The COVID-19 pandemic has wreaked economic havoc and created a breeding ground for fraud. Existing swindles will be uncovered as victims seeking liquidity attempt to withdraw their funds only to find that their rock solid investment was nothing but smoke. New scams will arise. Many investors desperately need income or growth that traditional investments can no longer provide. These investors will be primed for opportunities that promise returns untethered from market or general economic risk. Others are simply greedy, looking to profit on others’ misery. Scammers have deals for them, too.
Many of these scams will end up in bankruptcy court. There a trustee of a liquidating trust or maybe a chapter 11 trustee will attempt to recover funds dissipated from the debtor under section 548 of the Code or state fraudulent transfer law (usually a version of the Uniform Fraudulent Transfer Act or UFTA).[1] Under both state and federal law, the trustee proceeds under one of two theories. First, he can argue that the transfer was actually fraudulent; that is, the debtor transferred assets with the intent to hinder or defraud its creditors.[2] An actually fraudulent transfer is recoverable from the transferee unless the transferee can prove that it acted in good faith and provided reasonably equivalent value. Second, the trustee can argue that the transfer was constructively fraudulent; that is the debtor made the questioned transfer at a time when the debtor was currently or prospectively insolvent and for less than reasonable equivalent value.[3]
Ponzi schemes[4] present particular difficulties for courts and trustees. In a prototypical fraudulent transfer case, there are generally only a few easily identifiable transactions to insiders or others. In the typical case, the debtor facing mounting debts transfers assets to a new entity controlled by the debtor’s owner, a family member or a friend hoping to evade the debts but maintain the benefit of the assets. Litigation over these sorts of transfers is relatively straightforward.
A Ponzi case is completely different. There is no actual business. Instead, a criminal enterprise exists by taking money from new investors to pay fake “profits” to existing investors. Rather than a few easily identifiable transactions, the trustee faces a morass of transfers back and forth between the debtor and the investors. In even a medium sized scheme, the transferees can number in the thousands and questionable transfers in the tens of thousands.[5]
Typically, the trustee will sue the “net winners,” those investors who received more from the scheme than they contributed; those investors who were willing participants;[6] the sales agents and the principals. Such suits will require examination of thousands of potentially fraudulent transfers. Litigating fraudulent transfer claims in the ordinary fashion is a practical impossibility. To deal with these claims, the federal courts developed several evidentiary presumptions. First, transfers in furtherance of a Ponzi scheme are presumed to be made with an actual intent to hinder, delay or defraud a creditor. Second, the operator of a Ponzi scheme (the debtor) is insolvent at all relevant times. Third, the payments of false profits to investors or commissions to sales agents are transfers without the receipt of equivalent value.[7] These presumptions are often collectively referred to as the “Ponzi presumptions.” As traditionally used, the presumptions are evidentiary and subject to rebuttal by contrary evidence.[8]
In practice, the Ponzi presumptions greatly simplify fraudulent transfer litigation. Once the trustee demonstrates that a Ponzi scheme existed, which she can do by using the guilty pleas by the debtor’s principals, the trustee merely has to show that the ordinary investor received more than he invested in order to recover the excess.[9] Similarly, the trustee can easily recover fees paid to sales agents.[10] Moreover, the presumptions allow the trustee to recover all payments made to bad faith investors — those who invested knowing of the Ponzi scheme. Because the Court presumes that transfers in furtherance of the scheme were actually fraudulent, the bad faith investor must prove both that he gave reasonably equivalent value and that he acted in good faith, i.e., without knowledge of sufficient facts to put a reasonable person on notice of the scheme.[11]
Because they so strongly favor trustees, a few state courts have criticized the Ponzi presumptions as lacking basis in UFTA. In Finn v. Alliance Bank,[12] the Minnesota Supreme Court rejected a broad application of the presumptions criticizing their legal underpinnings. Finn involved an alleged Ponzi scheme based on participations in lending agreements. Most of the loan participations that the debtor sold were either oversubscribed or fake, but a few legitimate participations existed.[13] The receiver sued to recover participation payments received by Alliance Bank and other banks. Alliance Bank was party to a legitimate participation agreement; the other banks were not.[14] The court began by noting that UFTA does not expressly provide for the presumptions. It then turned to each presumption holding that none of the presumptions was supported by UFTA, at least applied categorically.[15] But, while rejecting the application of the Ponzi presumptions to an otherwise legitimate transaction involving the Ponzi schemer, the Finn court did apply the presumptions to transactions that were clearly part of the Ponzi scheme.[16] Finn, thus, represents something less than a wholesale repudiation of the Ponzi presumptions, but instead a significant limitation of their application.
