For the Defense: State Courts Reject the Ponzi-Scheme Presumptions in Fraudulent Transfer Actions

Bernie Madoff in New York, Tom Petters in Minneapolis, Allen Stanford in Houston, and Darren Berg in Seattle lead a rogues’ gallery of infamous Ponzi schemers. All are now serving time in prison, but the civil litigation arising from their Ponzi schemes and the Ponzi schemes of other less notorious fraudsters is not over. Ponzi schemes have spawned thousands of fraudulent transfer cases. Anglo-American fraudulent transfer law has a long history dating back four centuries to the Statute of 13 Elizabeth, enacted in 1571, and to the first reported fraudulent transfer case, Twyne’s Case, decided in 1601. Fraudulent transfer law is far from settled, however. In recent years, especially in fraudulent transfer cases arising out of Ponzi schemes, the law developed rapidly in a direction favoring the plaintiffs, but in 2015 and 2016 the direction began to turn.

In an effort to obtain funds for the victims of the Ponzi schemes, bankruptcy trustees and receivers have commenced fraudulent transfer cases to recover payments made by the Ponzi schemer. Many of the defendants had no knowledge of the Ponzi scheme. The defendants had loaned money or provided goods and services to the Ponzi schemer or the Ponzi schemer’s companies. These defendants did nothing wrong. Nevertheless, most of the defendants lost—at least in federal courts.

The federal courts frequently apply Ponzi- scheme presumptions that set high barriers for defendants. In 2015 and 2016, however, opinions issued by the highest courts of Minnesota and Texas rejected the Ponzi-scheme presumptions. Before discussing these recent state court decisions, it is best to put the decisions into context by first discussing Ponzi schemes and then by describing the federal courts’ Ponzi-scheme presumptions.

There is no precise definition of a Ponzi scheme. The Ninth Circuit describes a Ponzi scheme as: “a financial fraud that induces investment by promising extremely high, risk-free returns, usually in a short time period, from an allegedly legitimate business venture. The fraud consists of funneling proceeds from new investors to previous investors in the guise of profits from the alleged business venture, thereby cultivating the illusion that a legitimate profit-making business opportunity exists and inducing further investment.”  Donell v. Kowell, 533 F.3d 762, 767 n.2 (9th Cir. 2008). The Fifth Circuit describes a Ponzi scheme as “a pyramid scheme where earlier investors are paid from the investments of more recent investors, rather than from any underlying business concern, until the scheme ceases to attract new investors and the pyramid collapses.” Janvey v. Democratic Senatorial Campaign Comm., 712 F.3d 185, 188 n.1 (5th Cir. 2013).

In fraudulent transfer cases in which the transferor has been running a Ponzi scheme, many courts apply what have become known as Ponzi-scheme presumptions. All of the reported decisions that have applied the Ponzi-scheme presumptions are from federal courts. The cases typically originate as suits brought by bankruptcy trustees or receivers in cases in which the Ponzi schemer or one of his or her companies is the debtor.  The bankruptcy trustee seeks a judgment in the amount that the Ponzi schemer paid to the defendant. Even though many fraudulent transfer cases are brought pursuant to a state’s version of the Uniform Fraudulent Transfer Act (UFTA), the federal courts that apply the Ponzi-scheme presumptions cite as authority other federal cases. No state supreme court has yet applied the Ponzi-scheme presumptions.

There are three Ponzi-scheme presumptions.

1. Transfers from the debtor in furtherance of the Ponzi scheme are presumed to be made with fraudulent intent. The most commonly applied Ponzi-scheme presumption is the presumption that a transfer of property from the debtor in furtherance of the Ponzi scheme is a transfer made with fraudulent intent. When a court applies the Ponzi scheme “fraudulent intent” presumption, the trustee need only produce evidence that the debtor-transferor who was running a Ponzi scheme made payments to the defendant-transferee. The burden then shifts to the defendant-transferee, who must prove the affirmative defense that it accepted the payment: (1) in exchange for reasonably equivalent value; and (2) in good faith. Four Circuits—the Fifth, Ninth, Tenth, and Eleventh—have applied the presumption that a transfer of property in furtherance of a Ponzi scheme is made with fraudulent intent. E.g., Janvey v. Brown, 767 F.3d 430, 439 (5th Cir. 2014); Donell v. Kowell, 533 F.3d at 770 (9th Cir. 2008); Klein v. Cornelius, 786 F.3d 1310, 1320 (10th Cir.  2015); Wiand v. Lee, 753 F.3d 1194, 1201 (11th Cir. 2014).

