A Minnesota Supreme Court decision prohibiting the use of so-called Ponzi scheme presumptions is not fatal when a trustee sues to recover fraudulent transfers that occurred as part of an ongoing fraud, according to an opinion by Bankruptcy Judge Gregory F. Kishel of St. Paul, Minn.
Judge Kishel’s May 31 opinion is the third installment in a series of decisions over the last month emanating from the Thomas Petters Ponzi scheme. To read ABI’s discussion of the other two opinions, click here and here.
The Trustee’s Complaint
According to the trustee’s complaint, Petters was conducting a through-going Ponzi scheme where every new investment went to pay off principal or interest owing to prior investors. Petters conducted no legitimate business activities, according to the trustee.
In the bankruptcy that began in 2008, the trustee sued hundreds of defendants for receipt of fraudulent transfers on the theory that the supposed interest they were paid on their loans was actually stolen from other victims of the fraud. The trustee’s complaint relied on several presumptions that federal courts in particular have employed in the wake of proven Ponzi schemes.
The Minnesota Supreme Court seemingly blew a hole in the trustee’s suits when the state’s highest court held in February 2015, in a case called Finn v. Alliance Bank, that Minnesota’s version of the former Uniform Fraudulent Transfer Act does not permit the use of three Ponzi scheme presumptions.
In his May 31 opinion, Judge Kishel dissected Finn and prior Minnesota authority to conclude that the decision does not mean what it seems to say on a superficial reading. Traditional notions of Ponzi scheme fraudulent transfers survive, although Minnesota requires additional pleading and proof.
The Test Case Distinguished from Finn
In the Petters test case, the recipient of an alleged fraudulent transfer argued that the judge was compelled to dismiss the suit on the authority of Finn, because Minnesota law governed. Judge Kishel in substance denied the motion to dismiss, although he ruled that the trustee’s complaint must allege additional facts required by Finn to avoid dismissal.
Early on, Judge Kishel pointed out how the Petters case was factually distinguishable from Finn in important respects. Principally, Finn involved a company with some legitimate business in addition to being a Ponzi scheme.
In Finn, the defendants, who prevailed on a motion to dismiss, were parties to legitimate transactions that were not part of the fraud. They made loans used for legitimate purposes and received payments from non-fraudulent transactions. The same was not true with Petters, Judge Kishel said.
Admitting that his opinion was “long” and “turgid,” Judge Kishel interpreted and distinguished Finn in a manner that may allow the trustee to recover interest payments from those who made loans to the Petters Ponzi scheme.
The Reasonably Equivalent Value Defense
For the Petters trustee, the most potentially deadly holding in Finn was the Minnesota court’s conclusion that there is no presumption in a Ponzi scheme that the recipient did not give reasonably equivalent value in return for payments of interest. If Finn meant that interest paid on loans was made for equivalent value, the Petters defendants would have had a complete defense. For that matter, any lender to a Ponzi scheme would have a complete defense to any fraudulent transfer lawsuit whenever a fraudster paid interest required by contract.
Judge Kishel cited federal courts as traditionally holding that reasonably equivalent value is lacking in the payment of false profits from a Ponzi scheme. He said those courts reject the “legal enforceability of contractual promises to repay fraudulently incurred debts as contrary to public policy.”
Employing theories of restitution, those courts, according to Judge Kishel, allow recipients to retain repayments of principal but require disgorgement of interest “as the fruit of an unenforceable contract.”
Judge Kishel interpreted Finn to mean that Minnesota law only rejects the presumption of lack of reasonably equivalent value “to every single transaction” emanating from a Ponzi scheme.
When a company had legitimate transactions along with a Ponzi scheme, the Minnesota court rejected the presumption because simply preferring one bona fide creditor is not a fraudulent transfer under nonbankruptcy law. Judge Kishel said that Finn is not “categorical” and does not allow recipients to retain interest payments in all cases where interest was contractually required.
Based on prior Minnesota Supreme Court cases cited in Finn, Judge Kishel interpreted Finn to stand “for only one proposition” unequivocally: When the business is only partially a Ponzi scheme, using stolen money to pay interest is not fraudulent if the initial loan was used for legitimate purposes. The “permissible preference doctrine,” he said, allows the recipient to retain payments of interest if the original loan was used legitimately.
On the other hand, he said, Finn “does not acknowledge the actual-fraud exclusion for reasonably-equivalent value for dishonestly-incurred debt or fraudulently-enabled payment.”
To buttress his interpretation of Finn, Judge Kishel said that law from the first half of the twentieth century “simply would not have considered” that a payment was “honestly made” if it came from stolen money. He also said that Finn cited cases allowing a court “to look beyond the face of the documents.”
Judge Kishel believes that Finn does not bar the trustee’s suits for constructive fraud, although the complaint must allege that the initial loan was the result of fraudulent inducement and that the payment of interest on the loan was derived from funds obtained by fraud.
Two Other Presumptions Lost
The Petters opinion dealt with two other Ponzi scheme presumptions nixed by Finn.
Finn said there is no presumption of fraudulent intent accompanying every transaction in a Ponzi scheme because the presumption is not authorized by the state statute. Nonetheless, a trustee can allege facts in a complaint and submit evidence at trial to show actual intent to defraud.
Although the Minnesota Supreme Court similarly rejected the notion of a presumption of insolvency, Judge Kishel said the trustee likewise can plead facts in the complaint to allege insolvency.
Just like his decision on May 19, Judge Kishel’s opinion on Ponzi scheme presumptions is not an appealable order because it only laid down rules to be applied later in determining the adequacy of the trustee’s pleadings. Absent certification of an interlocutory appeal, a higher court will not be examining Judge Kishel’s interpretation of state law until there is a final order in one or more of the fraudulent transfer suits.