A Ponzi scheme is an arrangement whereby an enterprise makes payments to investors from the proceeds of a later investment rather than from profits of the underlying business venture as the investors expected. The fraud consists of transferring the proceeds received from a new investor to previous investors, thereby giving other investors the impression that a legitimate profit-making business opportunity exists, where in fact no such opportunity exists. Hayes v. Palm Seedlings Partners-A (In re Agricultural Research and Technology Group Inc.), 916 F.2d 548, 531 (9th Cir. 1990). In a Ponzi scheme, the enterprise operates and continues to operate at a loss. The enterprise gives the appearance of being profitable, however, the effect of the scheme is to put the enterprise farther and farther into debt by incurring more and more liability. Hirsch v. Arthur Andersen & Co., 72 F.3d 1085 (2d Cir. 1995). At the appropriate time, the Ponzi perpetrator typically absconds with the outstanding investments. As one author describes it, “he borrowed from Peter to pay Paul. And it worked … until Paul got wise.” United States v. Cook, 573 F.2d 281, 282 n.3 (5th Cir.) (quoting unnamed author), cert. denied, 439 U.S. 836 (1978).
Charles Ponzi was the first to develop an elaborate plan for swindling people out of thousands of dollars (or at least he was the most notorious). His scheme, and the lesser ones based on the same principles, steadily relieved people of their money through the twentieth century. In the “original” Ponzi scheme, Charles Ponzi promised investors a 50 percent return in 90 days. In the economic mess following World War I, he said he would buy international postal coupons in foreign countries and sell them in other foreign countries at a 100 percent mark-up. For a while, Ponzi did a large business, but a panic was touched off by a federal investigation, which revealed that Ponzi was paying dividends out of each new investor’s money. Charles Ponzi’s scheme became the subject of Cunningham v. Brown, 265 U.S. 1, 44 S.Ct. 424 (1924). In Cunningham, Ponzi paid the defendants a return on their investments between the time the scheme was discovered and the bankruptcy petition was filed. The trustee sued to avoid the repayments as preferences and the case made its way up to the U.S. Supreme Court. In its decision, the Supreme Court stated, “equality is equity” and that all victims were of one class, activated by the desire to “save themselves from Ponzi’s insolvency.” Thus, the foundation was laid for decades of litigation designed to equalize the financial pain Ponzi schemes cause.
Is it a Pyramid, a Ponzi or a legitimate Multilevel Marketing Program?
A “pyramid scheme” rewards participants for inducing other people to join the program, and a “Ponzi scheme” operates strictly by paying earlier investors with money tendered by later investors, while a legitimate “multilevel marketing program” survives by making money off product sales. U.S. v. Gold Unlimited Inc., 177 F.3d 472, 1999 FED App. 170P (6th Cir. 1999).
Although a pyramid and Ponzi scheme are different, they do share some of the same features. One person persuades two or three others to invest in a product or a business, and those investors persuade others to invest. The main difference is that pyramid schemes reward investors for signing up other investors, whereas Ponzi schemes use some of the initial investments to pay later investors. The result is usually the same: the scheme collapses because the pool of investors is used up.
What Assets are Available For the Trustee?
Hard Assets - Planes, Trains and Automobiles
These assets are a great source of money for a bankruptcy estate. Many perpetrators of Ponzi schemes make a lot of money and tend to live extravagant lifestyles. In many cases, perpetrators of Ponzi schemes accumulate numerous houses, fancy cars, boats and various other expensive luxury items. A background and asset check can often turn up valuable pots of gold for the bankruptcy trustee to administer.
Suing the Investors – “It’s MY MONEY and You Can’t Have It!” – You Think So, Huh?
You will not make very many friends going after the investors, but the major assets of the bankruptcy estate will usually consist of avoidable transfer claims by the trustee against the “winners” in the Ponzi scheme—those investors who received “returns” on their investments. Although such defendants, who usually had no actual knowledge of the Ponzi scheme, often believe that they are unfairly targeted in lawsuits brought by a trustee, the Bankruptcy Code’s policy of equitable distribution to creditors requires trustees to recover fraudulent or preferential transfers from such defendants so the amounts recovered may be distributed pro rata to the investors who suffered losses, as well as other non-investor creditors.
