Contributed by Debra McElligott
Although the bankruptcy world has long been acquainted with Ponzi schemes, the courts have not clearly answered the question of how to distribute investors’ funds after a scheme fails – especially in the scenario where certain investors profit. The United States Bankruptcy Court for the District of Utah recently weighed in on the issue in Gillman v. Russell (In re Twin Peaks Financial Services, Inc.), in which it considered whether returns to investors in a Ponzi scheme are recoverable as fraudulent transfers.
The Defendant’s Investment
The debtor in Twin Peaks operated a real estate investment firm. Apparently, however, the investment returns were not what they seemed, and the fund turned out to be a Ponzi scheme. After the scheme failed and the debtor filed for bankruptcy, the chapter 7 trustee commenced an adversary proceeding against the defendant, an investor in the scheme who had received over $440,000 from the debtor in excess of his original investment. The trustee argued, among other things, that the defendant’s proceeds were fraudulent transfers under section 548 of the Bankruptcy Code and moved for summary judgment.
The defendant argued that the court should consider his transactions not only with the debtor in this case, but also with a related (though not substantively consolidated) debtor whose operations were part of the same fraudulent scheme. In that broader universe, the defendant’s returns did not exceed his total investment. Second, the defendant disputed that the transfers were made with the intent to hinder, delay, or defraud creditors under section 548(a)(1)(A) of the Bankruptcy Code. Finally, the defendant argued that he had a fraud claim against the debtor, and that such claim constituted “value” given to the debtor for the purposes of section 548(a)(1)(B).
The court disagreed with the defendant’s assertion that his investments in a related, but separate, debtor must be considered simply because both debtors’ operations were part of the same fraudulent scheme. The court noted that both debtors’ bankruptcies had been pending for more than six years and had not been substantively consolidated. Because of that separateness, the court held, the situation was “akin to two individuals perpetuating a fraudulent scheme,” and that payments to one debtor could not also be deemed payments to the other.
The Ponzi Presumption
The court also dismissed the defendant’s argument that the transfers were not made with the intent to hinder, delay, and defraud creditors. The trustee established, and the defendant did not contest, that the debtor was operating a Ponzi scheme. As such, the “Ponzi presumption” – a presumption of the intent to defraud for the purposes of section 548 – arose, and the defendant had the burden to establish a defense. The court, relying on the opinion of the United States District Court for the District of Utah in Merrill v. Abbott (In re Independent Clearing House Co.), stated that no other reasonable inference is possible when a debtor operates a Ponzi scheme.
Fraud Claim: A Failing Argument
Finally, the court rejected the defendant’s argument that his fraud claim constituted “value” within the meaning of section 548. Under section 548(a)(1)(B), a trustee may avoid a transfer as a constructive fraudulent transfer if the debtor, among other things, received less than reasonably equivalent value in exchange. Although the parties did not contest that the defendant invested in the debtor, they disagreed over whether he gave “value” for the amount he received in excess of his investment.
The court first examined the meaning of the word “value,” which section 548(d)(2)(A) defines, in relevant part, as “property, or satisfaction . . . of a present or antecedent debt of the debtor[.]” Because the defendant did not give his investment – the “property” in this case – in exchange for the amount he received in excess of his investment, the court stated that the only “value” the defendant could give was “satisfaction of a present or antecedent debt.” The court held that the transfers could not have been in satisfaction of the defendant’s fraud claim because he received the funds under the terms of an investment contract at a time when the fraud claim did not exist.
The court briefly considered whether the defendant could retain his returns under section 548(c), which protects transferees to the extent they act in good faith and give value to the debtor in exchange for the interest transferred. Again deciding in favor of the trustee, the court stated that only the amount of a defendant’s investment constitutes “value” in a Ponzi scheme. Although the defendant desired to enforce a contract entitling him to returns on his investment, the court noted that enforcing that contract would allow the defendant to profit at the expense of other defrauded investors and thus frustrate the purpose of the fraudulent transfer statute.
Because the court in Twin Peaks took a strong stance that returns on investments in a Ponzi scheme are not transfers made “for value” to the extent they exceed the amount invested, it did not reach the question of whether the defendant transferee acted in good faith. It is worth noting that at least one other recent decision, that of the United States District Court for the Southern District of New York in SIPC v. Bernard L. Madoff Investment Securities LLC, addressed the issue of what constitutes “good faith” for direct and subsequent recipients of transfers from a failed Ponzi scheme. The Madoff ruling also shifted the burden to the trustee to prove that the transferee either had actual knowledge of the fraud or was willfully blind to circumstances indicating a high probability of fraud. In that case, the court did not address, and assumed for the purposes of the opinion, that the transfers were made for “value” within the meaning of section 548.
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