Ponzi Scheme Defenses to Fraudulent Transfers in Bankruptcy


Fraudulent Transfers in Bankruptcy – Adversary Proceedings

Fraudulent transfers are one type of adversary proceeding in bankruptcy in which the trustee attempts to recover property for the benefit of the creditors of the debtor’s estate. A full discussion on fraudulent transfer actions can be found on our blog post on Fraudulent Transfers in Bankruptcy.

In addition to fraudulent transfers, preference actions are another form of adversary proceeding brought by the trustee for the benefit of the creditors in bankruptcy. As an aside, ordinary course of business transfers and contemporaneous exchange of new value are the two most heavily litigated defenses to a preference action.

In both fraudulent transfer and preference adversary proceedings, a trustee in bankruptcy is incentivized to go after previous payments made to creditors by the debtor before the filing of its bankruptcy petition in order to maximize the trustee’s compensation. Fraudulent transfer actions being brought pursuant to a debtor who engaged in a Ponzi scheme are no different in that respect. However, the defenses available to defendants in a fraudulent transfer adversary proceeding are different in the context of a Ponzi scheme.

What is a Ponzi Scheme?

Given the effects that the presence of a Ponzi scheme may have on the defenses available to a defendant in a fraudulent transfer action, the question becomes: what is a Ponzi scheme anyway?

The bankruptcy appellate panel of the ninth circuit recently weighed in on the issue, noting:

A Ponzi scheme is a fraudulent arrangement in which an entity makes payments to investors from monies obtained from later investors rather than from any ‘profits’ of the underlying business venture. The fraud consists of funneling proceeds received from new investors to previous investors in the guise of profits from the alleged business venture, thereby cultivating an illusion that a legitimate profit-making business opportunity exists and inducing further investment.

In re Cohen, 199 B.R. 709, 717, fn. 9 (9th Cir. B.A.P. 1996).

With this understanding of the meaning of a Ponzi scheme, the special considerations which apply when a fraudulent transfer action in the context of a Ponzi scheme bankruptcy proceeding are more easily understood.

Ponzi Scheme Creates Presumption of Actual Fraud

When the debtor in bankruptcy was engaged in the operation of a Ponzi scheme, courts apply a Ponzi scheme presumption where the actual intent to defraud creditors is presumed. This is so because transfers “made in the course of a Ponzi scheme could have been made for no other purpose other than to hinder, delay or defraud creditors.” In re Dreier LLP, 452 B.R. 391, 424 (Bankr. S.D.N.Y. 2011). In other words: “[T]he mere existence of a Ponzi scheme is sufficient to establish the actual intent to defraud.” Donnell v. Kowell, 533 F.2d 762, 770 (9th Cir. 2008). 

Ponzi Scheme Investors as Defendants in Fraudulent Transfer Actions

Innocent investors into Ponzi schemes must fight to protect the money they invested into the scheme from the bankruptcy trustee trying to take it back.

In a typical bankruptcy, when a creditor receives a “fraudulent transfer” from a debtor in advance of the debtor’s filing of its bankruptcy petition, the entire transfer is clawed back by the trustee in the adversary fraudulent transfer proceeding. This is not the case in a fraudulent transfer action where the debtor was engaged in a Ponzi scheme. A court must use a three-step process to determine the amount of liability of a Ponzi scheme investor defendant.

Step One – The “Netting Rule”

Rather than claw-back all payments made by a Ponzi scheme debtor to a defendant in a fraudulent transfer action, the courts will apply a “netting rule” to determine the potential recovery of a trustee in a fraudulent transfer action in the context of a Ponzi scheme.

Amounts transferred by the Ponzi scheme perpetrator to the investor are netted against the initial amounts invested by that individual. If the net is positive, the receiver has established liability, and the court then determines the actual amount of liability, which may or may not be equal to the net gain, depending on factors such as whether transfers were made within the limitations period or whether the investor lacked good faith. If the net is negative, the good faith investor is not liable because payments received in amounts less than the initial investment, being payments against the good faith investor’s as-yet unsatisfied restitution claim against the Ponzi scheme perpetrator, are not avoidable within the meaning of the UFTA.

Donnell, supra, 533 F.3d at 771.

Step Two – Determination of Liability Amount

Next, the court must determine the amount of a defendant’s liability to return a fraudulent transfer received from a Ponzi scheme operator:

the court permits good faith investors to retain payments up to the amount invested, and requires disgorgement of only the ‘profits’ paid to them by the Ponzi scheme. … Payments of amounts up to the value of the initial investment are not, however, considered a ‘return of principal,’ because the initial payment is not considered a true investment. Rather, investors are permitted to retain these amounts because they have claims of restitution or recision against the debtor that operated the scheme up to the amount of the initial investment. Payments up to the amount of the initial investment are considered to be exchanged for ‘reasonably equivalent value,’ and thus not fraudulent, because they proportionally reduce the investors’ rights to restitution.

