Interesting New York court decision provides warning for financial institutions in relation to possible retention by recipients of mistaken payments

On 16 February 2021, Judge Jesse Furman of the United States District Court for the Southern District of New York ruled, in a 105-page decision, that recipients of erroneous transfers made by Citibank N.A. of its own money to creditors of Revlon, Inc. were entitled to retain the sums totaling more than $500 million: In re Citibank August 11, 2020 Wire Transfers.

While the court applied a well-established exception under New York law, known as the “discharge-for-value defense”, to the general rule that failure to return money wired by mistake constitutes unjust enrichment or conversion, this decision – notable not least for the large amounts in dispute (Citibank mistakenly transferred almost $900 million in all, but some of the recipients voluntarily returned the money upon realizing the error) – underscores the competing policy considerations of the defense and raises questions of its own.

This outcome contrasts with the legal position on mistaken payments in the UK, under which there is no equivalent discharge-for-value defence. The overall statutory regime governing this situation is the Payment Services Regulations 2017. In the UK, the recipient must instead rely on general restitutionary defences in particular the change of position defence. This sets a far higher bar for recipients to meet; they will be required to prove that their circumstances changed detrimentally as a result of the receipt of the enrichment and that they are not disqualified from relying on the defence.

Amal Bouchenaki, Christian Leathley, Liang-Ying Tan and Alisha Mathew from our New York office consider the decision further below.

Factual background

The relevant facts were largely undisputed: in 2016, Revlon took out a term loan set to mature on the earlier of 7 September 2023, or, if certain notes remained outstanding, 16 November 2020. Citibank was the administrative agent for the loan. On 11 August 2020 Citibank sought to make certain payments under a roll-up transaction aimed at facilitating the exit of five lenders from the original term loan. The easiest way for Citibank to pay the five lenders their share of the principal and interest and to reconstitute the loan with the remaining lenders using Citibank’s software, was for Citibank to input in the system that it was paying off the loan in its entirety, but to direct the principal portion of the payment into a Citibank internal “wash account”. The persons carrying out the transaction mistakenly believed they had assigned the principal to go to the wash account, as did the three people who reviewed the transaction under Citibank’s “six-eye” approval procedure. Instead, all the outstanding money on the loan – principal and interest – was distributed to the lenders.

When the error was discovered the next day, Citibank issued Recall Notices to the lenders explaining that the funds had been transferred in error, and asking for the principal to be returned. While some lenders returned the money, others withheld, leading Citibank to file lawsuits against the defendants – 10 investment advisory firms – claiming unjust enrichment, conversion, money had and received, and payment by mistake.

Issues

The primary issue in the proceedings was whether the defendants had established the elements of the discharge-for-value defense under New York law, which would be a complete defense to Citibank’s claims. In essence, this defense relieves a creditor from a duty to make restitution after a mistaken payment, provided the creditor made no misrepresentation, and did not have notice of the transferor’s mistake. Noting that the discharge-for-value defense was well established following the New York Court of Appeals’ 1991 decision in Banque Worms v. BankAmerica Int’l, 570 N.E.2d 192 (N.Y. 1991) (Banque Worms), Judge Furman first considered the relevant standards for invoking this defense.

Must the debt be due?

The first issue was whether the debt must be due at the time of discharge, rather than simply outstanding – with Citibank contending the former. Judge Furman considered the language in the Restatement (First) of Restitution, the decision by the Second Circuit and Court of Appeals in Banque Worms, and subsequent jurisprudence to conclude that there was no “present entitlement” element to the defense, i.e. the recipient did not need to show that an outstanding debt was due in order to rely on the defense.

When should notice be assessed?

Citibank then contended that the relevant time for assessing notice was at the moment payment is formally credited to the creditor, rather than when payment is received. Judge Furman disagreed, finding that the issue had already been decided in Banque Worms, and that notice is to be assessed at the time the money is received. Judge Furman also noted that the alternative would run contrary to the principle of finality, as it is difficult to pinpoint exactly when funds are formally credited. Rather than promoting finality, Judge Furman stated that this would be a “recipe for litigation.”

