United States: Courts Address Whether Lenders Must Warn Of Fraud

Originally published in Reed Smith’s Commercial Restructuring & Bankruptcy Alert, December 2006

If a lender knows or has reason to believe that a customer/borrower is committing a fraud, does the lender have an obligation to disclose this knowledge to other lenders or customers who may be adversely affected? Tough question, and one that the U.S. Court of Appeals for the Second Circuit grappled with in two recent opinions.

In In re Sharp International Corp., 403 F. 3d 43 (2nd Cir. 2005), the owners of the company falsified financial information to enable it to borrow large sums of money from the company’s lender and then diverted the funds to other entities they controlled. After the lender became aware of the fraud, it demanded the owners repay the loan in full. The new owners approached a group of existing investors holding subordinated notes for additional funds to pay the lender.

While the transaction went forward, the lender did not warn the investors of the fraud, did not return any phone calls from the investors, and gave its needed consent to the new indebtedness. After the company repaid the lender with the investors’ money, and after the investors learned about the fraud, the investors commenced an involuntary bankruptcy petition against the company. Thereafter, the bankruptcy trustee sued the lender, claiming the lender facilitated the victimization of the investors and the looting of the company by the owners.

The Second Circuit Court of Appeals addressed three primary issues.

First, was it wrong for the lender to demand that the company refinance the debt after the lender learned of the fraud? The court said that such a demand was not a corrupt inducement that would create aider and abettor liability—the demand was consistent with its legal and contractual rights.

Second, was it wrong for the lender not to: (a) reveal to the investors what it knew or suspected about the fraud; (b) foreclose on the loan; or (c) respond to inquiries from the investors? The court said that the lender’s silence or forbearance did not assist the fraud affirmatively, and that the lender did not have a duty to inform the company or the company’s creditors of the fraud.

Third, was the lender’s consent to the investors’ purchase of additional notes an act that affirmatively assisted the fraud? The court said that giving consent did no more than remove a contractual impediment to the transaction, and the lender’s exercise of that right "to protect itself rather than its improvident competitors did not constitute participation in the [owners’] fraud."

In dismissing the complaint, the court said the following, which will bring warmth to any lender’s heart:

403 F. 3d at 52-53¹*

However, lenders should not breathe too big a sigh of relief yet. It is important to note that the linchpin of the ruling in Sharp is that the lender did not have a duty to the borrower or the borrower’s creditors or investors to advise them of the fraud.

A year later, the court came to a different result addressing fraud involving fiduciary accounts maintained at the bank. In Lerner v. Fleet Bank, N.A., 459 F. 3d 273 (2nd Cir. 2006), certain investors alleged that the bank assisted a lawyer in defrauding the investors in a multimillion-dollar Ponzi scheme. They claimed the bank failed to report overdrafts on the attorney fiduciary accounts to the state bar for disciplinary action, and evaded its reporting duties by misleadingly marking some checks drawn against the accounts with insufficient funds as "Refer to Maker."

The Second Circuit noted that, as a general rule, a depository bank does not have a duty to monitor fiduciary accounts maintained at its branches in order to safeguard funds in those accounts from fiduciary misappropriation. However, if a bank has notice or knowledge of diversion or misappropriation of fiduciary funds, the bank is under a duty to make reasonable inquiry and endeavor to prevent the fraud. According to the court, evidence of overdrafts in fiduciary accounts would put the bank on notice of possible impropriety, which is why state bar associations require the reporting of such overdrafts in attorney escrow accounts.

As such, the court of appeals reversed the lower court’s decision dismissing the claims against the bank for aiding and abetting breaches of fiduciary duties.

Lerner raises more questions than it answers, especially in light of the ruling in Sharp. One could conclude that the simple distinction between the two cases is that Lerner involved fiduciary accounts and Sharp did not.

However, other complications are involved. Part of the answer may lie in the fact that different Second Circuit panels heard the two cases. The court in Lerner said that when a bank has notice of fraud involving a fiduciary account, it must take reasonable steps to endeavor to prevent the fraud.

Does that mean the bank has a duty to notify the clients that have deposited money resulting from the fiduciary’s fraud? In doing so, would the bank be violating the fiduciary’s right to privacy, a concept not discussed in either opinion? In Sharp, the court says that a bank does not have a duty to inform unsuspecting lenders and investors of fraud. But in Lerner, the court states the bank has the duty to take reasonable steps to endeavor to prevent the fraud. Or does the latter only have this duty regarding fiduciary accounts? Stay tuned.

This article is presented for informational purposes only and is not intended to constitute legal advice.