Id. at 772.

Step Three – Statute of Limitation Analysis

While the ‘profits’ made by investors may be able to be clawed back from a trustee in a fraudulent transfer action in the Ponzi scheme context, the applicable statute of limitations will still apply.

Although all payments of fictitious profits are avoidable as fraudulent transfers, the appropriate statute of limitations restricts the payments the Ponzi scheme investor may be required to disgorge. Only transfers made within the limitations period are avoidable. … Neilson v. Union Bank of Cal., N.A., 290 F.Supp.2d 1101, 1145-46 (holding that plaintiffs could prevail if they could prove at the trial that certain transfers made pursuant to a Ponzi scheme were made within the limitations period of California’s UFTA).

Donnell, supra, 533 F.3d at 772. The statute of limitations laid out in the United States Bankruptcy Code § 548 is two years before the filing of the petition. If a fraudulent transfer action is being brought pursuant to the California Uniform Voidable Transfer Act, the statute of limitations typically requires an action to be brought within four years of the transfer.

Thus, step one nets the amount of the initial investment against the amount transferred to the fraudulent transfer defendant from the Ponzi scheme operator debtor. Step two requires an analysis of how much is recoverable over and above the initial investment made by the defendant. Then, the applicable statute of limitations may serve to reduce the amount of recovery a trustee may have from a Ponzi scheme investor, even if the investor got more money out of the scheme than they initially invested.

Ponzi Scheme Fraudulent Transfer Actions – Constructive vs. Actual Fraud

In the context of a Ponzi scheme, whether the receiver seeks to recover from winning investors under the actual fraud or constructive fraud theories generally does not impact the amount of recovery from innocent investors.

Donnell, supra, 533 F.3d at 771. Given the lack of distinction between actual and constructive fraud theories when recovering from an innocent investor, the question becomes: what does it mean to be an innocent investor?

Good-Faith or Innocent Investors in a Ponzi Scheme

“[G]ood faith ‘is not susceptible of precise definition.'” In re Agricultural Research and Tech. Grp., Inc., 916 F.2d 528, 536 (9th Cir. 1990). Once court has gone so far as to pronounce that a lack of good faith is demonstrated simply by a transferee who knows that a debtor is operating a Ponzi scheme. In re Indep. Clearing House Co., 77 B.R. 843, 861 (D. Utah 1987). An early Supreme Court case stated that bad faith may be inferred if: “knowledge or actual notice of circumstances sufficient to put him, as a prudent man, upon inquiry as to whether [a debtor] intended to delay or defraud his creditors.” Shauer v Alterton, 151 U.S. 607, 621 (1894). Thus, Courts seemingly look to whether “the transferee objectively ‘knew or should have known’ in questions of good faith….” In re Agricultural Research and Tech. Grp., Inc., supra, 916 F.2d at 535-36.

Actual Fraud

In the presence of a bad faith investor who commits actual fraud when putting money into a Ponzi scheme, “the receiver may recover the entire amount paid to an investor, including amounts which could be considered ‘return of principal.'” Donnell, supra, 533 F.3d at 771. However, there is a good faith defense which permits an innocent winning investor to retain the full amount of its initial principal investment. In re Agricultural Research and Tech. Grp., Inc., supra, 916 F.2d at 535.

Constructive Fraud

Similar to the actual fraud theory of recovery Ponzi scheme context, if the investor acts in good faith, then the trustee may only recover the ‘profits’ derived from a Ponzi scheme over and above the initial investment. Scholes v. Lehmann, 56 F.3d 750, 757 (7th Cir. 1995). However, unlike a recovery action under actual fraud, the trustee (not the investor defendant) bears the burden of proving bad faith on the part of the investor defendant in the case of recovery under a constructive fraud theory in the context of a Ponzi scheme. Id. at 756-57.

Contact an Experienced Bankruptcy Attorney in Los Angeles, Orange County, San Diego, Riverside, San Bernardino, San Jose, Sacramento, and Surrounding Areas in California

Fraudulent transfer adversary proceedings, especially in the context of a Ponzi scheme, are very complex. As such, if a trustee has filed or may file an adversary proceeding against you alleging a fraudulent transfer, it is important to contact a skilled bankruptcy attorneys immediately. Talkov Law’s experienced bankruptcy attorneys can help determine what defenses may be available to you by working with you online or over the phone at (844) 4-TALKOV (825568)

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Nick Moss
About Nick Moss

Nick Moss is an attorney at Talkov Law in Los Angeles. The focus of his practice is real estate law, business litigation and bankruptcy in California. He can be reached at (310) 496-3300 or nick(at)talkovlaw.com.

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