Delving into a controversy where the Fifth Circuit and the Texas Supreme Court disagree, Bankruptcy Judge Paul W. Bonapfel of Atlanta scribed the outer limits of the so-called Ponzi scheme presumption in fraudulent transfer law.
In the bankruptcy of a Ponzi scheme, most courts presume that the fraudster had the requisite actual intent to hinder, delay or defraud creditors, as required by Section 548(a)(1)(A) and similar state laws. The presumption simplifies litigation and hastens the inevitable result when the trustee is suing to recover payments to investors who profited from the Ponzi scheme by taking out more cash than they invested and had no defenses apart from claimed innocence.
Were there no limits to the presumption, a trustee could recover any payments by a Ponzi schemer because the law only requires fraudulent intent on the part of the transferor, not the transferee. Therefore, the presumption becomes problematic when the trustee is suing an ordinary trade supplier, landlord or employee who gave equivalent value.
Janvey in the Fifth Circuit
In Janvey v. Golf Channel Inc., the trustee had sued a cable television channel to recover $5.8 million paid for advertising the business that was later shown to be a Ponzi scheme. The trustee contended that the payments were fraudulent transfers with “actual intent” under Texas’ non-uniform version of the Uniform Fraudulent Transfer Act, or TUFTA. The district court ruled against the trustee, saying that Golf Channel was an innocent supplier entitled to the good faith defense under state law by providing equivalent value and in good faith.
In March 2015, the Fifth Circuit reversed, holding that Golf Channel had not given reasonably equivalent value because the advertising did not benefit creditors. On motion for rehearing, the panel certified the state law question to the Texas Supreme Court.
The Texas court answered the certified question by ruling that “reasonably equivalent value” is provided under TUFTA when (1) services were fully provided under an arms’-length contract for “fair market value,” (2) the consideration had “objective value” and (3) the exchange occurred in the ordinary course of the defendant’s business.
Compelled by the Texas court’s interpretation of state law, the Fifth Circuit reversed its prior conclusion in August and upheld the district court’s granting of summary judgment absolving Golf Channel of fraudulent transfer liability.
Because Texas has a non-uniform definition of value, the Fifth Circuit panel said that its prior decisions continue to have binding effect with respect to Section 548 and the laws of other states. To read ABI’s discussion of the Fifth Circuit’s August opinion, click here.
Judge Bonapfel’s Case
In Judge Bonapfel’s case, the Ponzi scheme appeared to be an advisor providing investments to customers in hedge funds and limited partnerships. To park investors’ money and provide the outward appearance of a legitimate business, the mastermind maintained an account with a legitimate stock brokerage firm that did not know it was dealing with a Ponzi scheme.
Relying on the Ponzi scheme presumption that focuses only on the transferor’s intent, the trustee sued the broker under Section 548(a)(1)(A) to recover about $6 million paid within the year before bankruptcy in connection with ordinary, non-fraudulent brokerage transactions.
Because the transfers were within a year of bankruptcy, the broker had no safe harbor defense under Section 546(e). The broker nonetheless contended that the presumption should not apply. Judge Bonapfel agreed.
Judge Bonapfel’s Critique of the Presumption
Judge Bonapfel’s Jan. 10 opinion is a scholarly analysis of the history and logic (or lack of it) behind the Ponzi scheme presumption. He said that the Fifth, Sixth, Ninth, Tenth and Eleventh Circuits adopted the presumption, although “uncritically and without analysis of the fact that fraudulent inducement . . . differs from the fraudulent removal of assets beyond the reach of creditors.” He said that the Ninth and Tenth Circuits “present no analysis of the presumption” and that the Fifth Circuit relied on a Seventh Circuit case “which did not address” the presumption.
Judge Bonapfel conceded that the Eleventh Circuit adopted the presumption in one sentence in a 2011 decision called Perkins but said it was “quite clearly” dictum.
On the other hand, he pointed out how the Eighth Circuit “left the issue open,” while the Minnesota Supreme Court said there is no presumption under that state’s law.
Nonetheless bound by the presumption, Judge Bonapfel explored its outer limits, otherwise anyone who innocently supplies goods, services or labor could be liable for receipt of a fraudulent transfer. He noted that lower courts in the Eleventh Circuit and elsewhere apply the presumption only to transactions “in furtherance of” the Ponzi scheme. He said the Eleventh Circuit had not addressed when a transfer is considered “in furtherance of.”
Finding some courts’ formulations of “in furtherance of” to be unsatisfactory, Judge Bonapfel said the presumption applies only to a transfer that is “an inherent and integral part of the fraudulent inducement scheme, and the continuation of the fraudulent inducement must depend on the transfers.” In other words, a “transfer that does not induce future investors is not an inherent and integral part” of the fraud.
In addition, there must be a “direct and material” causal connection “between the transfer and the inducement of future investors.”
Applying the standards, Judge Bonafel held that the broker had no liability because the presumption did not apply and there was no evidence that the transfers removed assets or concealed them from creditors.
Innocent Supplier’s Other Defenses
Although the inapplicability of the presumption was enough to award judgment in favor of the broker, Judge Bonapfel went ahead and decided that the broker had a valid “good faith” defense under Section 548(c).
To counter the broker’s asserted good faith defense, the trustee contended there were “red flags” that should have impelled the broker to investigate. Judge Bonapfel said that an objective standard would impose liability for negligent failure to recognize “red flags.” He therefore declined to apply an objective standard to ordinary course, arms’-length transactions for equivalent value.
In the broker’s context, the good faith test is subjective, he said. To flunk the good faith test, the transferee must be “willfully blind.”
On that issue, the trustee presented evidence to show the broker violated regulatory requirements and compliance rules. Judge Bonapfel said the broker was not in a position to lose money on the account. Subjectively speaking, he therefore concluded that the broker acted “honestly and with integrity” in response to “compliance exception reports.” Overall, the “red flags” were not sufficient for a reasonable jury to conclude that the broker willfully ignored the possibility of fraud.
Applicability to Janvey
Judge Bonapfel’s standards support the Fifth Circuit’s conclusions in Janvey. There, television advertising was directly soliciting new investors to prolong the Ponzi scheme. Since the advertising was “in furtherance of” the Ponzi scheme, Judge Bonapfel presumably would have made the presumption applicable because there was no value from the perspective of creditors.
Whether Judge Bonapfel would have found good faith is a question we leave to the reader.