ABA Section of Business Law

Volume 15, Number1 September/October 2005

To blow the whistle or not?
Banks get mixed messages on dealing with customer fraud
    By Thomas P. Vartanian and Mark Fajfar

Abank discovers that one of its customers is cheating the bank. Does the bank have to report the fraud to other lenders of the cheater or to government agencies? The answer isn't easy.

Recent judicial and regulatory actions have sent mixed messages to financial institutions regarding their responsibility to detect and report financial improprieties in which their customers may be engaged. In the courts, headline-grabbing cases, such as those involving Enron, encourage banks to monitor their customers closely, while on the other hand recent decisions of the Second and Seventh circuits have reiterated the limited fiduciary duty that lending financial institutions owe to other creditors of failing companies.

The discrepancies between these precedents may be reconciled — but that reconciliation requires a careful, post-hoc legal analysis of whether the financial institution participated in, as opposed to being merely aware of, the fraud. Unfortunately, the financial institution may not be able to draw such neat distinctions in real time, when it is confronted by the ever-changing circumstances of a customer facing financial difficulties.

Financial institutions find no more certainty on the regulatory front, where mixed signals result when regulators are driven by conflicting priorities. The "triple threat" financial regulators face — terrorist financing, money laundering and corporate fraud — is counterbalanced by legitimate concerns regarding over-regulation.

Thus, while taking a strong stand against fraud, regulators also point out that the number of actual enforcement cases brought is very small and concentrated on those financial institutions facing allegations of serious impropriety. The regulators are also rightly concerned that since even the specter of regulatory action could create a "blacklist" of customers who would be unable to obtain financial services, an overly aggressive approach could do more harm than good. While the contradictory pressures the regulators face are understandable, financial institutions are justified in feeling that they are being hit both coming and going.

As it begins to suspect that a customer is involved in unusual financial activity, a financial institution's "know your customer" and Bank Secrecy Act (BSA) obligations may require that it take further due diligence steps, file a Suspicious Activity Report (SAR), raise the issue directly with a regulator, or even terminate the account.

On the other hand, such actions not only raise the institution's cost of doing business exponentially, they may hinder the customer when it is most in need of sensitive financial services. Thus, for the financial institution, the customer's financial difficulty is likely to present a series of imponderables: To what extent should the institution investigate the cause of its customer's difficulty? How aggressively should it work to assist its customer? Must it report the customer to a regulator?

A prime example of the regulators' mixed messages came in late April, when the federal banking agencies issued Interagency Interpretive Guidance on Providing Banking Services to Money Services Businesses Operating in the United States, OCC [Office of the Comptroller of the Currency] Bulletin 2005-19 (April 26, 2005) (the MSB Guidance). The MSB Guidance takes the unusual step of confirming that it is possible to comply with the law — a matter that is not typically in doubt — stating that financial institutions may "provide services to . . . money services businesses while remaining in compliance with the Bank Secrecy Act."

At the same time, the MSB Guidance reiterates the "long-standing practices" under which financial institutions are required to file a SAR when they know or suspect that a violation of law or regulation has occurred. In particular, the MSB Guidance indicates that a SAR is to be filed if a money service business has not registered (if required) with the Financial Crimes Enforcement Network (FinCEN), or has not obtained any license required by state law.

Overall, the MSB Guidance urges financial institutions to view their money service business customers through a "risk assessment" prism and evaluate the risk that a particular customer is involved in illicit activity.

While the MSB Guidance makes clear that a financial institution may inform the government when it suspects its customer has violated the law, the regulators are far more circumspect regarding a financial institution's duty, or even ability, to inform other private parties of a customer's suspicious activities.

For example, if a financial institution becomes aware that a customer is initiating suspicious wire transfers, it may take advanced due diligence steps and other actions, leading ultimately to closing the customer's account. In that event, however, the financial institution is not required — and may not even be permitted — to notify the bank that has received the suspect wire transfers.

One reason for this approach is that the federal banking regulators wish to avoid creating a "blacklist" of customers who are unable to obtain banking services. Thus, we return full circle to the main reason for the issuance of the MSB Guidance.

