known’ of the transferor’s mistake,” while Citibank argues that “inquiry notice” is the applicable standard.

The appellate court finds that Citibank had the “better” argument for what constitutes “constructive notice” in New York. Elaborating, the court writes:
“...to apply the inquiry notice test in these circumstances, it is necessary to imagine that the hypothetical reasonably prudent person, who, upon receiving the payments received by the Defendants, and knowing the facts available to the Defendants, faces a risk of loss if the payment turns out to be mistaken, a risk he could avoid by learning the true facts. If the suspicions and warnings raised by the red flags are so remote and improbable that it is consistent with reasonable prudence to ignore them without making inquiry, then the person is not on notice of the facts that reasonable inquiry would have revealed. On the other hand, if reasonable prudence on confronting those suspicions and warnings would call for making inquiry in the interest of avoiding a risk of the loss that would befall him if the payments proved mistaken, the person is on notice of the facts that would be revealed by reasonable inquiry.”

Red Flags

Under its evaluation of the facts, the court says that the Aug. 11 transfer exhibited “red warning flags” that would have caused a “reasonably prudent person who faced an avoidable risk of loss to make reasonable inquiry as to whether the transfer resulted from mistake.” The red flags were, in the court’s evaluation, sufficient to trigger a duty of inquiry notice. The Second Circuit concludes that, as a result, the defendants “are not shielded from Citibank’s claims for restitution under the discharge-for-value rule.”

The “red flags” include (i) the absence of prior notice of a prepayment from Citibank; (ii) the “apparent inability” Revlon to make the repayment; (iii) the current trading value of the 2016 Loan; and (iv) Revlon’s recent efforts to avoid acceleration of the loan.

The lack of prior prepayment “raised a substantial red flag supporting suspicion,” concludes the circuit court. The opinion states that the loan agreement required “‘irrevocable written notice’” from Revlon following which Citibank was required to “promptly” notify the lenders. The circuit court says that the defendants “received no prior notice” and “did not even receive such a notice of Revlon’s intent to prepay together with the payment” on Aug. 11, which was accompanied by a notice of interest payment “without reference to any payment of principal.”

The duty to inquire was compounded by the investors' awareness of Revlon’s “apparent deep insolvency,” the opinion says, adding that a “prudent investor” would have been “astonished” that Revlon “could find the resources to make a payment of nearly $1 billion.” The court says that the defendants “believed at the time” that Revlon “was insolvent by as much as $1.71 billion.” The investors’ “doubts would have been heightened” by Revlon’s then-recent shift in collateral from its 2016 loan to a 2020 loan in connection with efforts to secure $800 million in new financing, as well as Covid-19’s “disastrous effects” on Revlon’s business.

Revlon’s “perceived inability” to repay the 2016 loan flowed into a “third red flag” - the discounted trading prices for the loan. Given that the loan was currently trading at “20-30 cents on the dollar,” the opinion observes that the choice to retire through prepayment “would have seemed strange and improbable” given that the loan “could have been retired far more cheaply than by paying its full value.”

The fourth red flag was “Revlon’s elaborate contrivance only four days earlier to avoid acceleration of the 2016 Loan.” These efforts, says the opinion, would “make no sense if Revlon was planning to retire that debt a few days later.”

The circuit court says the lower court “never expressly stated a conclusion as to whether” the contextual facts surrounding the mistaken fund transfer were “suspicious enough to give rise to a duty to inquire,” and “depended heavily on its factual findings that the Defendants believed in good faith that the payments they received were not the product of mistake, coupled with the court’s conclusion that those beliefs were reasonable.” The opinion particularly notes that the lower court gave credence to the testimony that certain lenders believed that Revlon could have obtained financing through the “assistance” of Ronald Perelman and his holding company, MacAndrews & Forbes Inc., and found that “those beliefs ‘were not unreasonable’” in concluding that the prepayment reflected a “‘creative way to’ avert or neutralize the threatened lawsuit that was subsequently filed through UMB Bank the day after the transfers on Aug. 12.

