Ponzi schemes are increasingly in the news. Recently, the FBI released information about an $18 million Ponzi scheme based out of Nashville, Tenn., in which three men involved in the Hanover Corp. pled guilty to securities fraud, money laundering and conspiracy.[1] In that scheme, the three men offered clients the opportunity to invest in Hanover through promissory notes bearing high interest rates. In this classic Ponzi scheme, Hanover promised that the money would be invested in stock options and startup companies. In reality, the money went to repay earlier investors, pay Hanover’s salaries and overhead, or to line the pockets of the three defendants.[2]
Ponzi schemes can be quite elaborate. In general, “[a] ‘Ponzi Scheme’ is a fraudulent investment arrangement in which investors’ income [comes] from monies obtained from the new investors rather than an underlying business enterprise.”[3] The Ponzi scheme “gives the appearance of being profitable by obtaining new investors and using those investments to pay for the high premiums promised to earlier investors.”[4] In a recent case in Cincinnati, one schemer provided quarterly statements to his investors indicating gains and market growth, and even sent 1099 tax forms reporting income.[5]
Ponzi schemes sometimes surface in bankruptcy; in these situations, trustees can rely on § 548 to undo transfers to the early investors to make whole all investors. Take the most famous and elaborate recent Ponzi scheme involving Bernie Madoff. In a recent case involving his company, Bernard L. Madoff Investment Securities LLC, the trustee, Irving H. Picard, sought to undo transfers to multiple individuals on preference, fraudulent transfer and other grounds totaling nearly $245 million.[6] Just as with the smaller Cincinnati case above, Madoff generated investment advisory statements showing gains and losses in investors’ accounts and securities that had either been held or traded, which were entirely fictitious.[7] Some investors, however, withdrew amounts from the fictitious profit accounts. Picard used § 548 to attempt to recover those withdrawals for the benefit of the estate.[8]
The investor’s response to that § 548 action raises the thorny question of pleading. Section 548 provides:
The trustee may avoid any transfer (including any transfer to or for the benefit of an insider under an employment contract) of an interest of the debtor in property, or any obligation (including any obligation to or for the benefit of an insider under an employment contract) incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition, if the debtor voluntarily or involuntarily—
(A) made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted; or
(B)
(i) received less than a reasonably equivalent value in exchange for such transfer or obligation; and
(ii)
(I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation;
(II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital;
(III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured; or
(IV) made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of business.[9]
Investors in the Madoff case sought to dismiss for failure to plead. However, courts such as the one addressing the Bernie Madoff transfers have held that “[a]ctual fraudulent transfer claims brought under … section 548(a)(1)(A) of the Code … must meet the heightened pleading requirements of Rule 9(b) of the Federal Rules of Civil Procedure.”[10] This includes stating with particularity the circumstances that constitute fraud or stating conditions of the person’s mind, such as malice, intent or knowledge.[11]
The heightened-pleading requirement can be met by pleading three matters: (1) the property that was conveyed; (2) the timing and/or frequency of the transfer; and (3) the consideration for the transfer.[12] However, in bankruptcy matters, the heightened-pleading requirement is softened due to the trustee’s outsider status to the transfers. In complex cases, “the Trustee’s lack of personal knowledge is compounded with complicated issues and transactions [that] extend over lengthy periods of time…,” which drives a need for greater latitude.[13] This is particularly difficult in proving the actual intent element of § 548(a)(1)(A). “Pleading fraud on information and belief alone is acceptable if the specific fraudulent actions are inaccessible to the pleader.”[14]
The courts’ solution to this issue in cases involving elaborate Ponzi schemes is the so-called “Ponzi scheme presumption.” Where it applies, the actual intent element is met so long as the trustee can establish that the transferor ran a Ponzi scheme “because transfers made in the course of a Ponzi operation could have been made for no purpose other than to hinder, delay or defraud creditors.”[15] The fact that the transfers were accepted in good faith and in exchange for value serves only as an affirmative defense to a fraudulent transfer claim.[16]
To rely on the Ponzi scheme presumption, the trustee must sufficiently allege that the scheme was in existence at the time of each of the transfers sought to be avoided.[17] The trustee must also allege that the profits were fictitious.[18]
