If There’s No Diminution of the Estate, There’s No Preference or Fraudulent Transfer

Even if a debtor orchestrates a fraudulent transfer to foster a Ponzi scheme, the Seventh Circuit tells us it isn’t avoidable as a preference or a fraudulent transfer if there was no diminution of the estate.

The corporate debtor was conducting a Ponzi scheme. The strategy was simple: The debtor generated fake invoices representing receivables from fake customers. Then, the debtor factored the fake receivables with commercial factors. The debtor used advances from one factor to pay off other factors.

After the Ponzi scheme blew up, a bankruptcy trustee took over. The trustee filed a complaint alleging that one factor, whom we shall call the seller, was owed $10 million. The trustee alleged that the seller knew that the business was a Ponzi scheme and wanted out. The trustee surmised that the seller would keep quiet about the Ponzi scheme if it recovered the $10 million.

The trustee further alleged that the seller and the debtor together arranged for a new factor to assume the seller’s position by paying $10 million to the seller and taking over the seller’s position in fake accounts. We shall refer to the new factor as the buyer.

The $10 million passed directly from the buyer to the seller and never through the hands of the debtor.

In her June 22 opinion, Seventh Circuit Judge Amy J. St. Eve mentioned that the buyer had a lawsuit pending against the seller in a state court, alleging fraud.

The trustee also sued the seller for the $10 million, alleging that the transaction was both a preference and a fraudulent transfer avoidable under Sections 547 and 548.

The bankruptcy court granted the seller’s motion for summary judgment, and the district court affirmed. The trustee appealed to the circuit.

No Diminution of the Estate

First, Judge St. Eve examined the preference claim, noting that Section 547 permits a trustee to avoid a “transfer of an interest of the debtor in property.”

In the Seventh Circuit, the debtor has an interest in property if (1) the debtor can exercise control, and (2) the transfer diminishes the property of the estate. Judge St. Eve said that a “reasonable jury” might find satisfaction of the control requirement because the debtor could direct the transfer from the buyer to the seller.

However, Judge St. Eve was not required to resolve the control question, because “a diminution of estate analysis shows plainly that the transaction at issue here did not involve ‘an interest of the debtor in property.’” The funds “never actually passed through the debtor’s accounts,” she said.

Furthermore, there was no adverse effect on creditors nor a diminution of the estate, Judge St. Eve observed. She upheld dismissal of the preference claim because there was no transfer of the debtor’s interest in property.

With regard to fraudulent transfer, the trustee contended that control was not required given fraud. Judge St. Eve disagreed, observing that the “plain language” of Section 548 also requires the transfer of “an interest of the debtor in property.”

Even if the trustee could avoid the transfer, Judge St. Eve couldn’t figure out how the estate would have a recovery, because the transfer went from the buyer to the seller. If the transfer were avoided, she said, the court would return the $10 million to the buyer, not to the estate.

Judge St. Eve said that her “decision aligns comfortably with those of our sister circuits, several of which have held or suggested that, even in the Ponzi scheme context, outright fraud alone cannot bring a transaction within the avoiding powers of the Bankruptcy Code.”

Judge St. Eve upheld dismissal of the Section 548 claim “[b]cause the transaction in this case had no impact on the property of the Debtor [and] is not the type of fraud governed by the Bankruptcy Code.”