Actual or constructive notice?

Finally, at issue was whether the discharge-for-value defense could only be defeated if the recipient had actual notice, as opposed to constructive notice, with the defendants contending the former. On this point, Judge Furman agreed with Citibank, relying on earlier jurisprudence and drawing parallels to the bona fide purchaser rule. Additionally, Judge Furman noted that applying an actual notice standard would be impracticable, as it would only apply if the transferor in effect submitted notice that the payment was in error either before or when making the payment – a scenario that is unlikely to arise.

Analysis

It was undisputed that the defendants were bona fide creditors, and that they made no misrepresentations to induce the mistaken wire transfer. The issue therefore was whether the defendants had constructive notice of Citibank’s mistake at the time the wire transfer was received. Judge Furman found they did not.

First, Judge Furman found that the defendants had provided credible testamentary and documentary evidence that they reasonably believed the payments to be intentional prepayments of the original term loan. He noted the fact that the amounts received matched “to the penny” the amounts outstanding, as well as the fact that Citibank is one of the most sophisticated financial institutions. This, he said, made it plausible for the defendants to believe that the payments were prepayments rather than an error: “Put simply, where, as here, a lender is minding her own business, and receives an unexpected and unscheduled payment from a borrower that matches exactly the amount of the borrower’s outstanding debt, it is reasonable to assume that the borrower has intentionally paid off the debt. In fact, it might even be unreasonable to assume otherwise.” Judge Furman therefore dismissed Citibank’s argument that the size of the transfer should have led defendants to conclude that the payments had been made in error.

To the extent that the defendants had any duty to inquire (which the court left open), Judge Furman held that this was satisfied by the defendants having taken a closer look at the payment, confirming that they were made with respect to the original term loan, and consulting third-party market data.

Citibank also argued that the defendants should have realized that the payments were in error as they knew Revlon was insolvent and facing a severe liquidity crisis – in other words, Revlon could not have repaid its loan. Judge Furman dismissed this argument, noting that Revlon was known to have strong financial backing from its 85% equity holder and had paid off loans in May 2020.

Finally, Judge Furman also dismissed Citibank’s argument that allowing the defendants to retain the money would be bad policy, as it would chill the practice of wire transfers, and force banks to insure against errors thereby increasing costs for borrowers and lenders. Judge Furman noted that similar arguments had been made in Banque Worms, and that the significant time that has passed since that decision “casts considerable doubt on [Citibank’s] assertion that the sky will fall for the New York banking industry if the defendants here prevail.” Rather, Judge Furman noted that there are various steps that banks can take to mitigate against a similar situation recurring – such as implementing a practice of providing notice of a payment prior to sending the payment, such that any discrepancy in the payment amount would put the recipient on notice.

Judge Furman accordingly found that the defendants had established the discharge-for-value defense and were entitled to retain the money transferred. Anticipating that Citibank would appeal the decision, Judge Furman ordered that the temporary restraining orders placed over the money remain in place. The parties have since agreed to a timetable for a motion on the injunctions – with the motion to be filed by 2 March 2021.

Conclusion

In applying established principles of New York law on the discharge-for-value defense, this case underscores that a mistaken wire transfer to a creditor may not be recoverable. Crucially, in determining whether the recipient was on constructive notice of the mistake at the time of the transfer, witness testimony may be significant in establishing the reasonableness of a recipient’s belief that payment was intentional. Judge Furman’s decision is also notable for its attention to the underlying policy considerations, which might assuage concerns of unfairness in the outcome of this case.

Nonetheless, it appears likely that this case will be appealed, and the decision leaves open a number of questions (not before Judge Furman). For example, given the focus of the decision was on the defendants’ entitlement to retain the funds, the issue of how Citibank’s payments should be characterized remains unanswered, particularly given that the debt was not Citibank’s. Further, it remains to be seen whether Citibank could have any recourse against Revlon, if an eventual appeal against Judge Furman’s decision is dismissed.