According to the circuit court, the district court went on to conclude that any remaining duty of inquiry was discharged by the lenders “ascertaining that Citibank’s payment exactly matched the outstanding principal plus accrued interest.” The opinion holds that this conclusion and the district court’s “reasoning in deprecating” Citibank's arguments “depended on errors of law” in applying the inquiry notice test.

The opinion states that the test is not “dependant on what the actual recipient believed,” and instead is an objective test determined by “whether a prudent person, who faced some likelihood of avoidable loss if the receipt of funds proved illusory, would have seen fit in light of the warning signs to make reasonable inquiry in the interest of avoiding that risk of loss.” The test, says the circuit court, “comes out with the same result for each payee, regardless if a recipient is “optimistic,” “dwelled on the reasons to doubt” or was “oblivious to the issue.”

Concluding that any of the defendants reasonably believed that the payment was not mistaken does not “negate” the objective standard of a “reasonably prudent investor, to whom the red flag information was available,” and the “red flags were not explained away by the unlikelihood that a mistaken payment would have matched the amount of the outstanding debt,” the opinion says.

The opinion adds that the district court erred in its interpretation of the prepayment notice provisions requiring that Citibank promptly notify the lenders of a prepayment. The district court’s reading of this requirement was broad enough that the bank’s failure to make the notice was not, according to the district court, a “red flag.” This reading “stripped” the provisions of their “contractual purpose.”

The opinion further rejects the importance that the district court put on testimony from a Citibank executive that he did not know whether the prepayment notice provisions required the bank to make prior notice. The district court factored this into its analysis that the failure of the bank to make such notice was not a “red flag.” The opinion says that this testimony may have been the result of a natural reluctance of non-lawyers to give legal opinions on the stand. The Second Circuit also observes that the executive’s knowledge was not known one way or the other by the lenders.

Instead of the loan’s notice rules being dispositive, “[t]he crucial question was whether a hypothetical prudent investor who might have incurred avoidable loss if the surprise payment proved illusory would have seen Citibank’s failure to give notice as a factor supporting doubt, which, when taken together with the other visible red flags, would have led the prudent investor to make inquiry,” writes Judge Leval.

The opinion then turns to the district court’s reasons for minimizing the impact of Revlon’s “apparent insolvency” on whether the payment raised “red flags.” The Second Circuit writes that the district court relied on (i) the fact that Revlon had “managed” a few months earlier to raise over $800 million in new funding and (ii) that key shareholder Ronald Perelman “had a reputation for bailing out Revlon.” As to the recent transaction, the circuit court notes that the $800 million transaction involved a pledge of substantial unencumbered assets, making it less likely for a similar transaction to happen again. As for Perelman suddenly injecting $1 billion into Revlon, the opinion observes that “there had been no reports in the financial press of Revlon’s obtaining any new financing.”

The opinion then discusses how the lenders’ subjective knowledge and decision-making cannot guide the court’s analysis of how a hypothetical prudent investor would react (i.e. that the latter is assumed to have “awareness of all the information that was available to the recipients of the payments” and “a risk of avoidable loss if the payment proves illusory”).

The opinion then summarizes its conclusion regarding the “red flags”:
In sum, considering the factors correctly cited by the district court as supporting a reasonable belief that the payment was genuine, together with the factors identified by Citibank as red flags supporting doubt, we conclude that a reasonably prudent investor who faced an avoidable risk of loss if the payment proved mistaken and therefore subject to recall, would have seen fit to make a telephone call to inquire of Citibank” (emphasis added).

Reasonable Inquiry

The circuit opinion then rejects the district court’s decision that the inquiry made by the lenders was reasonable under the circumstances. The Second Circuit concludes that the lower court’s analysis was based on Citibank expert John Byrne’s characterization of “how a financial institution would investigate a circumstance in which it received from a bank more money than it expected.” Byrne noted such analysis would involve “third-party market date” and general “wisdom,” adding that if the tools aren’t available “in-house” you “go to the source.” The district court mistakenly interpreted this to mean that “​​a reasonably prudent financial institution would not have necessarily gone to the source to ask whether there was an error,” according to the Second Circuit.

