“Bank Error in Your Favor” Only Works in Monopoly

As modern software has made complex transactions easier to execute, it has also enabled banks to make enormous mistakes with a single click of a mouse.

A federal district court’s ruling last year in a case involving Citibank threatened to turn wire transfers into a game of high-stakes roulette, where some recipients of unintentional wires could legally claim “finders keepers.”

Thankfully, the decision was recently reversed by the Second Circuit Court of Appeals, which interpreted a legal defense called “discharge-for-value” in a way that should forestall further upheaval and give banks comfort that a missed checkbox won’t cost them millions.

Discharge-for-value is a defense that can be invoked by creditors who receive a payment that the debtor later claims was made in error. It allows a recipient to keep the supposedly mistaken payment, if it has already given value to the payor in exchange and had no advance notice that the payment was a mistake. Long a fixture of New York law, the defense was first recognized in Iowa in 2011, citing a 1991 Second Circuit case. See National Bank v. FCC Equipment Financing, Inc., 801 N.W.2d 17 (Iowa Ct. App. 2011) (citing Banque Worms v. BankAmerica International, 928 F.2d 538, 540 (2d Cir.1991)). In the context of bank transfers, discharge-for-value has historically been applied to payments that were made on a debt that was already due. But in the recent In re Citibank case, a federal district court held that it applied to an erroneous wire transfer that inadvertently paid off loans three years before they came due. If that decision had stood, Citibank’s “fat finger” mistake would have cost it $500 million.

The Error

The problem for Citibank began in August 2020, when it was instructed to process $7.8 million in interest payments to the debtholders of its client, Revlon. The interest payments were part of a “roll-up” transaction that would restructure Revlon’s $1.8 billion in existing loans, most of which were not due for another three years. In order to process the interest payments, Citibank employees used a software application called Flexcube, which automatically calculated the interest owed to each lender and routed the payments to the appropriate accounts. But the only way to complete the roll-up in Flexcube was to enter the transaction as if Revlon was paying off the loans in their entirety, while routing all payments of principal to an internal Citibank “wash account.” What happened next was a disaster: the Citibank employees only clicked one of three checkboxes necessary to keep the principal payments from leaving the bank. Approximately $894 million was wired to Revlon’s debtholders in error.

Citibank discovered the mistake the next morning and began sending recall notices that afternoon. Managers representing approximately 200 debtholders honored the recall notices and returned about $385 million to Citibank. But ten managers, representing 126 debtholders, refused to return approximately $500 million in mistakenly wired funds. At the time, Revlon’s debt was trading at 20 to 30 cents on the dollar, making the mistaken wire transfer an enormous potential windfall to those debtholders. 

Within six days of its mistake, Citibank brought a federal lawsuit against the recalcitrant debtholders in the Southern District of New York, with claims for unjust enrichment, conversion, and payment by mistake. The district court issued temporary restraining orders barring the defendants from disposing of the money, and in December 2020 it held a bench trial via Zoom.

The Initial Ruling

On February 16, 2021, the district court issued a ruling that shocked much of the financial world: The defendant debtholders were entitled to keep their $500 million windfall, and Citibank was on the hook for its enormous mistake. Applying the discharge-for-value defense, the court held that it did not matter that the loans were not due at the time of the wire transfer, because the defense did not require “present entitlement” to the funds received. The court also determined that the debtholders had no reason to suspect that the wire transfer was made in error. It reasoned that because the wires had totaled “to the penny” the amount of principal and interest owed to each debtholder, the debtholders were right to assume that Revlon intended to repay its debt in full, three years early. The court implied that Citibank did not have adequate internal controls, and opined that an erroneous payment made to the penny was an extremely unlikely “black swan event” unlikely to be repeated by a careful bank.

Reaction to the Ruling

The ruling was met with astonishment from legal observers inside and outside the United States, prompting publications in Canada, Hong Kong, and the UK to assure readers that the New York discharge-for-value defense did not apply under their local law. The ruling also roiled the market for commercial debt, causing hundreds of parties to new credit agreements to adopt so-called “Revlon blocker” provisions overriding the district court’s interpretation of discharge-for-value.