In his arsenal of avoiding powers, a trustee may invoke 11 U.S.C. §548 or similar provisions of the Uniform Fraudulent Conveyance Act or the Uniform Fraudulent Transfer Act to avoid and recover transfers made by the debtor to investors. Under each of these statutes, the trustee may allege two distinct theories of recovery against Ponzi scheme transferees: actual fraud and constructive fraud.
1. Actual Fraud - 11 U.S.C. §548(a)(1)(A)
In order for the trustee to prevail under an actual fraud theory, the trustee need only prove that the transfer was made with the actual intent to hinder, delay or defraud the debtor’s creditors. Many courts have held that if the trustee proves the existence of a Ponzi scheme, there is a presumption of the debtor’s actual fraudulent intent. Hayes v. Palm Seeding Partners (In re Agricultural Research and Technology Group Inc.), 916 F.2d 528 (9th Cir. 1990); In re National Liquidators Inc., 232 B.R. 915 (Bankr. S.D. Ohio 1998). Otherwise, the trustee will have to rely on ordinary circumstantial evidence of fraudulent intent. Jobin v. McKay (In re M & L Bus. Mach. Co.), 155 B.R. 531, 439-40 (Bankr. D. Colo. 1993), aff’d, 84 F.3d 1330 (10th Cir. 1996). Once the trustee has established the debtor was operating a Ponzi scheme at the time of the transfer, the trustee has established a prima facie case that the transfer is avoidable under §548 (a)(1). Upon establishing actual fraud, the burden then transfers to the transferee to establish a defense to the recovery of the transfer. Under §548(a)(1)(A), a trustee may recover the full amount paid to a Ponzi scheme investor unless the investor can establish the defense under §548(c) that it received payments from the scheme “for value and in good faith.” In re Lake States Commodities Inc. (Lake States Inc.), 253 B.R. 866, 878 (N.D. Ill. 2000). If a reasonable person would be placed on inquiry of a Ponzi scheme operator’s fraudulent purpose by the circumstances, and a diligent inquiry would have discovered the fraudulent purpose, then the transfer is fraudulent since there would have been no good faith. In re M&L Bus. Mach. Co., 84 F.3d at 1338. Courts consider such factors as the investor’s level of business knowledge and education, other investments made, the returns earned on the investment and the disparity between prevailing market rates and the rates promised by the Ponzi scheme operator, the investigation conducted by the investor, the plausibility for the promised high rates of return and any irregularities in the Ponzi scheme operator’s payments to the investors. McDermott, Mark A. “Ponzi Schemes and the Law of Preferential Transfers,” 72 Am.Bankr.L.J. 157, 178-79 (1998).
The advantage to prevailing on an actual fraud theory is that the trustee can recover all of the amounts that the Ponzi scheme operator transferred to the investor, which includes both the investor’s principal investment and the fictitious profits unless the investor can prove the requirements of the good faith defense. McDermott, Ponzi schemes, at 173; but see Rafoth v. Bailey (In re Baker & Getty Financial Services Inc.), 88 B.R. 792 (Bankr. N.D. Ohio 1988)(indicating that, even under an actual fraud theory of recovery, a trustee may recover only sums in excess of the investor’s principal investment).
2. Constructive Fraud - 11 U.S.C. §548(a)(1)(B)
In order for the trustee to prevail under a constructive fraud theory, the trustee must establish that the debtor: (1) received less than reasonably equivalent value in exchange for the transfer and (2) was insolvent, was made insolvent by the transaction, was operating or about to operate without property constituting reasonably sufficient capital or was unable to pay debts as they became due. 11 U.S.C. §548(a)(1)(B); In re United Energy Corp., 944 F.2d 589 (9th Cir. 1991).
