by James Walsh
A Ponzi scheme is considered—by definition—to involve fraudulent intent. In the wake of a Ponzi scheme collapse, a bankruptcy court can order the reversal of any transaction that occurred within one year before the bankruptcy filing. This one-year limit is known as the “reachback period.” The court can order any investor who took money out of the scheme within the reachback period to give it back.
Another Way to Overturn Ponzi Payments
The trustee can also void transfers on somewhat different grounds. If the debtor “received less than reasonably equivalent value” in exchange for a transfer of the debtor’s property, the trustee may avoid the transfer if several additional elements are established.
“Value” is defined for purposes of the Code as “property, or satisfaction or securing of a present or antecedent debt of the debtor.” Bankruptcy courts have concluded that a defrauded investor in a Ponzi scheme gives “value” to the debtor in the form of a dollar-for-dollar reduction in other investors’ restitution claims against the scheme.
On this subject, the federal appeals court in the Ponzi scheme case In re Independent Clearing House Co. ruled:
[T]o the extent the debtors’ payments to a defendant [investor] merely repaid his principal undertaking, the payments satisfied an antecedent “debt” of the debtors, and the debtors received “value” in exchange for the transfers. Moreover, to the extent a transfer merely repaid a defendant’s undertaking, the debtor received not only a “reasonably equivalent value” but the exact same value—dollar for dollar. We therefore hold that such transfers are not avoidable....
In theory, the trustee is not allowed to reverse transfers made for reasonably equivalent value because creditors are not hurt by such transfers. If the scheme no longer has the thing transferred, either it has something equivalent—which creditors take to satisfy their claims— or its liabilities have been proportionately reduced.
But a trustee has some leeway in reversing payments to Ponzi investors. If all the scheme receives in return for an investment is the use of an investor’s money to continue itself, there is nothing added to the estate for creditors to share. In fact, by helping the scheme perpetuate itself, the investors exacerbate the harm to creditors by increasing the amount of claims. As one federal court observed:
If the use of the [investors’] money was of value to the debtors, it was only because it allowed them to defraud more people of more money. Judged from any but the subjective viewpoint of the perpetrators of the scheme, the “value” of using others’ money for such a purpose is negative.
There’s an exception to this so-called value rule: a lender who accepted scheme assets as security can still collect the money it loaned.
Ponzi investors being forced to give back distributions will often argue against the one-year limit by claiming that the United States Constitution mandates people who are similarly situated receive like treatment under the law (this argument cites the theoretically complex Fourteenth Amendment).
The theory behind this argument is that a statute may single out a class of people for distinctive treatment only if that classification bears a rational relationship to the purpose of the statute. The argument implies that all investors in a Ponzi scheme are predominantly creditors of the same class and should be treated equally.
However, this argument usually relies on non-bankruptcy cases. As one court said, succinctly, “These cases are unhelpful.” The chief judge ruling in In re Independent Clearing House Co. offered a more specific analysis:
All investors in a Ponzi scheme are creditors of the same class, so in theory all should be treated equally.... The equitable solution would be either to apply the statute to all transfers to investors in a Ponzi scheme— without regard to when the transfers were made—or to apply the statute to none of the transfers. Yet this court is no more free to rewrite the statute to bring the early undertakers into its net than it is to ignore the statute to treat later undertakers equally. Courts must apply the statute as written.
The Bankruptcy Code allows some transfers to stand because they are part of “the ordinary course of business.” However, the Code insulates the transferees of an avoided fraudulent transfer who take “for value and in good faith” by providing that such a transferee has a lien, or may retain the interest transferred, to the extent the transferee gave “value to the debtor” in exchange for the transfer.
Judge James H. Williams of the U.S. Bankruptcy Court in northern Ohio wrote a number of decisions revolving around In re Plus Gold, Inc.—a case of a collapsed multi-level marketing Ponzi scheme. Most of Williams’ decisions had to do with burned investors arguing that the court should reverse payments that earlier investors had received.
The investors’ money was spent buying “spots” in the Plus Gold “matrix.” A spot was the designation used for a membership or distributorship; each spot cost $265.00.
However, some spots on the matrix were designated as “APS” or “additional pay spot” spots. Whenever a distributor had recruited fourteen other participants, an additional pay spot would be given to the distributor for free. Periodically, the people who had these free spots would receive the same pay-outs as people who’d paid for theirs.
The trustee in the case—as well as a group of angry investors—wanted the APS people to give back the money they’d taken out. The APS people argued that they were merely being reimbursed for time and money they’d spent marketing Plus Gold’s scheme.
The court ruled that, since Plus Gold had received nothing of value in return for the free spots it gave these people, the money it paid them had to come back.
In recognizing claims for rescission and restitution, courts usually assume that the investors had no knowledge of the fraud the debtors were perpetrating. If investments were made with culpable knowledge, all subsequent payments made to such investors within one year of the debtors’ bankruptcy would be avoidable, regardless of the amount invested, because the debtors would not have exchanged a reasonably equivalent value for the payments.
