‘Innocent’ Transferee Held Potentially Liable for Payment from a Ponzi Scheme

District Judge Raymond J. Dearie of Brooklyn, N.Y., wrote a primer on the fine distinctions between state and federal fraudulent transfer law when the defendant is not one of the victims of a Ponzi scheme.

The essential facts were not complex. A convicted fraudster operated a Ponzi-like scheme for about four years. During that time, he lost almost $4.7 million gambling at a casino.

The chapter 7 trustee sued the casino in district court to recover the $4.7 million, alleging receipt of actual and constructively fraudulent transfers. The trustee alleged that gambling was part of the fraudulent scheme because the fraudster intended on using winnings to repay investors from whom he was stealing.

The trustee made cogent contentions in the complaint that the casino should have known it received fraudulent representations from the fraudster about his financial condition and the source of the funds he used to repay loans the casino made. The trustee lodged claims under the Bankruptcy Code and New York’s Debtor and Creditor Law because 75% of the transfers occurred more than two years before bankruptcy.

The casino filed a motion to dismiss. Perhaps counterintuitively, Judge Dearie denied the motion to dismiss the actual fraud claims but dismissed the claims for constructive fraud under state law.

On the actual fraud claims, the casino contended that the repayment of loans it made was an act by the fraudster to repay one of his creditors, not to defraud creditors. The casino argued that it was no more liable than a grocery store for selling goods to a Ponzi scheme operator at fair value. In that regard, the trustee conceded that gambling entertainment and the repayment of loans were “fair equivalent value.”

Nonetheless, the so-called Ponzi scheme presumption defeated the casino’s motion to dismiss the actual fraud claims. Citing Second Circuit authority, Judge Dearie said that the transfers were presumptively fraudulent, because the conduct of a Ponzi scheme establishes the transferor’s fraudulent intent, a necessary element of a claim for actual intent to hinder, delay or defraud.

The casino argued against application of the presumption because it was not one of the victims that the fraudster was repaying with funds stolen from others. Citing decisions by the late Bankruptcy Judge Burton R. Lifland and others, Judge Dearie listed cases where the presumption was applied to recipients other than investors.

However, Judge Dearie agreed with the casino’s contention that the presumption applies only when the transfers were designed “to sustain or advance the Ponzi scheme in some way.”

Nonetheless, Judge Dearie ruled that the complaint was legally sufficient in that regard because the trustee alleged that the transfers were in furtherance of the Ponzi scheme since they were part of the fraudster’s plan to use winnings to repay victims.

Next, the casino argued that it was in good faith under the Section 548 and acted “without knowledge of fraud” under the New York Debtor and Creditor Law.

Although Judge Dearie said the casino’s contention that it was an “‘innocent transferee’ has some equitable appeal . . . , once again the controlling law supports the Trustee” on a motion to dismiss. The casino’s lack of knowledge and good faith, he said, “are fact-intensive, affirmative defenses that need not and should not be reached” on a motion to dismiss.

In other words, Judge Dearie kept the trustee’s actual fraud claims alive while giving the casino a ray of hope that it would prevail at trial or on a motion for summary judgment.

Although actual fraud claims survived the motion to dismiss, the casino did win dismissal of the constructive fraud claims. That’s where Judge Dearie said the finer points of New York law are “a horse of a different color,” because the state statute puts a twist on the casino’s good faith argument.

To prevail on allegations of constructively fraudulent transfers under New York law, the trustee must prove both lack of fair consideration and lack of good faith on the part of the transferee. Since the trustee conceded that the casino gave fair equivalent value, the only issue was the casino’s good faith.

Judge Dearie said that “binding Second Circuit precedent forecloses the precise theory of lack of good faith on which the Trustee relies.” The appeals court, he said, “discouraged efforts ‘to assert lack of good faith’ as an ‘independent ground’ for voiding transactions” under New York law, which holds that preferring one creditor over another is not a fraudulent transfer.

Under New York law, the Second Circuit said that knowledge of the transferor’s insolvency does not show bad faith because state law does not aim to invalidate transfers that were made for fair consideration. Judge Dearie said, in substance, that the defendant must have participated in the fraud to lose the good faith defense.

Because the trustee did not allege that the casino participated in the fraudulent scheme, Judge Dearie dismissed the counts in the complaint based on constructive fraud under state law.

Caution: Judge Dearie only ruled on the sufficiency of the complaint on a motion to dismiss. The trustee may not prevail at trial or on motion for summary judgment. Assuming that gambling is a legitimate business activity, the casino may be no different from a vendor providing goods and services to the legitimate side of a business that includes a Ponzi scheme.