Bankruptcy courts have generally allowed Ponzi scheme investors to retain payments up to the amount invested because investors have claims for restitution or rescission against the debtor that operated the scheme. Lake States, 253 B.R. at 871 citing Jobin v. McKay (In re M&L Business Machine Co.), 84 F.3d 1330, 1341-42 (10th Cir. 1996); Merrill v. Abbott (In re Independent Clearing House Co.), 77 B.R. 843, 857 (D. Utah 1987). Since investors’ rights to restitution are proportionately reduced by payments received from a Ponzi scheme, to the extent of invested principal, payments from the debtor are deemed to be made in exchange for reasonably equivalent value and, therefore, likely not avoidable. Lake States, 253 B.R. at 872 citing Wyle v. C.H. Rider & Family (In re United Energy Corp.), 944 F.2d 589, 595 (9th Cir. 1991); Jobin v. Cervenka (In re M&L Business Machine Co.), 1994 B.R. 496, 502 (D. Colo. 1996). If, however, the trustee can prove that the investor had knowledge of the debtor’s fraudulent scheme, the trustee may recover the investor’s return of principal as well as any fictitious profit. In re United Energy Corp., 944 F.2d 589, fn 7 (9th Cir. 1991) (If an investment is made in a Ponzi scheme with culpable knowledge, all subsequent payments made by debtor to investor within one year of debtor’s bankruptcy are avoidable as fraudulent transfers under Bankruptcy Code on ground that debtor would not have exchanged reasonably equivalent value for payments.)
To the extent that investors receive more than they invested, the result is different. Where causes of action under §548(a)(1)(B) are brought against Ponzi scheme investors, the rule applied in the majority of cases is that to the extent that investors have received payments in excess of the amounts they have invested, those payments are voidable as fraudulent transfers. In re Lake States Commodities Inc., 253 B.R. 866, 871 (N.D. Ill. 2000) citing In re Hedged-Investments Inc., 84 F.32d 1286, 1290 (10th Cir. 1996): Scholes v. Lehmann, 56 F.3d 750, 757 (7th Cir.), cert. denied sub nom. Payments in excess of amounts invested are considered fictitious profits because they do not represent a return on legitimate investment activity. Lake States, 253 B.R. at 871 citing Noland v. Morefield (In re National Liquidators Inc.), 232 B.R. 915, 919-20 (Bankr. S.D. Ohio 1998); Martino v. Edison Worldwide Capital (In re Randy), 189 B.R. 425, 437-38 (Bankr.N.D.Ill. 1995). Since these “false profits” are not paid in exchange for reasonably equivalent value, they may be recovered under §548(a)(1)(B). Lake States, 253 B.R. at 871 citing United Energy, 944 F.2d at 595 n.6.
After the trustee establishes that the debtor received less than reasonably equivalent value, it is then necessary to prove that the debtor was insolvent, was made insolvent by the transaction, was operating or about to operate without property constituting reasonably sufficient capital, or was unable to pay debts as they became due at the time of each transfer sought to be avoided. This can usually be easily demonstrated as long as the existence of a Ponzi scheme is established. In fact, several courts have held that, as a matter of law, a Ponzi scheme operator is deemed insolvent from the inception of the scheme. Scholes v. Lehmann, 56 F.3d 750, 755 (9th Cir. 1995); Merril v. Abbott (In re Independent Clearing House Co.), 77 B.R. 843, 871 (D. Utah 1987); Martino v. Edison Worldwide Capital (In re Randy), 189 B.R. 425, 441 (Bankr. N.D. Ill. 1995); Emerson v. Maples (In re Mark Benskin & Co.), 161 B.R. 644, 650 (Bankr. W.D. Tenn. 1993).
3. Good Faith Defense
>As discussed above, the “good faith” defense applies to both actual and constructive fraud claims. To the extent that a transferee gave value and took in good faith, the trustee may not avoid the transfer. Under §548(c), the burden is on the defendant to prove that he or she acted in good faith. Even if the transferee gave reasonably equivalent value in exchange for the transfer avoided on either of the alternate theories, the transferee may not recover such value if the exchange was not in good faith because good faith is “indispensable” for the transferee who would recover any value given pursuant to 11 U.S.C. §548(c). In re Agricultural Research and Technology Group Inc., 916 F.2d 528 (9th Cir. 1990). Some courts have held that “good faith” under §548(c) is an objective standard whereas others have held it is a subjective standard.
4. Preferential Transfers
The trustee can also sue investors for recovery of preferential transfers. A preferential transfer is defined by §547 of the Bankruptcy Code. Under the Code, a trustee can recover as a preference any transfer of an interest of the Ponzi-scheme operator in property within the 90-day period prior to the fling of the Ponzi scheme operator’s bankruptcy case if the transfer was made:
a. to or for the benefit of a creditor;
b. for or on account of an antecedent debt;
c. while the Ponzi scheme operator was insolvent; and
d. such that it enabled the investor (creditor) to receive more than would have been received by the investor as an unsecured creditor in a liquidation of the Ponzi scheme operator’s estate under chapter 7 of the Bankruptcy Code.