Similarly, if there is a question about a recipient’s innocence at the time he received a payment under a Ponzi scheme, avoidance of the transfer might be sought. This claim usually requires a court to consider the good faith of an investor who wished to retain payments, or portions of payments, received from the debtor.
Exceptions to the Code Rules
A common problem in pyramid schemes is that goods, services and cash are often shuffled among many people—including some who have little or no involvement in the underlying scheme.
The law gives innocent bystanders a break. Subsequent transferees (that is, transferees of the initial transferee), who take for value without knowledge of the original fraudulent transfer are not liable for any recovery. Nor are their subsequent good faith transferees liable. The Bankruptcy Code does not define “good faith.” As a result, courts applying the good faith exception have generally refused to formulate precise definitions. However, after noting that “[g]ood faith is an intangible and abstract quantity with no technical meaning,” Black’s Law Dictionary states that the term includes not only “honest belief, the absence of malice and the absence of design to defraud or to seek an unconscionable advantage” but also “freedom from knowledge of circumstances which ought to put the holder on inquiry.”
The Eighth Circuit Court of Appeals has written that “a transferee does not act in good faith when he has sufficient knowledge to place him on inquiry notice of the debtor’s possible insolvency.”
So, a transferee who reasonably should have known of a debtor’s insolvency or of the fraudulent intent underlying the transfer is not entitled to the good faith defense.
The In re Independent Clearing House court explained (in a mixed anatomical metaphor) the determination of good faith in a manner that emphasized objective factors: “The test is whether the transaction in question bears the earmarks of an arm’s length bargain.”
Bankruptcy Crimes
Often, Po
nzi perps will try to hide money from a scheme in the days...or hours...before filing bankruptcy. This is certainly a major concern that burned investors have after the scheme collapses.
The Bankrupcty Code provides criminal penalties for any person who,
in a personal capacity or as an agent or officer of any person or corporation, in contemplation of a case under title 11 by or against the person or any other person or corporation, or with intent to defeat the provisions of title 11, knowingly and fraudulently transfers or conceals any of his property or the property of such other person or corporation.
People charged with these crimes sometimes answer that, for an act of bankruptcy fraud to constitute a predicate act under RICO, an actual bankruptcy case must have been filed. However, the Code also allows criminal charges against a person who merely transfers or conceals assets “in contemplation of a case... or with intent to defeat the provisions of [the Code].”
All that it requires is that the defendant transfer assets with the ultimate intent to defraud a bankruptcy court, whether or not such proceedings ever actually commence.
Fraudulent Conveyance
Without any doubt, the claim most often made in Ponzi scheme bankruptcies—in fact, in all bankruptcies—is fraudulent conveyance. But this claim is harder to make stick that might first seem.
For a bankruptcy trustee to avoid a transfer as fraudulent, four elements must be satisfied:
1) the transfer must have involved property of the bankrupt company;
2) the transfer must have been made within one year of the filing of the petition;
3) the bankrupt company must not have received reasonably equivalent value in exchange for the property transferred; and
4) the bankrupt company must have been insolvent, been made insolvent by the transaction, be operating or about to operate without property constituting reasonable sufficient capital, or be unable to pay debts as they become due.
Most people focus on the fourth of these elements. They argue some variation on the theme that: “The company was dying when it made the deal, so it can’t be enforced.”
But all four elements need to be satisfied before a deal—or payment— can be reversed.
On the question of fraudulent conveyance, California bankruptcy law states:
The trustee may avoid any transfer of an interest of the debtor in property... that was made... on or within one year before date of the filing of the petition, if the debtor... received less than a reasonably equivalent value in exchange for such transfer... and was insolvent on the date that such transfer was made... or became insolvent as a result of such transfer... was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital; or... intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured.
California’s fraudulent conveyance statutes are similar in form and substance to the Code’s fraudulent transfer provisions. Both allow a transfer to be avoided where “the debtor did not receive a reasonably equivalent value in exchange for the transfer and [the debtor] was either insolvent at the time of the transfer or was engaged in business with unreasonably small capital.”
It’s likely that burned Ponzi investors will make fraudulent conveyance claims at some point in the legal wrangling that follows a scheme’s collapse. However, in the Court TV culture of armchair legal experts, some legal concepts get more attention than they deserve. Fraudulent conveyance claims can work for burned investors—but the claims often seem like a bigger tool than they really are.
Case Study: The Scrappy Trustee of M&L Business Machines
Beginning in the 1970s, M&L Business Machines operated as a computer sales, leasing and repair firm in the Denver area. In the early 1980s, Robert Joseph acquired approximately 50 percent of the stock in M&L. By 1986, most of Joseph’s stock—and the remaining 50 percent—had been transferred to David Parrish and Daniel Hatch.
