The Sixth Circuit declined to follow the Second Circuit’s 1991 decision in Shearson Lehman Hutton, Inc. v. Wagoner and raised the odds that a trustee can mount a successful suit on behalf of Ponzi scheme victims by announcing an exception to the in pari delicto doctrine.
The Cincinnati appeals court’s decision runs counter to opinions by the Second Circuit and New York district courts that barred lawsuits by the trustee in the Bernard Madoff Ponzi scheme.
The Ponzi Scheme
The case involved a prototypical fraud where two men purchased a legitimate business in 2002 that for years had sold notes to investors to finance a factoring business. Immediately after the sale, the new owners caused the company to begin issuing vastly larger amounts of notes to generate funds that they loaned to their other businesses and ultimately used to finance their elaborate lifestyles.
According to the Aug. 23 opinion by Circuit Judge Andre M. Davis, the buyers turned the company into a typical Ponzi scheme, by selling new notes to pay off prior investors. After the FBI raided the company’s office in 2009 and exposed the fraud, investors initiated an involuntary chapter 7 case in early 2010. By that time, the related companies owed $233 million to the bankrupt company. Judge Davis said that the related companies never made any significant payments on their loans. Innocent noteholders had claims for $208 million.
The Trustee’s Suit
The target of the trustee’s lawsuit was a sophisticated lender that helped finance the acquisition with a secured loan in 2002, along with a co-lender. In 2004, the lender refinanced the 2002 loan, in the process paying off the co-lender, which wanted to exit the credit. Later wanting to exit the credit itself, the lender recovered the entire $17 million it was owed with proceeds from a sale of assets in 2007.
Just before the two-year window was about to close under Section 108(a), the trustee filed suit in bankruptcy court in early 2012 alleging that the lender knew about or was willfully blind to the fraud. The trustee made claims for aiding and abetting, conspiracy, and actual and constructive fraudulent transfers under the Ohio Uniform Fraudulent Transfer Act, seeking to recover, among other things, the entire $316 million the lender was paid in connection with the loan. The district court withdrew the reference but referred the lender’s motion to dismiss to the bankruptcy court for a report and recommendation.
Although the bankruptcy judge recommended denying the motion, the district court dismissed the suit, prompting the trustee’s successful appeal to the Sixth Circuit.
Don’t Find Disputed Facts on a Motion to Dismiss
The trustee alleged that the 2004 loan and subsequent payments were actual or constructive fraudulent transfers. The district court dismissed the suit, in part relying on the notion that the original lien from 2002 remained in effect and thus provided adequate consideration for the later payments on the refinanced loan.
The circuit court in substance concluded that the district court erred by making findings of fact on a motion to dismiss based on disputed facts. Interpreting the allegations in a light most favorable to the trustee, the Sixth Circuit said that the complaint at least raised an ambiguity about the parties’ intent in 2004 to effect a novation and extinguish the 2002 security interest, replacing it with a new loan. With a new loan in place, the appeals court said the complaint made out plausible fraudulent transfer claims that the 2004 refinancing and subsequent transactions were “undertaken in an effort to perpetuate a Ponzi scheme.”
The Statute of Limitations Defense
Alternatively, the lender argued that the complaint was time barred because the statute of limitations in Ohio for a fraudulent transfer is four years after the transfer or one year after it “was or reasonably could have been discovered.”
The appeals court agreed that the constructive fraud claim was barred by the statute of limitations. On the actual fraud claim, the Ohio Supreme Court has not decided whether discovery occurs when the transfer is discovered or when the transfer’s fraudulent nature is discoverable.
The Sixth Circuit made a so-called Erie guess and decided that Ohio’s highest court would focus on discovery of the fraudulent nature of the transactions. Because the plaintiff would not have known about the fraud until the FBI’s raid in 2009, the suit was timely since bankruptcy occurred in 2010.
Judge Davis’ opinion is significant for the rationale behind the Erie guess. He said that the purpose of the UFTA is to “discourage fraud” and provide recovery for defrauded creditors. Running the statute from discovery of the transaction, not the disclosure of its fraudulent nature, he said, would be “directly at odds with the animating purpose of the UFTA.” He said that timing the discovery period from knowledge of the transaction would reward those who conceal fraud and injure creditors whose claims would “lapse before even becoming aware of the damage.”
Sixth Circuit Won’t Follow Wagoner
Next, the lender argued that the trustee lacked standing to bring the civil conspiracy claim, relying on the Second Circuit’s Wagoner decision. Wagoner stands for the proposition that the trustee cannot sue on behalf of the company because the company was a participant in the fraud.
Judge Davis declined to follow Wagner because it “appears to conflate the affirmative defense of in pari delicto with the issue of standing.” Citing the Eighth, Eleventh and Third Circuits as being in disagreement with Wagoner, he held that the trustee had standing for his civil conspiracy claim.
Exceptions to In Pari Delicto
Although in pari delicto does not deprive the trustee of standing, the doctrine, Judge Davis said, “is likely” to bar the civil conspiracy claim, absent an exception that allows the suit to survive. The trustee thus argued that the innocent insider exception permits the suit to stand.
The Sixth Circuit had to make another Erie guess, this time deciding whether the Ohio Supreme Court would recognize the innocent insider exception. Courts that recognize the exception do not apply in pari delicto to dismiss a suit when there is an innocent person inside the company with power to stop the fraud if he or she knew it was happening.
At that juncture, the lender argued that the complaint made no allegations showing the existence of the required innocent insider. On that issue, the Sixth Circuit again reversed the district court, holding that a plaintiff is not required to plead facts in a complaint to defeat an affirmative defense.
Adverse Domination
The appeals courts made a third Erie guess, this time on the question of whether the doctrine of adverse domination tolls the statute of limitations for civil conspiracy. According to Judge Davis, the Sixth Circuit issued a decision early this year that appeared to say that Ohio would not adopt the doctrine.
That decision, Judge Davis said, was not a precedential opinion and thus not binding. He therefore went on to predict that the Ohio Supreme Court would adopt the adverse domination doctrine to toll the statute of limitations.