Case Summary – Citibank, N.A. v. Brigade Capital Management, LP, 2022 WL 4102227 (2d Cir. Sept. 8, 2022)
In a recent decision from the U.S. Court of Appeals for the Second Circuit (the “Second Circuit”), a lower court decision allowing lenders to retain mistaken payments of approximately $500 million in outstanding principal was overturned. The lower court concluded that the lenders established the discharge-for-value defense because the payments they received were in exact amounts owed and because they did not have notice of the mistake. On appeal, the Second Circuit held that the discharge-for-value defense only applied if recipients of mistaken payments did not have inquiry notice of the mistake and if the recipients were entitled to the funds received. Because the lenders were aware of the debtor’s financial troubles, because the debt at issue was trading for 20-30 cents on the dollar, and because there was no advance notice of the principal payment as required under the loan documents, the Second Circuit held that the lenders should have inquired into whether the payments of principal were the result of a mistake. Additionally, because the loan was not yet mature, the Second Circuit held that the lenders were not entitled to the mistaken payments of outstanding principal.
The Second Circuit’s decision highlights how lenders’ knowledge of a debtor’s financial troubles and provisions requiring prior notice of unscheduled payments can result in restitution of payments mistakenly made on the debtor’s behalf. To avoid a similar result, lenders may consider allowing payments from debtors at any time without prior notice. Additionally, lenders may consider inserting provisions in their loan agreements whereby the parties agree that the lenders are under no obligation to investigate the genuineness of any payments they receive on account of amounts owed under the loan.
I. Factual & Procedural Background
In 2016, Revlon, Inc. (“Revlon”) took out a seven-year $1.8 billion syndicated loan (the “2016 Loan”), with Citibank, N.A. (“Citibank”) serving as Administrative Agent of the loan. Among Citibank’s responsibilities was to receive payments of principal and interest from Revlon due under the 2016 Loan, and then transmit those payments to the various participating lenders.
In the spring of 2020, Revlon was experiencing severe liquidity issues and needed to raise additional capital. To facilitate the capital infusion, Revlon entered into an agreement with some of the participating lenders, whereby the 2016 Loan agreement was amended and the principal owed to this subset of participating lenders was rolled-up with new loans maturing in 2025. Not all of the participating lenders, however, consented to this transaction (the “May 2020 Transaction”), with some filing suit against Revlon. In this suit, the lenders argued that the May 2020 Transaction violated the 2016 Loan agreement, and improperly siphoned away collateral securing the 2016 Loan. The lenders further alleged that Revlon was still in severe liquidity crisis, and expressed concern that Revlon would be unable to repay the 2016 Loan.
As part of the May 2020 Transaction, Revlon was required to pay outstanding interest owed to the subset of participating lenders, with the outstanding principal owed to these lenders being rolled-up in new notes issued by Revlon. While no interest payment was due under the terms of the 2016 Loan, Revlon decided to pay outstanding interest to all participating lenders, rather than just the subset of lenders whose debt was being rolled-up into new loans. Accordingly, Revlon instructed Citibank to pay all outstanding interest on the 2016 Loan as of August 11, 2020. Unfortunately, due to an error of Citibank’s employees, the entire amount owed under the 2016 Loan was released to the participating lenders, rather than just the outstanding interest.
After some of the lenders refused to refund the mistaken principal payments, Citibank filed suit in the U.S. District Court for the Southern District of New York (the “District Court”), asserting claims of unjust enrichment, conversion, money had and received and payment by mistake. The District Court, relying on Banque Worms v. BankAmerica Int’l, 77 N.Y.2d 362 (1991), held that the defendant lenders did not have to repay the mistaken principal payments to Citibank because the District Court found that the lenders established the elements of the discharge-for-value defense. The District Court concluded that because the defendants were creditors of Revlon, each of whom were owed principal and interest from Revlon in amounts equal to the payments they received from Citibank, and because the defendants did not make misrepresentations to induce the mistaken payments and were not on notice of Citibank’s mistake, their obligation to repay the mistaken principal payments was excused.
