Over the past several years, creditors, bankruptcy trustees and receivers have used § 548 of the Bankruptcy Code and the Uniform Fraudulent Transfer Act (UFTA) to “claw back” amounts paid to winning investors in a Ponzi scheme (i.e., payments made to investors greater than their investment). In such cases, several courts have held that once the plaintiff proves the existence of a Ponzi scheme, then it is presumed that the transfers were made with the actual intent to hinder, delay or defraud the transferor’s creditors. The so-called Ponzi scheme presumption is a powerful tool for a plaintiff seeking to recover payments made to winning investors.
On Feb. 18, 2015, however, the Minnesota Supreme Court in the case Finn v. Alliance Bank[1] rejected the Ponzi scheme presumption, holding that creditors seeking to “claw back” payments to the winners of a Ponzi scheme must prove that the transfers at issue were fraudulent in the same manner as any other plaintiff.
Underlying Facts in Finn
Finn arose from the collapse of First United Funding, LLC, a loan originator that sold participation interests in loans that it originated.[2] Beginning in 2002, however, First United began to oversell participation interests (i.e., interests that were larger than the underlying loan) and to sell interests for which no loans existed.[3] Even after 2002, however, not all of the interests First United sold were fraudulent; it continued to sell both legitimate and fraudulent interests.[4] However, the company commingled funds that it received from legitimate interests and fraudulent interests, and used those funds to pay both holders of legitimate and fraudulent loans. First United’s operations became a Ponzi scheme because it used funds from the sale of “new” loans to pay the participants of the fictitious or oversold loans.[5]
After 2002, Alliance Bank, Home Federal Bank, Klein Bank, Merchant’s Bank, M & I Marshal and Ilsley Bank (collectively, the “banks”) each bought legitimate participation interests.[6] While the banks’ interests were legitimate, they were paid in part with funds fraudulently obtained from First United’s sale of fictitious or oversold loans. Alliance’s interest in particular was substantial. It bought participation rights in a $3.18 million loan, on which First United eventually paid Alliance over $4.3 million.[7]
In September 2009, Patrick Finn and Lighthouse Management (collectively, the “receiver”) were appointed as receiver of First United and were authorized to bring claims against third parties.[8] In May 2011, the receiver sued the banks in Minnesota state court, asserting that the payments from First United to the banks were voidable as both actual and constructive fraudulent transfers under Minnesota’s version of the UFTA (the “MUFTA”) and seeking to claw back all payments.[9]
The trial court dismissed the claims against the banks other than Alliance on limitations grounds.[10] The receiver and Alliance filed cross-motions for summary judgment. The trial court entered a judgment for the receiver for approximately $1.2 million.[11] The receiver argued, and the trial court agreed, that the MUFTA adopted the Ponzi scheme presumption.[12] The appellate court reversed on grounds that it could not presume, based solely on the fact that First United operated in part as a Ponzi scheme, that the transfers to Alliance were presumptively fraudulent.[13] The receiver appealed to the Minnesota Supreme Court.