2. The debtor who runs a Ponzi scheme is presumed to be insolvent. Insolvency is not a necessary element in Ponzi-scheme cases in which the trustee alleges actual fraud. Trustees often also allege constructive fraud, however, and in constructive fraud cases insolvency or financial distress is a necessary element.

Four Circuits—the Fifth, Ninth, Tenth and Eleventh—have applied the presumption that a debtor who is running a Ponzi scheme is insolvent or in financial distress. E.g., Warfield v. Byron, 436 F.3d 551, 558 (5th Cir. 2006); Donell v. Kowell, 533 F.3d at 770–71 (9th Cir. 2008); Klein v. Cornelius, 786 F.3d at 1320 (10th Cir. 2015); Wiand v. Lee, 753 F.3d at 1201(11th Cir. 2014).

3. “Value” is limited to the principal or original investment portion of the obligation. Sections 8(a) and 8(d) of the UFTA provide a defendant-transferee with an affirmative defense. The defendant must prove that it accepted the transfer in good faith, and that it gave “value” in exchange. To the extent that the defendant-transferee gave “value” to the debtor, the defendant can retain the property it received from the debtor.

“Value” is defined in section 3 of the UFTA to include the satisfaction of an antecedent debt. Notwithstanding the statutory definition, courts that apply the third Ponzi- scheme presumption limit “value” to satisfaction of the principal portion of the debt or to payment of the amount of the original investment. These courts presume that “value” does not include the interest or profits that a debtor owes to the transferee. In cases where the debtor-transferor repaid principal plus interest or an amount above the original investment, the courts that apply this Ponzi-scheme presumption limit “value” to principal or to the amount of the original investment. They avoid as fraudulent transfers the debtor’s payments of interest or profits.

Five Circuits—the Fifth, Seventh, Ninth, Tenth, and Eleventh—have applied this Ponzi-scheme presumption and limited the meaning of “value” to the amount of the principal portion of the debt or the amount of the  original  investment.  E.g.,  Janvey v.  Brown, 767 F.3d  430, 440–42 (5th  Cir. 2014); Scholes v. Lehmann, 56 F.3d 750, 756–59 (7th Cir. 1995); Donell v. Kowell, 533 F.3d at 772 (9th Cir. 2008); Sender v. Buchanan (In re Hedged-Investments Assoc., Inc., 84 F.3d 1286, 1289–90 (10th Cir. 1996);  Perkins  v.  Haines, 661 F.3d 623, 627–28 (11th Cir. 2011).

Two recent state supreme court decisions examine and reject the Ponzi-scheme presumptions.

Finn v. Alliance Bank, 860 N.W.2d 638 (Minn. 2015), casts a cold eye on all three of the Ponzi-scheme presumptions. Finn examines the reasoning that supports the presumptions, and then enumerates persuasive reasons to oppose the presumptions. Finn concludes that none of the three Ponzi- scheme presumptions is justified by the text of UFTA.

Finn observes that the Ponzi-scheme presumption on fraudulent intent requires a court to conclusively presume that fraudulent intent accompanies all transfers by the debt or in furtherance of a Ponzi scheme. Finn then looks to the text of UFTA to see whether there is any statutory justification for relieving the plaintiff “of its burden of proving—or for preventing the transferee from attempting to disprove—fraudulent intent.”

UFTA contains 11 nonexclusive factors that courts may consider in determining actual fraudulent intent. These factors, many of which were enumerated in Twyne’s Case, 76 Engl. Rep. 809 (Star Chamber 1601), are commonly referred to as “badges of fraud.” Finn notes that these factors are nonexclusive so that a court could properly consider as a factor a debtor’s operation of a Ponzi scheme: “But the Legislature’s enumeration of a specific list of badges of fraud, none of which are conclusive, precludes an interpretation that it intended a non-enumerated badge of fraud to be conclusive.”

Finn holds that there is nothing in UFTA to justify a presumption that transfers from a debtor who is operating a Ponzi scheme were made with fraudulent intent.

Finn observes that the Ponzi-scheme presumption of insolvency requires a court to presume that a debtor who operates a Ponzi scheme is insolvent when it transfers assets. Finn looks to the text of the statute to see whether it supports the Ponzi-scheme presumption of insolvency.

Finn notes that UFTA “does contain a presumption that allows a court to conclude that a debtor is insolvent, but the presumption does not depend on the existence of a Ponzi scheme. Rather, ‘[a] debtor who is not generally paying debts as they become due is presumed to be insolvent.’” (Emphasis in original.) Finn concludes that the Ponzi-scheme presumption of insolvency “lacks textual support.”