Similarly, the Texas Supreme Court in Janvey v. Golf Channel criticized the presumptions as unmoored in the language of UFTA.[17] Admittedly, the court’s criticism was dicta and placed in a footnote. But, dicta and footnotes in high court opinions are often a signal that the court is dissatisfied with an area of the law and, thus, can carry great weight.[18]
Despite these criticisms from state courts, the Ponzi presumptions remain alive and well — at least in courts outside of Minnesota. For example, in Klein v. Cornelius, the Tenth Circuit relied on the Ponzi presumptions to affirm a summary judgment against an innocent transferee.[19] That trend continues through today. In a case decided in May 2020, Gordon v. Royal Palm Real Estate Investment Fund I, LLLP, the court relied on the Ponzi presumptions to hold that an investment by the Ponzi scheme into an unrelated investment fund was an actually fraudulent transfer leaving the fund’s good faith defense as the only issue for trial.[20] The Gordon court applied the presumption without any analysis or particular controversy.
And, even under Minnesota law following Finn, the existence of a Ponzi scheme remains highly relevant to fraudulent transfer actions and can support a finding that a particular transfer was fraudulent.[21] The court in Finn expressly recognized that “[w]ithout a legally enforceable contractual claim, any payment made to an investor beyond its principal investment is not for antecedent debt, and therefore cannot be in exchange for reasonably equivalent value.[22]” Thus, courts applying Minnesota law continue to hold that payment of fictitious profits or interest on an investment in a Ponzi scheme does not qualify as payment of an antecedent debt for purposes of establishing reasonably equivalent value.[23]
As we begin to recover from the economic dislocation caused by COVID-19, regulators and investors will discover numerous, significant fraudulent schemes. Bankruptcy and receivership professionals will be called upon to resolve these schemes. For those professionals representing trustees, the Ponzi presumptions will be an invaluable aid in recovering assets. For those representing transferees, the presumptions remain a significant obstacle, but cases like Finn and Golf Channel provide some relief and suggest limits to the presumptions.
[1] While the fraudulent transfer provisions of the Code are not identical to UFTA, they are sufficiently similar that the fraudulent transfer analysis at issue is the same under either state or federal law. Janvey v. Golf Channel, Inc., 487 S.W.3d 560, 572 (Tex. 2016)
[2] 11 U.S.C. § 548(A).
[3] 11 U.S.C. § 548(B).
[4] A Ponzi scheme is a “fraudulent investment scheme in which money contributed by later investors generates artificially high dividends or returns for the original investors, whose example attracts even larger investments.” Janvey v. Alguire, 647 F.3d 585, 597 (5th Cir. 2011) (quoting BLACK’S LAW DICTIONARY 1198 (8th ed. 2004)).
[5] For example, in In re Independent Clearing House Co., 77 B.R. 843 (D. Utah 1987), the trustee brought more than 2,000 adversary proceedings to recover allegedly fraudulent transfers to investors in a Ponzi scheme.
[6] In every Ponzi scheme, there are those who invest knowing that it is a scheme but hoping to make a quick profit before the scheme collapses.
[7] The first two presumptions are based on fraudulent transfer concepts — preventing creditors from timely obtaining access to their funds and undertaking more debt than can reasonably be repaid. The third is based on the equitable doctrine of in pari delicto, which prevents even innocent parties from enforcing illegal contracts where it would be inequitable to do so. The inequity here is that the funds used to pay the false profits are stolen from other investors and that paying false profits would prevent other defrauded investors from recovering. See Janvey v. Brown, 767 F.3d 430, 441-43 (5th Cir. 2014) (holding that ordinary principles of equity would not allow even innocent investors to enforce illegal contracts).