The district court found that the lenders inquiry duty was discharged by their (i) inquiry into whether other lenders received a full paydown (they had) and (ii) the lender’s determination that the funds they received “matched the outstanding principal and interest to the penny,” especially emphasizing testimony that such payment amounts are “a clear indication of” a paydown.

“The problem” according to the circuit court, is that the red flags identified by the opinion and discussed above still remained despite the two areas of inquiry undertaken by the lenders. The opinion also notes New York law duty for a party to access information that is readily available if such information will “either confirm or quiet their suspicions.”

The opinion concludes:
“In sum, while it was reasonable for the Defendants to begin their inquiry to resolve the red flags by ascertaining that the payments equaled the size of the debt, when that fact failed to explain away the red flags, the inquiry notice test required them to take the easy further step of placing a call to their agent Citibank, which had sent the payment. Having failed to make that call, they were chargeable with notice of what they would have learned. We conclude that the Defendants were on notice of Citibank’s mistake and were thus ineligible to claim the discharge-for-value defense” (emphasis added).

The Debt Was ‘Not Yet Payable’

The opinion observes that “every precedential ruling on which the Banque Worms opinion relied in support of denying restitution of a mistaken payment involved present entitlement of the payee to the money it received and two of the precedents expressly stated that that the rule was for circumstances in which the money was ‘due’ to the recipient of the funds.”

Such a reading of the discharge-for-value rule, “better harmonizes with New York’s ‘general rule’ covering the receipt of mistaken payments, which is that a party receiving money as the result of a mistake must return it,” the opinion adds, further observing that this reading of the rule is in harmony with the “reasons” for the rule - “as an administratively convenient way to allocate a loss between two parties where ‘there is no reason in justice why one should suffer rather than the other.” Where a mistaken payment is made on a debt that is not yet due, “substantial” interests weigh in favor of returning the funds to the mistaken side, including avoiding a “huge windfall,” according to the Second Circuit.

After distinguishing the case law relied on by the district court, the circuit court writes:
“In summary, the Court of Appeals’s specified requirement of entitlement to the money, combined with the cases it cited as precedents for the rule, and its continued espousal of New York’s general rule that mistaken payments should be returned, lead us to conclude that, in New York, a creditor may not invoke the discharge-for-value rule unless the debt at issue is presently payable. Here, the debt on which Citibank mistakenly made a payment was not due for another three years. As a result, Defendants may not invoke the discharge-for-value rule as a shield against Citibank’s claims for restitution” (emphasis added).

In the present case, payment was not due for three years and the lenders were not entitled to the funds. The opinion notes that a creditor only has a “legal right” to funds loaned only when “the debtor has an obligation to pay those funds.”

The majority opinion thus vacates and remands the case for further proceedings, requiring the lender defendants not to dispose or transfer the applicable funds until there is a further court order.

Response to Concurrence

Judge Leval writes solely for himself in an “addendum” to the opinion. First he questions whether the discharge-for-value rule can apply where “Citibank had no intention to discharge Revlon’s debt” and “had no intention to make a payment at all.” Although the question was not briefed, the judge says that the case law implies that where the “the payment was made by accident and unintentionally,” the rule might not apply at all.

Next Judge Leval responds to Judge Park’s “complaint” regarding the time it took for the opinion to be written. “Judge Park’s complaint on that ground has some merit. I truly regret that I did not get the job done faster,” Judge Leval writes. However he then notes that the delay was caused in part by a “change in disposition” in that Judge Leval and Judge Sack “originally determined to certify the question to the New York Court of Appeals” and a draft opinion on that basis was written (emphasis added). “We then decided against certification -- primarily because certification ordinarily results in at least a year’s further delay and because we became increasingly persuaded, despite initial uncertainties, that the law of New York, for the reasons explained above, favors Citibank’s position.”