Citibank promptly appealed the decision. As part of the appeal, multiple amicus briefs were filed urging reversal of the district court’s ruling and warning about the dangers of a financial system that punished mistaken wire transfers. These included briefs from the American Bankers Association, the Loan Syndications and Trading Association, and the Securities Industry and Financial Markets Association.

Prior to joining Dickinson, I was the primary drafter of one such brief, on behalf of former United States Comptroller of the Currency Robert L. Clarke. In that brief, Mr. Clarke warned the Court of Appeals that no amount of oversight or technical sophistication on the part of banks could completely eliminate the risk of misdirected fund transfers, so long as automated transfer systems require some degree of human involvement. In researching Mr. Clarke’s brief, I discovered that five such “black swan” mistaken wire transfers—each totaling hundreds of millions of dollars—had been publicly reported since 2014. Mr. Clarke and other amici urged the Court of Appeals not to interpret discharge-for-value to needlessly prioritize finality over fairness with regard to inadvertent wire transfers.

The Second Circuit Decision

On September 8, 2022, the Court of Appeals for the Second Circuit reversed the district court’s opinion. The court found two independent reasons that the debtholders were not entitled to rely on the discharge-for-value defense. First, the debtholders had “constructive notice” that the payments were a mistake because of numerous “red flags.” These included the fact that at the time, Revlon was so widely suspected to be insolvent that its debt was trading at 20 to 30 cents on the dollar. Second, the Court determined that under New York law, the discharge-for-value defense only applies when the recipient is legally entitled to the money at the time of the payment. Because Revlon’s loans were not due for three years, its debtholders could not rely on discharge-for-value to keep the mistaken payments.

In a separate addendum, Judge Pierre Leval, who also authored the majority opinion, questioned whether the discharge-for-value rule should even apply at all to money transferred purely by accident. He noted that the issue had not been raised by the parties to the lawsuit, and given the outcome, was not something the Court needed to decide this time. But he wrote that it “appears to me that the discharge for value rule has no application to the payment made in this case—an accidental payment made without intent to pay, without intent to discharge a debt or lien, and without mistake as to the transferor’s duties or interest.” He offered that he hoped his discussion of the issue “may be helpful in the analysis of future similar disputes.”

The Aftermath of the Case

While the lawsuit and appeal were pending, Revlon was unable to secure necessary senior financing, because no one could agree on who would constitute a majority of its creditors. Revlon filed for Chapter 11 bankruptcy on June 15, 2022, and blamed its “significant and unprecedented difficulty in managing its capital structure” on the fact the Second Circuit had not yet issued a decision in the Citibank case. 

In a separate concurring opinion, Judge Michael Park lamented the delay, writing, “the correct conclusion in this case was clear from the start. At bottom, Defendants received a payment to which they were not entitled, for which they did not bargain, and on which they did not rely. Their only real asserted justification for keeping Citibank’s money is ‘finality’—the fact that they have it. But that is not enough to claim ownership over someone else’s property. Possession is not ten-tenths of the law.”

Takeaways

The final outcome of the case, In re Citibank August 11, 2020 Wire Transfers, should offer some measure of reassurance to banks and the market that the long-understood status quo remains intact: if a bank or other agent sends funds by mistake, the law requires that those funds must be returned. But the case also exposed some ambiguity in the discharge-for-value defense that may come up in other jurisdictions where the defense is recognized—including Iowa. 

Importantly, Citibank benefited from the fact that Revlon’s debtholders could be located and reached through legal process. Not every party that sends an unauthorized wire transfer is as fortunate. This blog recently covered the legal status of funds once a wire transfer is completed. In this case, Citibank was not entitled to recall the wire transfer, but instead had to rely on independent legal claims to freeze and return the funds. In many instances of fraudulent transfers the recipient of the funds either disappears or is unreachable by U.S. Courts. In those cases, once the funds have been disbursed to the recipient, there may not be any opportunity reclaim the funds.

Finally, the case serves as a reminder that it’s better to take all possible precautions to avoid errors, instead of risking spending years sorting them out in court.