[8] E.g., In re Polaroid Corp., 472 B.R. 22, 42 (Bankr. D. Minn. 2012) (applying the presumptions where the defendant failed to provide evidence to rebut them).
[9] Donell v. Kowell, 533 F.3d 762, 770 (9th Cir. 2008) (affirming summary judgment requiring repayment of amounts in excess of investment and holding that in Ponzi scheme cases, “the general rule is that to the extent innocent investors have received payments in excess of the amounts of principal that they originally invested, those payments are avoidable as fraudulent transfers”). The Donell court set forth the standard “net investment” analysis (dollars in less dollars out) used by most courts in evaluating the liability of Ponzi investors for fraudulent transfers. Id. at 771-72.
[10] Warfield v. Byron, 436 F.3d 551, 559-60 (5th Cir. 2006) (affirming summary judgment requiring sales agent to repay commissions received for soliciting investments and noting that it “takes cheek to contend that in exchange for the payments he received, the RDI Ponzi scheme benefited from his efforts to extend the fraud by securing new investments”). The Warfield court cited Ramirez Rodriguez v. Dunson (In re Ramirez Rodriguez), 209 B.R. 424, 434 (Bankr. S.D. Tex. 1997); Randy v. Edison Worldwide Capital (In re Randy), 189 B.R. 425, 438–39 (Bankr. N.D. Ill. 1995); and Dicello v. Jenkins (In re Int’l Loan Network, Inc.), 160 B.R. 1, 16 (Bankr. D. D.C. 1993) — each of which held that contracts for broker services in furtherance of Ponzi scheme were illegal and provided no benefit to debtor).
[11] Janvey v. GMAG, LLC, 592 S.W.3d 125, 129-131 (Tex. 2019) (holding that a transferee on inquiry notice must return all payments from Ponzi scheme because it did not conduct a diligent inquiry into the suspected fraud).
[12] Finn v. Alliance Bank, 860 N.W.2d 638 (Minn. 2015). For a more detailed analysis of Finn and its reasoning, please see Michael Napoli & Eduardo Espinosa, Fraudulent Transfers in the Ponzi Era, 12 Pratt's J. Bankr. L. 12-6-I (2016).
[13] Id. at 642.
[14] Id. at 643.
[15] Id. at 647-52.
[16] Id. at 654-55.
[17] Janvey v. Golf Channel, Inc., 487 S.W.3d 560, 567 n.27 (Tex. 2016) (“We express no opinion regarding the validity of the Fifth Circuit's conclusive Ponzi-scheme presumptions.… Though we need not consider the validity vel non of the Ponzi-scheme presumptions, we note that TUFTA provides only one express presumption: “A debtor who is generally not paying the debtor's debts as they become due is presumed to be insolvent.’”).
[18] For example, in Kokesh v. SEC, 137 S. Ct. 1635, 1642 n.3 (2017), the Supreme Court questioned in a footnote “whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context.” This footnote lead to considerable litigation over the SEC’s right to disgorgement culminating in Liu v. SEC, 140 S. Ct. 1936, 1946-47 (2020), which recognized but limited the remedy.
[19] Klein v. Cornelius, 786 F.3d 1310, 1320 (10th Cir. 2015) (“And, because Ponzi schemes are insolvent by definition, we presume that transfers from such entities involve actual intent to defraud.”).
[20] Gordon v. Royal Palm Real Estate Investment Fund I, LLLP, 2020 WL 2836312, *8, Case No. 09-11770 (E.D. Mich. May 31, 2020).
[21] Stoebner v. Opportunity Finance, LLC, 909 F.3d 219, 226 (8th Cir. 2019) (acknowledging that under Finn “a court could make a reasonable inference from the existence of a Ponzi scheme that a particular transaction was made with fraudulent intent” but that trustee could not apply that inference to payments due under legitimate financing arrangements by an affiliate of the schemer).
[22] Finn, 860 N.W.2d at 651.
[23] Kelley v. Boosalis, 2018 WL 6322631, Case No. 0:18-cv-00868 (D. Minn. Dec. 3, 2018)(approving jury instruction providing that payment of interest “is not in satisfaction of a valid antecedent debt if it was made in furtherance of a fraud, enabled by a fraud, or paid on dishonestly-incurred debt”).