II. The Discharge-for-Value Exception
On appeal, the Second Circuit noted that the default rule governing mistaken payments under New York law requires restitution of the payment “unless the recipient so significantly changed its position in reliance on the mistake that it would be unjust to require repayment.” This rule “is predicated upon the principal that a party who pays money under a mistake of fact, to one who is not entitled thereto, must in equity and good conscience be permitted to get it back.”
The discharge-for-value rule is an exception to this default principal and was adopted by the New York Court of Appeals in Banque Worms. In that case, the New York Court of Appeals explained the policy behind the exception, stating that:
When 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.
Banque, 77 N.Y.2d at 373. Accordingly, based upon this policy rationale, the Second Circuit concluded that the discharge-for-value exception is not applicable under New York law when the beneficiary of a mistaken transfer has constructive knowledge of the mistake or when the beneficiary is not entitled to the funds received.
a. Defendants Were on Inquiry Notice
While the parties disagreed as to the applicable standard to determine if recipients of mistaken payments had constructive knowledge of the mistake, the Second Circuit found that the inquiry notice standard applies, which provides that:
If a person has knowledge of such facts as would lead a fair and prudent man, using ordinary thoughtfulness and care, to make further accessible inquiries, and he avoids the inquiry, he is chargeable with the knowledge which by ordinary diligence he would have acquired.
i. Red Flags
In applying the inquiry notice standard, the Second Circuit stated that there were several red warning flags that required the defendant lenders to inquire as to whether the principal payments were the result of a mistake. First, the Second Circuit noted that under the terms of the 2016 Loan agreement, Revlon was permitted to make prepayments of principal, but only upon irrevocable written notice to Citibank 3 days in advance, and that Citibank was in turn required to “promptly” notify the participating lenders of the prepayment. Citibank provided no notice to the participating lenders of any prepayment of the 2016 Loan by Revlon prior to the mistaken payments of principal. While “promptly” was not a defined term, the Second Circuit rejected arguments that notice could be given after the prepayments were made, noting that prior notice to participating lenders allowed them the opportunity to redeploy the funds into other investments quickly upon receipt. Thus, the Second Circuit found that Citibank’s failure to provide such notice was suggestive of a mistake.
Second, Revlon’s financial condition and apparent insolvency were also suggestive of a mistake. The Second Circuit relied heavily on the lenders’ complaint challenging the 2020 May Transaction where they expressed concern that Revlon would be unable to repay the 2016 Loan. Accordingly, the Second Circuit stated that the lenders were aware of Revlon’s distressed financial condition. Thus, Revlon’s sudden and unexpected deployment of nearly $1 billion to retire the 2016 Loan would have stimulated doubt in the mind of a prudent investor. Additionally, the Second Circuit noted that at the time of the mistaken principal payments, participations in the 2016 Loan were trading around 20-30 cents on the dollar. As a result, Revlon could have retired the debt far more cheaply by purchasing these participations on the open market.
The District Court dismissed many of these red flags by finding that it was reasonable for the defendant lenders to assume that the payments they received in exact amounts owed under the 2016 Loan by Citibank, one of the largest and most sophisticated financial institutions in the world, would not have been the result of a mistake. The Second Circuit, however, noted that the inquiry notice test is objective rather than subjective. Thus, because the red flags were not explained away by the unlikelihood that a mistaken payment would have matched the amount of the outstanding debt, the Second Circuit concluded that a prudent investor would have at least made a telephone call to Citibank to inquire as to whether the payments were the result of mistake, a call which would have revealed the mistaken nature of the payments.
b. Defendants Were Not Entitled to the Principal Payments
Additionally, the Second Circuit held that the discharge-for-value exception did not shield the defendant lenders from restitution because it concluded that the lenders were not entitled to the principal payments. Since the 2016 Loan did not mature for another 3 years, payment of outstanding principal by Revlon was not required and, therefore, the defendants were not “entitled” to such payments. The Second Circuit distinguished Banque because the loan at issue in that case, was due and payable, and the lender had made demand for such payment. The Second Circuit further noted that the word “entitled” denotes “a legal right,” and that creditors only have a “legal right” to the funds loaned when the debtor has an obligation to repay those funds.