There is a second reason why Finn rejects the Ponzi-scheme presumption of insolvency. The presumption may in some cases result in the wrong conclusion as a matter of fact. Finn notes that there is a temporal aspect to fraudulent transfer cases. The trustee must prove that the debtor was insolvent at the time that the debtor made the transfer.

The temporal element is important because, as a factual matter, it is not at all clear that every fraudulent investment arrangement that is later determined to be a Ponzi scheme necessarily will have been insolvent from its inception. For example, it is not hard to imagine a debtor that begins as a legitimate business and eventually turns to fraud . . . . Similarly, a debtor could have assets or legitimate business operations aside from the Ponzi scheme . . . . Such an entity could be financially stable for a time, whether its stability is measured by the technical definition of insolvency in [UFTA § 2] or the alternate methods of measuring financial distress in [UFTA §§ 4(a)(2)(i) and (ii)]. Such a Ponzi scheme may be rare, but when the statute requires a creditor to prove a fraudulent transfer claim, a conclusive presumption that a Ponzi scheme is insolvent from its inception may be incorrect, both as a matter of law and as a matter of fact.

There is a third reason why Finn rejects the Ponzi-scheme presumption of insolvency. Finn criticizes the legal scholarship of those courts that rely on the original Ponzi-scheme case, Cunningham v. Brown, 265 U.S. 1 (1924), for the proposition that Ponzi schemes, as a matter of law, are insolvent from their inception. The particular postage-stamp swindle operated by Charles Ponzi never operated legitimately and was insolvent from the beginning, but the original Ponzi case does not stand for the proposition that all Ponzi schemes are necessarily insolvent from their inception.

Finn rejects the Ponzi-scheme presumption of insolvency for three reasons: the presumption lacks textual, factual, and scholarly support.

Finn observes that the Ponzi-scheme presumption on value requires the court to presume that a debtor operating a Ponzi scheme cannot receive reasonably equivalent value for the “interest” or “profits” it pays to investors. Once again, Finn looks to the text of the statute to see whether it supports the Ponzi-scheme presumption on value. UFTA includes in its definition of “value” “the satisfaction of an antecedent debt.” After considering case law and the statutory definitions of “debt,” Finn concludes, “that any legally enforceable right to payment against the debtor is sufficient to qualify as antecedent debt.” After considering case law and the statutory definitions of “debt,” Finn concludes, “that any legally enforceable right to payment against the debtor is sufficient to qualify as antecedent debt.”

Finn observes that courts that apply the Ponzi-scheme value presumption deem a contract between the operator of a Ponzi scheme and an investor to be unenforceable by the investor as a matter of public policy to the extent that the investor seeks a return in excess of its original principal. Finn identifies two principles that guide the reasoning of courts that apply the Ponzi-scheme value presumption. The first principle is that, due to the nature of Ponzi schemes, the money paid to the investors comes solely from money stolen from other investors. This is true of some Ponzi schemes, like the original scheme run by Charles Ponzi, but it is not true of all Ponzi schemes, some of which have a legitimate source of earnings. The second principle is “a dubious assumption about the purpose of fraudulent transfer laws” to achieve greater equity in favor of unsatisfied creditors and investors. Finn is blunt: “[E]quality among a debtor’s creditors, even if they are the victims of a Ponzi scheme, is not the purpose” of fraudulent transfer law.

Finn holds that payment of an honest debt is not fraudulent. A payment is constructively fraudulent “only if it depletes the assets of the debtor without a reasonably equivalent reduction in the debtor’s liabilities.” Finn rejects the Ponzi-scheme presumption on value.

Finn, the first decision by a state supreme court to address the applicability of the Ponzi-scheme presumptions in a case brought under UFTA, rejects all three presumptions.

On June 30, 2015, the Fifth Circuit certified The Golf Channel case to the Texas Supreme Court, asking a question regarding the interpretation of the Texas Uniform Fraudulent Transfer Act as applied in a Ponzi-scheme case. This is novel. The Golf Channel is the first federal case to seek an authoritative interpretation of UFTA, a state statute, from the highest court of the state.

The Golf Channel is one of many fraudulent transfer cases that resulted from Allen Stanford’s Ponzi scheme. Stanford owned Stanford International Bank and numerous other related entities that issued high-interest certificates of deposit to the public. He represented that the investors’ funds would be reinvested in high-quality securities. In fact, however, much of the investors’ money was not reinvested in securities but was used mainly to pay other investors the promised returns.

Stanford became a sponsor of an annual PGA Tour event: the Stanford St. Jude’s Championship. The Golf Channel provided commercials, live coverage of the tournament, messaging regarding Stanford’s charitable contributions, and other marketing activities. Over time, Stanford paid $5.9 million to The Golf Channel in exchange for The Golf Channel’s services.