In view of these regulatory practices, the recent decisions of the Second and Seventh Circuit Courts of Appeals are less of a surprise. The decisions involve financial institutions that suspected a bad credit risk and stopped lending to the customer, but continued to accept payments on the credit outstanding. When the customers involved later went out of business, other creditors filed suit, claiming the financial institutions should have alerted the other creditors to the potential for loss.

In both instances, the court held that the financial institution did not have a fiduciary duty toward the other creditors and therefore had no duty to notify. Because financial institutions have recently been inundated with (justifiably) dire warnings of potential BSA liability, it is worthwhile to examine these decisions in depth, in order to bring perspective and balance to the issue.

In B.E.L.T. Inc. v. Wachovia Corp., 403 F.3d 474 (7th Cir. 2005), the Seventh Circuit held that a bank that accepted loan repayments from a company it suspected of fraud is not liable to other lenders. In Sharp International Corp. v. State Street Bank and Trust Co., 403 F.3d 43 (2d Cir. 2005), the Second Circuit concluded that "the complaint says no more than that State Street relied on its own wits and resources to extricate itself from peril, without warning persons it had no duty to warn," since under New York law, State Street had no fiduciary duty to other creditors.

B.E.L.T. v. Wachovia highlights the distinction between the broad regulatory requirement to file SARs and the narrow duty to warn other lenders of a potential bad credit risk. In this case, predecessors to Wachovia — institutions that Wachovia acquired — were creditors of Lacrad International Corp. By 1999, when Lacrad and its managers owed more than $2 million on a revolving loan and credit cards, Wachovia's predecessors determined that Lacrad was a credit risk and stopped making loans, but continued to accept payments from Lacrad. Lacrad was subsequently liquidated outside bankruptcy.

Other lenders sued Wachovia, contending that Wachovia should have told bank regulators of its suspicions. Even though Lacrad's former CEO eventually pleaded guilty to fraud and money laundering, the court rejected these contentions, ruling that "no one is entitled to the benefit of regulator intervention." The court pointed out that 12 C.F.R. § 21.11 (the OCC's SAR requirement) "does not create a private right of action for damages." Moreover, the court noted that 12 C.F.R. § 21.11(k) and Illinois law "instruct[] banks not to tell other private parties about their borrowers' activities."

The other lenders also claimed that they furnished Lacrad with the money used to pay down the Wachovia debt, and that since Wachovia did not tell them about its suspicions, it was liable for the return of such funds. The Seventh Circuit affirmed the district court's dismissal of the complaint, noting that Illinois law does not require one bank to warn other banks that a borrower is a potential credit risk. The court explained that Wachovia neither had any duty to plaintiffs to inform them of Lacrad's financial difficulties, nor did it act with an intent to hinder or defraud any of Lacrad's other creditors.

Sharp International Corp. v. State Street Bank and Trust Co. revolves around the systematic looting of Sharp by its controlling shareholders. Through its trustee in bankruptcy, Sharp sued one of its former lenders, State Street, claiming State Street suspected the fraud and managed to get most of its line of credit paid off before Sharp fell into bankruptcy.

The facts found by the court are: Beginning in 1997 and continuing through 1999, Sharp's controlling shareholders "falsified sales, inventory and accounts receivable, and invented customers, in order to report fictitious revenue on Sharp's nonpublic financial records." They then relied on these inflated revenue figures to borrow "increasingly large sums of money." They also allegedly diverted more than $44 million from Sharp to their various entities.

A State Street senior lending officer began to suspect fraud in the summer of 1998. Even though Sharp was current with its loan payments, the loan officer alerted more senior State Street employees of her concerns, an employee was especially assigned to assist with the account, and State Street hired outside legal counsel specializing in troubled loans. State Street also asked to see the work papers of Sharp's outside auditor and sought more information from Sharp about its largest customers. At the same time, State Street's outside counsel retained a financial investigation firm to conduct an inquiry.