The trustee must, however, be clear as to each of the alleged transfers, identifying transferor, recipient, amount and date of transfer.[19] Where the trustee fails to do so, such as by indicating that the date of the transfer was “various” or similar, the court will grant a motion to dismiss.[20] Courts also require specificity as to the defendants. “[The Ponzi scheme presumption] does not permit plaintiffs to ‘merely lump multiple defendants together but requires [the complaint to] … inform each defendant separately of the allegations surrounding his alleged participation in the fraud.’”[21]
Other courts have codified the requirements to meet the Ponzi scheme presumption as requiring proof “of two basic facts: the existence and operation of a Ponzi Scheme using a debtor-entity that is under the jurisdiction of the court; and a transfer of property by the debtor-entity to another party, made in furtherance of the scheme.”[22] The element that the transfer be in furtherance of the scheme requires sufficient facts to “plausibly tie a given transfer functionally into the maintenance and perpetuation of a Ponzi scheme.”[23] This raises questions, in pleadings where transfers were made to employees or others not directly involved in the Ponzi scheme, as to whether they were in furtherance of the scheme.[24] Courts have ruled that a background pleading concerning the scheme can be relied on to establish how specific transactions could plausibly be in furtherance of the scheme.[25] For example, in In re Petters Co., the bankruptcy court found that lenders could be part of the Ponzi scheme:
So, as long as the Trustee specifically asserts the use of lender infusions in the flow through to earlier investors, and the payment out to earlier lenders and other purposes as a means to avoid default and to sustain the façade against collapse, there is a plausible basis for the furtherance element and the Trustee’s complaints against all varieties of lenders are adequately pled.[26]
The court applied similar reasoning in clawing back bonuses made to employees.[27] As to the pleading standard, the court held that “the ‘furtherance’ is properly pleaded by stating their status as employees, the time and duration of their employment, the circumstances under which they received their bonuses … and the Trustee’s factual theory as to the Debtor’s true motivation for awarding the bonuses.”[28]
Given this line of cases, it seems clear that a trustee must marshall as many facts as possible to plead the existence and operations of the Ponzi Scheme in a fraudulent transfer claim and provide as much detail about the facts of the transfers, such as a chart detailing transactions to specific defendants with specific dates, and any other details collected.
[1] FBI Press Release, “Three Tennessee Men Plead Guilty in $18 Million Ponzi Scheme,” Jan. 31, 2014, available at www.justice.gove/opa/pr/three-tennessee-men-plead-guilty-18-million-pon….
[2] Id.
[3] Bauman v. Bliese (In re McCarn’s Allstate Fin. Inc.), 326 B.R. 843 (Bankr. M.D. Fla. 2005).
[4] Janvey v. Alguire, 846 F. Supp. 2d 662 (N.D. Tex. 2011).
[5] Steve Watkins, “Another Cincinnati Adviser Admits to Running Ponzi Scheme,” Cincinnati Business Courier, Sept. 23, 2014, available at www.bizjournals.com/cincinnati/news/2014/09/23/another-cincinnati-advis….
[6] Picard v. Cohmad Sec. Corp. (In re Bernard L. Madoff Inv. Sec. LLC), 454 B.R. 317, 323 (Bankr. S.D.N.Y. 2011).
[7] Id. at 324.
[8] Id.
[9] 11 U.S.C. § 548. Fraudulent transfers may also be avoided under state law theories. Federal courts will then require that a trustee allege the existence of an actual creditor holding an allowable unsecured claim who could avoid a transfer under applicable state law in the absence of a bankruptcy proceeding. Neilson v. Union Bank of Cal., N.A., 290 F. Supp. 1101 (C.D. Cal. 2003).
[10] Picard v. Cohmad Sec. Corp. (In re Bernard L. Madoff Inv. Sec. LLC), 454 B.R. at 329.
[11] Id.
[12] Id.
[13] Id.
[14] In re NJ Affordable Homes Corp., 2013 Bankr. LEXIS 4798at *47 (Bankr. D.N.J. Nov. 8, 2013).
[15] Id. citing Gredd v. Bear Stearns Sec. Corp. (In re Manhattan Inv. Fund Ltd.), 359 B.R. 510, 517-18 (Bankr. S.D.N.Y. 2007).
[16] Id. at 331. This was discussed even further in the more recent case decided in the district court. There, the court examined the requirement that the transferee accepted the transfer with a lack of good faith as to the subjective standard of willful blindness or the objective standard of inquiry notice. Sec. Investor Prot. Corp. v. Bernard L. Madoff Inv. Sec. LLC, 2014 U.S. Dist. LEXIS 58709 (S.D.N.Y. Apr. 27, 2014).
[17] Hill v. Oria (In re Juliet Homes LP), 2001 Bankr. LEXIS 5116 at *37 (S.D. Tex. Dec. 28, 2011).
[18] Id.
[19] Id.
[20] Id.
[21] In re NJ Affordable Homes Corp., 2013 Bankr. LEXIS 4798 at *52 (Bankr. D.N.J. Nov. 8, 2013). However, in that case the trustee was tasked with unraveling fraud involving 500 investors, 77 entities and individuals, and comingled books and records across the entities. In this case, the court ruled that “it is evident that the Trustee would neither be able to, nor should he be required to, plead facts particular to each and every fraudulent transaction.” Id. at 54.
[22] In re Petters Co., 495 B.R. 887, 906 (D. Minn. 2013).
[23] Id. at 908.
[24] Id.
[25] Id. at 910.
[26] Id.
[27] Id. at 911.
[28] Id. at 912.