Judge Leval adds that the answers in the case are not as “straightforward, obvious, and easy” as Judge Park implies, and Judge Park’s “solutions” “were not advanced by Citibank or debated in the parties’ briefing. Nor, in my view, do they reflect the law of New York.”

The judge then provides a discussion of the dual purpose of a court of appeals decision: to tell the parties as quickly as possible who “won” and also to provide clear explanations of sound legal principles to serve as precedent going forward. The judge concludes: “A decision of a precedential court that rests on unsound, poorly reasoned, or poorly explained, legal principles will therefore cause great future mischief. Finding the best accommodation between the objectives of speed and legal soundness is not always easy.”

Concurrence

Judge Michael Park’s concurrence stresses the “common sense” rule that “When people receive money by mistake, the law usually requires them to give it back.” The “narrow” exception protects “a recipient who was owed the mistakenly paid money.” “Under this narrow equitable defense, called ‘discharge for value,’ a creditor who receives a payment in discharge of a debt he is owed can defeat restitution by invoking his own competing claim to the disputed funds.”

“But here, Defendants had no such claim - not when they received Citibank’s money, and not when they were asked to give it back - because they were not entitled to payment for another three years after Citibank erroneously sent them half a billion dollars. Allowing them to keep that money would turn equity on its head and topple the settled expectations of participants in the multi-trillion dollar corporate-debt market. It would also be brutally unfair,” the concurrence states.

“In my view, this is a straightforward case that many smart people have grossly overcomplicated and that we should have decided many months ago,” Judge Park writes, adding that “Defendants’ case fails on a more basic level: A recipient of mistakenly transferred funds cannot invoke the discharge-for-value defense - a general legal rule incorporated by the Restatement (First) of Restitution and the New York Court of Appeals - unless and until it has a present entitlement against the debtor. Put simply, you don’t get to keep money sent to you by mistake unless you’re entitled to it anyway” (emphasis added).

The concurrence takes the position that the discharge-for-value defense actually arises out of the principle of bona fide purchase, which protects an innocent purchaser from claims that another party has better title to the purchased goods. Judge Park explains that the discharge-for-value defense operates as a kind of setoff application of the principles of bona fide purchase, where a third party pays the debt of another. “Through setoff, the creditor gives value by applying mistakenly transferred funds to discharge an unpaid debt, thus taking title to the funds in exchange for surrendering a valuable claim against the debtor,” according to the concurrence, adding that unwinding this based on a mistake would be “inequitable.”

According to the concurrence:

“As a form of bona fide purchase, the discharge-for-value defense (1) requires a creditor to give ‘value’ by setting off mistakenly transferred funds against a debt, and (2) rests on the premise that it would be inequitable to deprive a creditor of a payment he fairly bargained for. Both these features of discharge for value lead to the same conclusion: Discharge for value requires a preexisting entitlement to mistakenly transferred funds.”

Further, the “massive windfall” the lenders stood to gain in the current case defeats the discharge-for-value rule: “At a minimum, a creditor invoking the defense must have received only what he was owed. But the Creditors here received an unearned gain - and will have suffered no loss after restitution - because they were not yet entitled to be paid.”

Judge Park also stresses the “critical” difference between this case and Banque Worms - “ Unlike the Creditors here, Banque Worms was entitled to the money it mistakenly received.”

“At bottom, Defendants received a payment to which they were not entitled, for which they did not bargain, and on which they did not rely. Their only real asserted justification for keeping Citibank’s money is ‘finality’ - the fact that they have it. But that is not enough to claim ownership over someone else’s property. Possession is not ten-tenths of the law.”

Judge Park adds that although the majority has “ultimately arrived at the correct conclusion,” its “delay” is unfortunate in that it has caused Citibank to lose interest on the funds and led to “dire repercussions” for Revlon, in that Revlon’s ability to negotiate with its creditors was clouded by the uncertain status of the 2016 loan and Citibank’s subrogation rights, if any.
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