In November 1998, State Street learned that one of Sharp's customers could not be located, one had been out of business since 1991, and others were not engaged in the businesses as stated by Sharp. Based on the results of its investigation, State Street demanded that Sharp get new financing to pay off State Street's line of credit, in exchange for additional time to retire the debt to State Street and avoid foreclosure. Sharp thereafter approached its noteholders for an additional $25 million in financing, of which it used $12.25 million to pay the State Street debt.

In July 1999, Sharp's accountant refused to issue a 1999 opinion, withdrew its 1997 and 1998 opinions, and terminated its engagement with Sharp. In September 1999, the Sharp noteholders filed an involuntary Chapter 11 bankruptcy proceeding against Sharp. The bankruptcy court entered a $44.38 million judgment against the controlling shareholders and their affiliates, some of whom subsequently pled guilty to criminal charges of defrauding State Street and others.

Sharp's bankruptcy trustee filed suit in bankruptcy court, claiming that State Street enabled (aided and abetted) the breach of fiduciary duty of the controlling shareholders and that the payment State Street received from Sharp was a fraudulent conveyance. The district court affirmed the bankruptcy court's dismissal of these claims, because even if Sharp had adequately alleged State Street's actual knowledge of the entire scheme, it did not allege that State Street participated in or induced the fraud. The Second Circuit affirmed.

The Second Circuit reasoned that since the damages claimed by Sharp are premised on the looting of $19 million from Sharp by its controlling shareholders, and not on the controlling shareholders' fraudulent borrowing on Sharp's behalf, the plaintiffs would have to show that State Street aided or abetted the fraudulent looting. In this regard, the court found that under applicable New York law, the relevant question is whether the actions highlighted by plaintiffs in alleging State Street's liability constitute State Street's participation in or inducement of that fraud.

The court held that State Street's demand that Sharp obtain new sources of financing to retire the State Street debt cannot be characterized as either participation or inducement. Rather, demand for repayment of a bona fide debt is consistent with the lender's contractual and legal rights, and does not create aider and abettor liability.

Sharp also claimed that State Street induced the fraud by giving its express written consent to the noteholders' purchase of an additional $25 million of subordinated notes. The Second Circuit, however, held that State Street's consent was a mere forbearance and did no more than remove a potential hurdle to the additional borrowing that State Street had a right to invoke. State Street had no duty to consider the interests of other parties in determining whether or not to consent, and the fact that State Street protected itself without necessarily taking steps to protect other lenders did not constitute participation in the fraud.

The Second Circuit concluded that State Street did not participate in or induce the controlling shareholders' fraud, because such a finding is proper only where the bank "affirmatively assists, helps conceal or fails to act when required to do so, thereby enabling the breach to occur. Mere inaction of an alleged aider constitutes substantial assistance only if the defendant owes a fiduciary duty directly to the plaintiff."

In this case, however, State Street owed no duty directly to Sharp, since, quoting Bank Leumi Trust Co. v. Block 3102 Corp., 580 N.Y.S.2d 299, 301 (1st Dep't A.D. 1992) for New York law, the "legal relationship between a borrower and a bank is a contractual one of debtor and creditor and does not create a fiduciary relationship."

In the final analysis, the court found that State Street's knowledge of the fraud was the result of "its own diligent inquiries that any other lender could have made," and in deciding what to do with that knowledge, State Street's fiduciary duty ran to its own shareholders, rather than to Sharp or other creditors of Sharp.

While financial institutions may take some comfort from the Wachovia and State Street decisions, they should certainly not misapprehend the financial regulators' commitment to vigorous, if prudent, enforcement of the SAR filing requirement and other provisions of the BSA. Although the regulators have signaled that they intend to focus their enforcement efforts on those institutions with the greatest risk of noncompliance (and such institutions likely know who they are), the regulators' discretion presupposes that other financial institutions will continue the diligent compliance efforts they have demonstrated in the past.

Moreover, in the final analysis, the courts, the regulators and all other stakeholders agree that a financial institution has a responsibility to its shareholders and customers to operate continually in a safe and sound matter. That requires prudent attention and enhanced due diligence steps when a financial institution begins to suspect that a customer may be involved in financial impropriety.