In early 1987, Joseph, Parrish and Hatch began taking in money from third parties whom they called “private lenders” or “private investors.” These investors were promised high rates of return for the use of their money to enable M&L to buy large quantities of expensive computers and office equipment.
Some investors were told that they would earn interest at 10 percent per month—120 percent per year—for M&L’s use of their money. They were told they would share in large profits upon the resale of the computers and office equipment. Some investors were actually paid the usurious interest, often in the form of post-dated checks offered as security for the loans.
However, the dividends were funded by new investor capital, loan proceeds and check kiting. By the end of 1987, M&L had become a full-fledged Ponzi scheme. The principals were able to keep the scheme running for a little more than two years—then it collapsed.
When M&L collapsed, nearly $83 million in post-dated checks remained in the hands of various private investors. In October 1990, M&L filed a Chapter 7 bankruptcy. In December 1990, Denver lawyer Christine Jobin was appointed M&L’s trustee.
Unsecured claims against M&L which were related to leigitmate loans from investors totalled about $21 million. In addition, the Resolution Trust Corporation (RTC) as receiver of Capital Federal Savings and Loan had an unsecured claim for about $9 million which was related to other loans to M&L. There were also some relatively insignificant unsecured claims for goods or services. On the asset side, there wasn’t much. M&L had accounts receiveable worth about $10,000. Most of its money was supposedly tied up in inventory.
In February 1991, Jobin removed M&L’s inventory from its warehouse. Over the next several months, she opened and inspected more than 700 computer boxes. Most of them contained only bricks and dirt or hardened foam.
In September 1991, Jobin started suing people. In time, she filed over 400 adversary actions—against everyone from the Ponzi perps to investors who got money out, lawyers who gave advice and banks that made foolish loans. Rarely has there been a better example of fighting like hell in bankruptcy court.
In March 1992, a federal grand jury handed down a 41-count indictment against the M&L principals and a handful of confidantes. In announcing the indictments after a year-long investigation, law-enforcement officials credited each other for cooperation among federal, state and local agencies. In July 1993, the indicted M&L officers and employees drew federal prison terms of various lengths for what the sentencing judge called a “scam from day one.”
None of this did very much for Jobin. She tried to claim all rights to sue the M&L Ponzi perps. This effort resulted in a legal tangle with some people who loaned M&L money. From its opening remarks, the court seemed soured by the tone of the proceedings:
Rarely does the Court have the displeasure of reviewing such antagonistic pleadings wherein at times counsel on both sides lost sight of the issues.
In the case, some of the people who’d loaned money to M&L argued that their claims against the perps were not assets of estate and, therefore, that Jobin had no standing to absorb their claims.
Jobin argued that the Bankruptcy Code weighs in favor of allowing only a trustee to pursue these claims so that all similarly situated creditors will be treated alike. This meant that only she had the right to pursue any action against the M&L Ponzi perps. The investors countered that Jobin would only have the rights she claimed if there were voidable transfers for her to recover. Because she was not claiming that the property in the hands of the perps belonged to M&L, she had to get out of their way.
The court sided with the lenders, allowing them to proceed with their own claims against the perps. Jobin simply redirected her efforts.
In December 1992, she sued Gregory Lalan, an investor who’d gotten some money out of the scheme. Jobin wanted Lalan to give back money which he’d received from M&L during the year preceding its bankruptcy petition. The bankruptcy court ruled in her f
avor and order Lalan to return $409,476, plus costs and interest. He appealed.
Lalan had owned a dry cleaning business since 1975. He was a conservative businessman. For years, he’d had a line of credit secured by the business, but he’d never used it; he owned his home, free and clear. In the summer of 1989, a friend told Lalan about investment opportunities available with M&L. He suspected the promised returns, telling the friend that “there was no way to make money that quick without a catch.” But Lalan eventually visited M&L’s offices and—in October 1989—invested $10,000 cash.
Lalan didn’t see any of the contracts in which he was supposedly investing. He didn’t ask for any detailed financial records or statements. Whenever he invested money in M&L, he’d receive two post-dated checks—one for his principal investment, and one for his profit. This process confirmed his understanding that he faced no risk.
However, Lalan could not always cash the checks on the dates they matured. Sometimes he was told to hang on to the checks a few extra days. He became suspicious after about six months—but continued to participate because the returns were so good.
The bankruptcy court concluded:
[Lalan] ignored his own initial intuition and plunged headlong into the scam because of the huge profits he was promised, and which he received. Is it reasonable to expect profits of 125 percent to 512 percent? Especially when there is supposedly “no risk” for the investment? Is it reasonable to expect a legitimate business to demand cash for an investment—at a minimum of $10,000? Is it reasonable to hand over that amount of cash without at least some investigation? Is it reasonable to accept post-dated checks for large sums of money from a person, but not be able to negotiate such checks on their due dates until permission from the maker is received? The answer to all these questions is a resounding NO!