The receiver sued under the actual fraud provision of UFTA to recover $5.9 million from The Golf Channel. The parties stipulated to the Ponzi scheme fraudulent-intent presumption. There was no dispute about The Golf Channel’s good faith. The issue before the court was whether The Golf Channel provided “reasonably equivalent value” in exchange for Stanford’s $5.9 million in payments.

The Fifth Circuit initially held that, for purposes of a fraudulent transfer defense, “value” is not market value but the benefit received by the debtor’s creditors. The Golf Channel requested that the Fifth Circuit certify to the Texas Supreme Court the question of the definition of “value.” The Fifth Circuit agreed that there is no decision of the Texas Supreme Court that resolves the issue, and it certified the question.

On April 1, 2016, the Texas Supreme Court issued its decision. Janvey v. The Golf Channel, 2016 WL 1268188, S.W. 3d ___(2016). Like the Minnesota Supreme Court, the Texas Supreme Court held that there was nothing in the text of UFTA that requires or permits a court to apply a different standard of interpretation in Ponzi-scheme cases than in other fraudulent transfer cases.

We therefore conduct the same “value” and “reasonably equivalent value” analysis inquiry under TUFTA regardless of whether the debtor was operating a Ponzi scheme or a legitimate enterprise. We ask whether the debtor received value (i.e., whether the debtor received consideration with objective, economic value, not merely consideration with some subjective, ephemeral, or emotional value) and whether the value exchanged was reasonably equivalent.

The Texas Supreme Court added:

[T]he value of the services or goods provided to a debtor does not hinge on whether a debtor utilizes services or goods to further an illegal scheme or to pursue a legitimate business endeavor. Valuing consideration based on how the debtor decides to use it improperly applies a post hoc evaluation of the transaction.

The conclusion follows:

Whether a debtor obtained reasonably equivalent value in a particular transaction is determined from a reasonable creditor’s perspective at the time of the exchange, without regard to the subjective needs or perspectives of the debtor or transferee and without the wisdom hindsight often brings. . . . [W]e conclude the reasonably equivalent value requirement . . . is satisfied when the transferee fully performed in an arm’s-length transaction in the ordinary course of business at market rates.

The Golf Channel can keep the money it was paid in exchange for its services.

A Practice Tip for the Defense

A defendant who is sued in bankruptcy court or federal district court under the state UFTA should promptly file a motion under the Uniform Certification of Questions of Law Act or other similar statute or court rule. The motion should request the federal court to certify to the highest state court all material questions of interpretation of UFTA that have not yet been decided by the highest state court. The list of such questions may include the following regarding the applicability of the Ponzi-scheme presumptions in a fraudulent transfer case arising out of a Ponzi scheme:

  • Whether the plaintiff must offer evidence proving that the debtor-transferor made the transfer with intent to hinder, delay, or defraud, or whether such intent is presumed.
  • Whether the plaintiff must offer evidence proving that the debtor-transferor was insolvent on the date of the transfer, or whether insolvency is presumed.
  • Whether “value” in UFTA sections 8(a) and 8(d) is limited to the amount of the principal portion of a debt or of the original investment and excludes satisfaction of the interest portion of a debt or a contractual obligation to pay a profit, notwithstanding UFTA section 3(a), which includes in the definition of “value” satisfaction of an antecedent debt and makes no distinction between the principal portion and the interest portion of the debt or between the amount of the original investment and a contractual profit.
  • Whether “value” means something different from what it means in fraudulent transfer cases that do not arise out of a Ponzi scheme.

Finn and Janvey indicate that the transferee-defendant will be more likely to escape the constrictions of the Ponzi-scheme presumptions in state court than in federal court.

This article was originally published in the August 2016 edition of Business Law Today by the American Bar Association.

Bruce Borrus has been practicing bankruptcy law in Seattle for 35 years. In a previous life he taught writing and English literature at the University of Washington, where he wrote a dissertation on Saul Bellow.

The opinions expressed in this article are those of the author and do not necessarily reflect the views of Riddell Williams or its clients.  This article is for general informational purposes and is not intended to be, and should not be taken as, legal advice.

The Riddell Williams Financial Services and Creditors’ Rights practice group covers the entire field of creditor and debtor law; including bankruptcies, receiverships, foreclosures, workouts, loan documentation and collections. Our attorneys assist clients from the United States and numerous other countries in bankruptcy and creditors’ rights matters throughout the U.S. We work in close cooperation with other practice areas in the firm to advise on secured and unsecured financing, commercial and real estate transactions, the purchase and sale of financially troubled companies, technology licensing, corporate matters and a multitude of other business situations.