Contributed by Laura Napoli
When is a fraud a Ponzi scheme, and when is it just ordinary fraud? The Bankruptcy Court for the Eastern District of Virginia recently provided insight into this question in Gold v. First Tennessee Bank, N.A. (In re Taneja), No. 10-01225, 2012 WL 3073175 (Bankr. E.D. Va. 2012), a case that involved allegations of mortgage fraud.
Background: The Fraudulent Scheme
The debtor, Vijay Taneja, owned and controlled Financial Mortgage, Inc. (“FMI”). On the surface, FMI was an ordinary mortgage broker that originated home mortgages. According to the court, however, as part of its business FMI also created fraudulent loans. Unsuspecting “warehouse” lenders funded these loans on an interim basis by advancing money on a line of credit until a secondary mortgage purchaser could be found to purchase the loan and pay off the advance. FMI would then proceed to make monthly payments on the fraudulent loan to the secondary mortgage purchaser.
The business collapsed when the real estate bubble burst in July 2007. Secondary mortgage purchasers developed more stringent lending standards and either reduced or stopped purchasing mortgage loans altogether. When the music stopped, some of the warehouse lenders still held outstanding fraudulent loans on their lines of credit. FMI satisfied some, but not all of these outstanding obligations to the warehouse lenders before Taneja filed for bankruptcy, pled guilty to money laundering, and went to jail.
Fraud or Ponzi Scheme?
After Taneja filed for bankruptcy, the bankruptcy trustee sought to recover approximately $4 million from First Tennessee Bank, one of the warehouse lenders, on the theory that FMI’s payments to First Tennessee were fraudulent conveyances. The trustee also asserted that Taneja’s entire fraudulent loan scheme was a Ponzi scheme.
Labeling the scheme a Ponzi scheme was more than just finger pointing on the trustee’s part. Once a fraudulent scheme is shown to be a Ponzi scheme, a presumption arises that all of the transactions that made up the scheme were made with the intent to hinder, delay, or defraud creditors. Showing such intent is a critical element of proving actual fraud, so the trustee would have an easier time proving a fraudulent conveyance once he could establish that it was part of a Ponzi scheme.
For the Ponzi presumption to arise, the trustee had to prove both that a Ponzi scheme existed and that the transactions were part of that scheme. In this case, the trustee failed to show that a Ponzi scheme existed in the first place.
The court began by looking at how Ponzi schemes are generally defined. Although there is no single legal definition of a Ponzi scheme, the court was able to identify several defining characteristics of Ponzi schemes to aid its analysis. For example, the general structure of a Ponzi scheme involves using money contributed by new investors to pay artificially high dividends to older investors. This creates the illusion that the venture is profitable and in turn, attracts new investors to the fraud. Ponzi schemes also frequently do not involve legitimate business ventures—the primary purpose of a business venture in a Ponzi scheme is to create and perpetuate a fraud. Consequently, any legitimate portion of the business is usually insignificant.
The court also examined the Ponzi presumption itself, concluding that it is often invoked for reasons of equity. In other words, the presumption is often used to help distribute the damage among investors because in a typical Ponzi scheme the most recent investors are left with the fallout from the scheme, but earlier investors often escape unscathed or with profits.
With this background knowledge, the court turned to the facts of the case and concluded that the trustee had not sustained his burden of proving that Taneja’s scheme was a Ponzi scheme. According to the court, all of the transactions between FMI and First Tennessee were at market interest rates negotiated through ordinary, arms-length commercial means. None of the transactions had the artificially high rates of return that typically characterize a Ponzi scheme. In addition, the court observed that, although FMI had made fraudulent loans, it was also primarily a legitimate mortgage broker. Prior to its collapse, only a small percentage of FMI’s mortgages were fraudulent.
The court also found that the equity justification for applying the Ponzi presumption was lacking. Neither the warehouse lenders nor the secondary mortgage purchasers were investing in FMI, so none of them benefitted from FMI’s success or shared in its profits the way early investors typically do in a Ponzi scheme. Nor did the number of warehouse lenders increase over time, the way duped investors tend to multiply in a Ponzi scheme.
Finally, the court found no evidence of a Ponzi scheme when it looked at the fraudulent loans themselves. Taneja’s fraud did involve a great deal of money; however, there was no evidence that the money was used to further support the fraud. Instead, Taneja used the money for his own purposes, building a luxurious mansion for himself and supporting his entertainment business.
Based on all of the evidence, the court concluded that Taneja’s fraud was not sufficient to qualify as a Ponzi scheme and refused to apply the Ponzi presumption. Without the Ponzi presumption, the trustee would ordinarily have to prove that each transaction he sought to recover was made with the intent to hinder, delay, or defraud the debtor’s creditors to show that the transactions were fraudulent conveyances. Yet, the court determined that because First Tennessee had successfully asserted a good faith defense based on evidence it submitted in court, resolution of the fraudulent conveyance intent issue was not necessary.
The court’s decision illustrates that not every fraud is a Ponzi scheme and helps clarify some of the factors courts will look to in order to determine whether a fraud rises to the level of a Ponzi scheme or whether it is just a garden variety fraud.
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