Minnesota Supreme Court’s Decision
The receiver asked the Minnesota Supreme Court to embrace the Ponzi scheme presumption. The Supreme Court began by recognizing that the Ponzi scheme presumption “actually consists of three separate presumptions”: (1) “that the debtor had fraudulent intent, which means that [the presumption] treats all transfers from a Ponzi scheme as actually fraudulent”; (2) that “the mere existence of a Ponzi scheme would prove as a matter of law that the debtor was ‘insolvent’ at the time of a disputed transfer, regardless of the transfer’s timing and the actual operations of the debtor”; and (3) “that any transfer from a Ponzi scheme was not for reasonably equivalent value, which would both establish the second requirement of a constructive-fraud claim and negate the statutory element of an actual-fraud claim.”[14]
The court also noted initially that, contrary to the receiver’s argument, there is no firm definition of what precisely a Ponzi scheme is:
Notably, … MUFTA neither mentions nor defines a “Ponzi scheme,” a label coined from a fraud perpetrated by Charles Ponzi, who had promised Boston investors in the 1920s a 50 percent return for lending him money over a 90-day period, ostensibly to purchase international postage coupons…. As it turned out, Ponzi was using funds paid by later investors to provide the returns promised to early investors, which eventually earned him 5 years in prison for mail fraud…. Although the moniker “Ponzi scheme” generally refers to a financial arrangement similar to the one operated by Charles Ponzi, even those courts that have recognized a Ponzi scheme presumption have struggled to define its scope, in no small part due to the multitude of different forms that a fraudulent-investment scheme can take.[15]
As the court noted, the MUFTA does not refer to Ponzi schemes or use the word “Ponzi.” [16] Instead, it directs courts to examine each transfer at issue with respect to the elements of actual or constructive fraud.[17]
The court then examined each of the three presumptions, and found them all wanting. First, the court held that the MUFTA does not permit a court to presume that a transferor had actual intent to defraud based solely on the existence of a Ponzi scheme because the statute explicitly directs the court to apply the badges of fraud.[18] To be sure, the existence of a Ponzi scheme may support a “rational inference” of fraudulent intent, but “there is no statutory justification for relieving the [creditor] of its burden of proving — or for preventing the transferee from disproving — fraudulent intent[,]” which “must be determined in light of the facts and circumstances of each case.”[19]
Second, the court held that it cannot presume that a debtor is insolvent based solely on the existence of a Ponzi scheme. The MUFTA already explicitly defines insolvency for the purposes of constructive fraudulent transfer claims, and neither definition turns on the existence of a Ponzi scheme. On the one hand, the MUFTA permits a creditor to recover property transferred after his debt came into existence if the debtor failed to obtain reasonably equivalent value and was “insolvent” at the time of the transfer.[20] “Insolvency” itself is a defined term. “A debtor is insolvent if the sum of the debtor’s debts is greater than all of the debtor’s assets, at a fair valuation.”[21] And a debtor “is presumed to be insolvent” if it “is generally not paying debts when they become due[.]”[22] The court reasoned that the receiver simply sought to replace the explicit statutory presumption with one preferred on policy grounds, which it cannot do.[23]
The UFTA allows a creditor to recover transferred property, regardless of the time when his claim arose, if at the time of the transfer the debtor was inadequately capitalized or unable to regularly pay its debts.[24] The receiver argued that Ponzi schemes are inherently unable to pay debts as they are due.[25] The court rejected this argument because the statute requires the court to ask whether the company was insolvent “at the time the transfer was made.”[26] And “[a]s a practical matter, even if we were to assume that every entity operating a Ponzi scheme becomes insolvent by the time it is subject to one or more fraudulent-transfer claims, such an assumption still would not prove that such an entity was insolvent at the time it transferred its assets.”[27] In other words, it’s possible that some Ponzi schemes are solvent at some point in time:
The temporal element is important because, as a factual matter, it is not at all clear that every fraudulent investment arrangement that is later determined to be a Ponzi scheme necessarily will have been insolvent from its inception. For example, it is not hard to imagine a debtor that begins as a legitimate business and eventually turns to fraud, which the Respondent Banks insist occurred here. Similarly, a debtor could have assets or legitimate business operations aside from the Ponzi scheme, as Alliance Bank argues here, that it uses to stave off insolvency, at least for a while. Such an entity could be financially stable for a time, whether its stability is measured by the technical definition of insolvency in Minn. Stat. §§ 513.42 and 513.45(a), or the alternate methods of measuring financial distress in Minn. Stat. § 513.44(a)(2). Such a Ponzi scheme may be rare, but when the statute requires a creditor to prove a fraudulent-transfer claim, a conclusive presumption that a Ponzi scheme is insolvent from its inception may be incorrect, both as a matter of law and as a matter of fact.[28]
Third, the court rejected the presumption that a Ponzi scheme transferor is incapable of giving reasonably equivalent value. It held that the MUFTA and Minnesota cases make clear that “deciding whether a debtor has received reasonably equivalent value is a function of the relative value received by the debtor in the underlying exchange,” and “the satisfaction of an antecedent debt can constitute reasonably equivalent value.”[29] The court thought that the statutory definition of “debt” was broad enough to cover contractual liabilities that Ponzi schemes owe to investors.[30] Moreover, the court reasoned that “courts that adopt the Ponzi-scheme presumption effectively deem a contract between the operator of a Ponzi scheme and an investor to be unenforceable as a matter of public policy.”[31] This means that the transferee never has a claim for funds beyond his initial investment, because they are not for payment of an antecedent debt.[32]
The court acknowledged that courts applying the Ponzi scheme presumption sought to prevent some investors from reaping ill-gotten gains at the expense of others and to treat all investors equally.[33] But it also stressed that while “[i]n many Ponzi schemes, it is true that there is no legitimate source of earnings[,]” “not every Ponzi scheme lacks a legitimate source of earnings,” and in Finn there was “no dispute that the banks … purchased non-oversold participation interests in actual loans to real borrowers, which provided First United with a legitimate source of earnings with which to pay back the banks.”[34] Moreover, the court thought, “equality among a debtor’s creditors” is not a general animating purpose of the MUFTA; it was instead meant to unwind specified kinds of fraudulent transfers according to a detailed statutory framework.[35]
Finn’s Wake
While the Ponzi scheme presumption has a strong moral appeal, and numerous courts apply it, Finn provides a plain reading of the relevant provisions of the UFTA. Finn will provide ammunition to transferee defendants in jurisdictions that have not yet weighed in on the Ponzi scheme presumption and may lead other jurisdictions to reject it. Practitioners in jurisdictions that have not yet taken sides should be aware of Finn. Counsel for creditors of Ponzi schemes doubtless will seek to distinguish Finn on grounds that, unlike most Ponzi schemes, First United actually had significant legitimate revenues and that its payments to creditors therefore were in large part legitimate. While that argument may have some appeal, it is not tied to any of the specific arguments set forth in the Minnesota Supreme Court’s opinion about the specific provisions of the UFTA. Finn may require creditors’ counsel to develop a factual record supporting the claim that the scheme at issue in fact was animated by actual fraudulent intent, was insolvent, and failed to provide the transferee with reasonably equivalent value.
[1] Finn v. Alliance Bank, Nos. A12-1930, A12-2092, --- N.W.2d ---, 2015 WL 672406 (Minn. Feb. 18, 2015).
[2] Id. at *2.
[3] Id.
[4] Id.
[5] Id.; see also Black’s Law Dictionary 1278 (9th Ed. 2011) (defining a Ponzi scheme as “[a] fraudulent investment scheme in which money contributed by later investors generates artificially high dividends or returns for the original investors, whose example attracts even larger investments. Money from the new investors is used directly to repay or pay interest to earlier investors, usu[ally] without any operation or revenue-producing activity other than the continual raising of new funds”).
[6] Finn, 2015 WL 672406, at *3.
[7] Id.
[8] Id. at *2.
[9] Id. at *3.
[10] Id. at *3. The limitations issue was also addressed in the Minnesota Supreme Court’s opinion. It is not relevant to this article.
[11] Id.
[12] Id.
[13] Id. at *4.
[14] Id. at *6.
[15] Id.
[16] Id. at *7.
[17] Id.
[18] Id. at *8.
[19] Id.
[20] Minn. Stat. Ann. § 513.45 (West 2015).
[21] Id., § 513.42(a).
[22] Id., § 513.42(b).
[23] Finn, 2015 WL 672406, at *8.
[24] Minn. Stat. Ann. § 513.44 (West 2015).
[25] Finn, 2015 WL 672406, at *9.
[26] Id.
[27] Id.
[28] Id.
[29] Id. at **10-11.
[30] Id. at *11.
[31] Id. at *12.
[32] Id.
[33] Id.
[34] Id.
[35] Id. at *13.