The potential advantage to proceeding under a preference theory is that the trustee may even be able to recover the return of the investor’s principal even though the investment was made in subjective and objective good faith.
Suing the Ponzi Perpetrator’s Bank
The Ponzi perpetrator’s bank cannot merely close its eyes to the actions of its customer and attempt to assert a good faith defense in order to avoid potential liability for receiving fraudulent transfers. In In re Cannon, the court found that a transferee cannot put on blinders where circumstances place it on inquiry notice “of the debtor’s fraudulent purpose or insolvency.” 230 B.R. 546, 592 (Bankr.W.D. Tenn. 1999). The fraudulent intent required to avoid a transfer as having been made with actual intent to hinder, delay or defraud creditors may be proven through circumstantial evidence, including these badges of fraud: (1) The transfer was to an insider; (2) The debtor retained possession or control of the property transferred after the transfer; (3) The transfer was disclosed or concealed; (4) Before the transfer was made the debtor had been sued or threatened with suit; (5) The transfer was of substantially off the debtor’s assets; (6) The debtor absconded; (7) The debtor removed or concealed assets; (8) The value of the consideration received by the debtor was reasonably equivalent to the value of the asset transferred; (9) The debtor was insolvent or became insolvent shortly after the transfer was made; (10) The transfer occurred shortly before or shortly after a substantial debt was incurred; and (11) The debtor transferred the essential assets of the business to a lienor who transferred the assets to an insider of the debtor. In re Model Imperial Inc., 250 B.R. 776 (Bankr. S.D. Fla. 2000).
If a bank is aware of the activities of its customers, or is willfully ignorant to its customers’ activities, it cannot assert that it is a mere conduit that cannot be held liable for receiving a fraudulent transfer. The “mere conduit” defense immunizes a good faith recipient of an otherwise avoidable transfer that acts as a mere intermediary and cannot exercise dominion or control over the transferred property, where equitable principles justify such an exception. See, e.g., Nordberg v. Sanchez (In re Chase & Sanborn Corp.), 813 F.2d 1177 (11th Cir. 1987); In re Harbour, 845 F.2d 1254, 1257 (4th Cir. 1988) (finding that in order for court to find that initial recipient of transfer was mere conduit and not initial transferee (as defined by §550(a)(1)), court must find that recipient did not act inequitably or in bad faith). However, a transferee that does not act in good faith can never be deemed a “mere conduit.” Harbour, 845 F.2d at 1258.
Discovery into the what the bank did and did not know about its Ponzi perpetrator customer and whether the bank violated industry practices and or its own written policies and procedures regarding knowledge of their client can be well worth the effort and lead to a deep-pocket defendant.
Preference Recovery from Ordinary Trade Creditors
Recovery of preferential payments to ordinary trade creditors can be another asset for the trustee to pursue. The standard defense asserted by such a target is the ordinary course of business defense. However, in certain businesses, trades or industries, there may be no possibility of showing the customs and norms necessary to establish an ordinary course defense. In Henderson v. Buchanan, 985 F.2d 1021 (9th Cir. 1993), the debtor was in the “business” of carrying out a Ponzi scheme. The court held that payments by a debtor in connection with a Ponzi scheme were not in the ordinary course of business. The defendant could argue that the business of the debtor was carrying out a Ponzi scheme, and that the use of new funds to pay old investors is indeed an industry norm for this particular type of business, reprehensible as it might be. However, courts considering that issue have held that Ponzi schemes are simply not legitimate businesses that Congress intended to protect through the “ordinary course” exception. Matter of Bishop, Baldwin, Rewald, Dillingham & Wong Inc., 819 F.2d 214 (9th Cir. 1987); and In re Western World Funding Inc., 54 B.R. 470 (Bankr. D. Nev. 1985). However, the approach described above may be changing. In In re M & L Business Mach. Co. Inc., 84 F.3d 1330 (10th Cir. 1996), cert. denied, 117 S. Ct. 608, 136 L. Ed. 2d 534 (U.S. 1996) the court recognized that many courts had held that a Ponzi scheme was not, as a matter of law, an ordinary business for purposes of preference recovery. However, the court chose a more moderate approach, holding that the defense or exception was only unavailable to investor/creditors. Ordinary trade creditors were not prevented from asserting this exception as a defense to liability.