A recent decision by the Second Circuit Court of Appeals has saved Citibank from the ramifications of an internal error that could have cost it nearly $900 million. Although the recipients of an unintended transfer of Citibank’s funds could have reasonably believed that they were receiving early payment on a loan and had no actual knowledge that the payment was made by mistake, the Second Circuit ruled that the facts presented created a duty to inquire. Such an inquiry, in the Court’s view, would have put the recipients on notice of Citibank’s error and eliminated any legal right to retain the funds.
In August 2020, Citibank was serving as administrative agent for the lenders of a large syndicated loan to cosmetics giant Revlon. In that capacity, Citibank had the responsibility to collect interest and principal payments from Revlon and transmit them to the lenders. In connection with making a $7.8 million interest payment on behalf of Revlon, Citibank employees, through a misunderstanding of a software program, accidentally transmitted approximately $900 million of Citibank’s own funds – the entire outstanding principal balance of the loan, which was not due until 2023 – to the lenders.
Citibank recognized its error almost immediately and requested the return of the mistaken payment from each lender the following day. Some complied. However, Revlon was experiencing severe financial distress (and has since commenced a reorganization under chapter 11 of the Bankruptcy Code), with the debt evidenced by the loan trading at the time for less than 30 cents on the dollar. Many of the lenders chose not to forego the unexpected windfall of full payment and declined Citibank’s request.
Under New York law, a payment made in mistake generally must be returned. One exception to this requirement is the “discharge-for-value” doctrine, which can be invoked by a payee that is entitled to the funds, has no knowledge that the payment was erroneous, and made no false representations to the payor in connection with the payment. Following a trial in the Southern District of New York, the District Court ruled that the lenders had satisfied the requirements of “discharge-for-value” under New York law and were entitled to keep the funds sent by Citibank.
On appeal, the Second Circuit disagreed with the District Court that the requirements of the discharge-for-value doctrine were satisfied.
Although the lenders had no actual knowledge that Citibank’s payment was in error, the Second Circuit held that that the facts established at the trial created an obligation to inquire. As any inquiry to Citibank would have immediately made clear that the payment of principal was erroneous, the Second Circuit held that the “no knowledge” prong of the discharge-for-value doctrine could not be satisfied, and reversed the District Court’s judgment in favor of the lenders.
The Second Circuit particularly focused on four “red flags” that it believed would have led a hypothetical “reasonably prudent person” to believe that Citibank made the full principal payment erroneously:
- There was no notice given by Revlon of the early prepayment as required under the loan documents;
- Revlon would have been paying off the loan in full three years early despite being in poor financial shape;
- If Revlon did intend to retire the loan early, it could have done so far more cheaply by buying the debt evidenced by the loan on the open market for under 30 cents of the dollar; and
- Revlon had been going through complicated financial gyrations, including an exchange offer for a series of its bonds begun a few days earlier, which were expressly designed to prevent an early acceleration of the $900 million loan.
The District Court had considered these facts but had concluded that they did not create an obligation to inquire on the lenders’ part. The District Court noted reasons why the lenders could have reasonably believed that the payment was deliberate on Citibank’s part and therefore did not need to make an inquiry. Most important, in the District Court’s view, was the fact that each lender was paid precisely the percentage amount of principal and accrued interest which it was owed. The lenders, the District Court determined, were justified in believing that the payment was intentional because of the precision of payment and the unlikelihood “that Citibank, one of the most sophisticated financial institutions in the world, had make a mistake that had never happened before, to the tune of nearly $1 billion.”
The Second Circuit, in reversing, held that a lender’s subjective good faith belief in the validity of the payments was irrelevant.
The test is not whether the recipient of the mistaken payment reasonably believed that the payment was genuine and not the result of mistake. The test is whether a prudent person . . . would have seen fit in light of the warning signs to make reasonable inquiry . . . in which case the recipient would be chargeable with the knowledge that such reasonable inquiry would have revealed. It is an objective test, not dependent on what the actual recipient believed.
In sum, the Second Circuit held that each of the recipient lenders should “have seen fit to make a telephone call to inquire of Citibank[,]” and ruled, for purposes of the discharge-for-value doctrine, that they were on inquiry notice, meaning that they were deemed to have knowledge of what such a call would have revealed.
Entitlement to Funds
The Second Circuit further found that the lenders could not satisfy the discharge-for-value doctrine because the loan was not due to mature until 2023. After parsing the applicable precedent cases, the Court determined that the discharge-for-value doctrine under New York law required that the recipient of a mistaken payment have a “present entitlement” to the funds, either due to loan maturity or acceleration of the debt following a default. Since the lenders had no “present entitlement” to the funds at the time of Citibank’s mistaken transfer, the Court held that the lenders “may not invoke the discharge-for-value rule against Citibank’s claims for restitution.”
In the end, the Second Circuit appears to have been swayed in large part by equitable considerations, stating that “[a]pplication of the discharge-for-value rule to our facts brings the Lenders a huge windfall over and above what they bargained for, while an order of restitution would leave them exactly where they contracted to be.”
Although the particular facts presented of Citibank, N.A. v. Brigade Management, et al., are unlikely to arise again, there are numerous legal doctrines in which, similar to the discharge-for-value doctrine, a person’s knowledge of particular facts can be determinative. The Second Circuit’s holding that inquiry notice rests on an objective standard rather than a person’s subjective good faith belief for purposes of imputing such knowledge will be cited in such cases.