Fifth Circuit Muses on the Split over Pleading Standards for Fraudulent Schemes

The Fifth Circuit wrote a primer on pleading standards for claims of fraudulent transfer, preference, equitable subordination, negligent misrepresentation, and breach of fiduciary duty.

In her May 31 opinion, Circuit Judge Jennifer Walker Elrod avoided taking sides on a circuit split regarding the pleading standards for fraudulent transfers, but she does lay out standards for pleading actual fraud and reasonably equivalent value that are not impossible to achieve.

The Life Partners Fraud

The appeal arose from the $1.8 billion Life Partners fraud, where the company recruited so-called licensees to sell investments in life insurance policies purchased from individuals who were not expected to live long.

The business plan looked like this: The company would pay a lump sum to an elderly person or someone in ill health to purchase a life insurance policy. The company was betting that the purchase price and the future premiums it must pay would be less than the death benefit when the seller dies.

To raise the money to purchase policies and pay premiums, the company utilized the licensees to find investors who would supply the cash in return for the right to participate in the proceeds when death benefits were paid later.

According to the allegations in the complaint, about 12% of what investors paid for their interests in life insurance policies went out as commissions to the licensees, who were essentially salesmen.

The company grossly underestimated the life expectancy of the sellers of the policies, turning the purchased policies into bad investments, but the company continued selling investments in the policies. Unfavorable publicity and investigations preceded the company’s collapse into chapter 11, where a trustee was appointed. The trustee sued the licensees to recover commissions, contending they were fraudulent transfers and preferences, among other things. The trustee of a liquidating trust took over prosecution of the suits following confirmation of a chapter 11 plan.

The licensees filed motions to dismiss, but the district judge withdrew the reference to the bankruptcy court. However, the district judge referred the dismissal motions to the bankruptcy court for a report and recommendation.

The bankruptcy court recommended dismissal of claims for fraudulent transfer, preference, negligent misrepresentation, and breach of fiduciary duty. However, the bankruptcy judge recommended granting leave to amend the complaint.

The district court dismissed all the claims with prejudice but did not permit the trustee to file an amended complaint. The district court also ruled that the heightened pleading standard for fraud in F.R.C.P. 9(b) applied throughout the complaint.

The trustee appealed and won the reinstatement of much of his complaint in Judge Elrod’s 34-page opinion.

The Pleading Standard

The complaint alleged that commissions paid to the licensees were actually or constructively fraudulent transfers. First, Judge Elrod discussed whether the pleading standard was contained in F.R.C.P. 8(a) or in F.R.C.P. 9(b). Rule 8(a) only requires a “short and plain statement of the claim,” whereas Rule 9(b) demands pleading the “circumstances” of fraud “with particularity.”

Judge Elrod said the Fifth Circuit is yet to decide which pleading standard applies to actually fraudulent transfer claims. The lower courts in the Fifth Circuit are split, she said.

Three circuits invoke Rule 9(b) on fraudulent transfer claims, and so does the Wright & Miller treatise. Four circuits are yet to decide, while the lower courts in three other circuits are divided like those in the Fifth.

Judge Elrod did not take sides because she concluded that the complaint stated claims under both rules.

The trustee’s actual fraud claims were sufficient under Rule 8(a) because, she said, in a “Ponzi-like scheme,” the plaintiff is not required to identify which entity made the fraudulent transfer. The plaintiff need not plead fraudulent activity on the part of the recipients of the transfers, because the fraudulent intent of the transferor is all that matters. The complaint, Judge Elrod said, pleased numerous “badges of fraud.”

Significantly, Judge Elrod concluded that the complaint was also sufficient under Rule 9(b) because it identified the transferor, transferees, amount and time periods, plus “pages of allegations detailing the underlying fraudulent scheme.”

Consequently, Judge Elrod reinstated claims for actually fraudulent transfers under the Texas Uniform Fraudulent Transfer Act and Section 548(a)(1)(A). She upheld dismissal of claims on transfers that were time-barred under state and federal law.

The trustee also alleged that the payments of commissions were constructively fraudulent transfers under UFTA and Section 548(a)(1)(B). Again, Judge Elrod said the complaint passed muster under both Rules 8(a) and 9(b).

Citing an opinion by District Judge Barbara Lynn as a prime example, Judge Elrod said that district courts in the Fifth Circuit have “suggested” that only Rule 8(a) applies to constructively fraudulent transfers. She quoted Judge Lynn as saying that “‘fraud has nothing to do with [a] constructive fraudulent transfer claim’” because the claim is based on the transferor’s financial condition and the value of the consideration provided by the transferee.

Although Judge Lynn’s “reasoning has persuasive value,” Judge Elrod conceded that two circuits require compliance with Rule 9(b).

Even applying Rule 9(b), Judge Elrod found the complaint sufficient because it “plausibly” alleged the transferor’s insolvency.

Significant for Ponzi scheme cases, Judge Elrod said the complaint adequately alleged the lack of reasonably equivalent value “because providing services in furtherance of a fraudulent Ponzi-like scheme . . . does not confer reasonably equivalent value as a matter of law.”

Judge Elrod therefore reinstated the state and federal constructively fraudulent transfer claims, except those pertaining to transfers that were time-barred.

The trustee did not fare so well with his preference claims. Judge Elrod upheld dismissal because the complaint did not plead facts to show that the transferees received more than they would have in chapter 7.  

The district court had dismissed equitable subordination claims, applying Rule 9(b) standards. Judge Elrod disagreed on the pleading standard, because proving equitable subordination does not require proof of fraud by the recipient, only “inequitable conduct.” She nonetheless upheld dismissal because the complaint did not allege that the licensees were fiduciaries of the debtor or controlled the debtor.

The trustee’s complaint also asserted negligent misrepresentation claims on behalf of investors in the life insurance policies.

Judge Elrod likewise concluded that only Rule 8(a) applied to claims of negligent misrepresentation because the complaint did not rely on fraudulent behavior by the transferees. Instead, she said the district court erred in dismissing those claims because the complaint had “a separate focus” on the transferees’ negligent misrepresentations.

Judge Elrod suggested that Rule 9(b) would have applied if the claims for negligent misrepresentation had relied on fraudulent activities.

Finally, Judge Elrod dealt with claims for breach of fiduciary duty, again invoking Rule 8(a) as the applicable pleading standard, because the complaint was grounded on allegations of negligence, not fraud. Nonetheless, she upheld dismissal of those claims because the complaint did not lay out “the nature of the fiduciary duty.”