By Andrew E. Weissman, Drinker Biddle & Reath LLP
The discovery of several massive Ponzi schemes over the last several years, including those involving Bernie Madoff, Marc Dreier, Allen Stanford and Tom Petters, have been a tough blow to many hedge funds, investment managers and individual investors. Not only have investors lost billions of dollars due to these massive fraud schemes; but to add insult to injury, many of these same investors have become the targets of claw-back suits brought by the trustees and receivers overseeing the wind-down and liquidation of the fraudulent schemes.
These suits seek to recover distributions received by investors in the months and years prior to the collapse of the Ponzi schemes as preferences or fraudulent transfers. Essentially, trustees argue that all or a portion of these distributions can be clawed back as fraudulent transfers because the distributions were made by the fraudulent debtors with actual intent to hinder, delay and defraud creditors in furtherance of the perpetrators' fraudulent schemes. In addition, trustees argue that any transfer of “false profits” from the Ponzi schemes, in essence distributions in excess of the original investment, can be clawed back as constructive fraudulent transfers because the Debtor did not receive reasonably equivalent value in exchange for the distribution.
While defenses to avoidance suits in the Ponzi scheme context are often limited, one of the principal defenses available to defendants of claims where the trustee seeks to claw back a transfer as having been made with actual intent to hinder, delay or defraud creditors, is that the investor took the transfer for value and in good faith.1 While this defense does not generally protect against the recovery of “false profits,” it can protect against the recovery of the investors' principal investments. Seeking to thwart the good faith defense and recover the entire distribution, including an investor's principal investment, trustees often argue that investors, particularly sophisticated investors, did not take the transfers in good faith. The basis for this argument is often that the investors knew, or should have known, of the fraudsters' illicit schemes, or that there were “red flags” alerting the investors that there was trouble with the funds.
Pinning down exactly what constitutes an investor's good faith, however, has proven difficult. Courts have offered varied and conflicting interpretations of what constitutes good faith on the part of the transferee. Courts have also offered conflicting conclusions on whether the transferee's good faith is to be judged on an objective or subjective standard.
Some recent cases show that the standard for measuring good faith applied to a particular case may ultimately turn on the specific law being used to claw back the distribution. Specifically, the standard applied to measure good faith may depend on whether the trustee is seeking to claw back the transfer under the United States Bankruptcy Code, under state fraudulent conveyance statutes, or as part of a liquidation under the Securities Investor Protection Act (“SIPA”).
A Ponzi scheme is a fraudulent investment scheme in which money contributed by later investors is used to pay artificially high dividends to the original investors, creating an illusion of profitability, thus attracting new investors.2 A “Ponzi scheme” typically describes 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.3 Thus, in a Ponzi scheme, returns to investors are not financed through the success of the underlying business venture, but are taken from principal sums of newly attracted investments.4 Many Ponzi schemes arise out of purported securities investment funds or loan portfolios. The inflated returns obtained by early investors attract new investors to perpetuate the scheme. Moreover, the managers of the Ponzi scheme are often able to shield their fraudulent investment schemes by claiming that their investment strategy is proprietary.
This pattern was repeated over and over again in schemes run by Bernie Madoff, Marc Dreier, Tom Petters, Allen Stanford and many others. Eventually, the schemes will collapse, either because the underlying fraud is uncovered, or because too many investors demand redemptions at the same time. Once the scheme collapses, most investors will suffer large losses of principal because there are no new investors coming in to pay out dividends to old investors.
In most instances, collapsed Ponzi schemes will be placed into a receivership or some other type of liquidation proceeding. Often, a bankruptcy proceeding will also be initiated so that the trustee or receiver overseeing the liquidation of a fraudulent scheme can take advantage of the strong-arm powers of the Bankruptcy Code, including initiating preference and fraudulent conveyance actions. In Ponzi scheme cases involving the sale of securities, a liquidation proceeding under SIPA may also be initiated.
Upon the commencement of a liquidation under SIPA, a trustee is appointed by Securities Investor Protection Corp. and the proceeding is removed to the bankruptcy court for liquidation of the securities firm's assets. 15 U.S.C. §78eee(b)(4). After a bankruptcy case is filed or SIPA liquidation commenced, the trustee for the Ponzi scheme debtor will then generally file adversary cases seeking to avoid and recover redemptions made to the scheme's investors. These adversary cases will generally assert preference claims under Section 547 of the Bankruptcy Code for transfers made within 90 days of the bankruptcy filing, fraudulent conveyance claims under Section 548 of the Bankruptcy Code for transfers made within two years of the bankruptcy filing, or fraudulent conveyance claims under applicable state law for transfers made more than two years prior to the bankruptcy filing.
By avoiding and recovering all transfers made prior to the collapse of the fraudulent fund, the recovered funds can be distributed equally to all investors and creditors of the collapsed Ponzi scheme, not just those that were able to receive a distribution prior to the fund's collapse.
Fraudulent conveyance claims, both under the Bankruptcy Code and applicable state law, generally come in two varieties. The first variety, which is codified under Section 548(a)(1)(A) of the Bankruptcy Code and generally referred to as an “actual fraudulent transfer” claim, is a claim seeking to avoid and recover a transfer made by a debtor with actual intent to hinder, delay or defraud any entity to which the debtor was or became indebted.5 Actual fraudulent conveyance claims under Section 548(a)(1)(A) turn on the intent of the debtor in making the transfer; the state of mind of the transferee is irrelevant.6 Only the intent to hinder, delay or defraud need be shown; success in this regard need not be demonstrated for a transfer to constitute an actual fraudulent conveyance. Moreover, a transfer that constitutes an actual or intentional fraudulent conveyance may be avoided in its entirety—as to both invested principal and profits—whether or not the debtor received value in exchange for the transfer.7
A finding that a Ponzi scheme exists is particularly important to proving that a transfer was an actual fraudulent conveyance. “Actual [fraudulent] intent … may … be established as a matter of law in cases in which the debtor runs a Ponzi scheme or a similar illegitimate enterprise, because transfers made in the course of a Ponzi operation could have been made for no purpose other than to hinder, delay or defraud creditors.”8 Once a trustee proves that a Ponzi scheme existed, there is then a presumption that all transfers out of the scheme were made with intent to hinder, delay or defraud creditors.9Accordingly, once the trustee proves the existence of the Ponzi scheme, then all transfers from the Ponzi scheme are deemed by law to be actual fraudulent transfers. The only defense then available to recipients of transfers during the statutory avoidance period is that they took the transfers for value and in good faith.
The second variety of fraudulent transfer claim, generally referred to as a “constructive fraudulent transfer” and codified under Section 548(a)(1)(B) of the Bankruptcy Code, is a claim seeking to avoid and recover a transfer for which the debtor did not receive reasonably equivalent value in exchange for such transfer and the debtor was insolvent when the transfer was made or was rendered insolvent by the transfer. Trustees of Ponzi scheme debtors do not need to rely as much on constructive fraudulent conveyance claims since there exists the presumption in Ponzi scheme cases that transfers made under the fraudulent scheme were actual fraudulent transfers made to hinder, delay or defraud creditors. Moreover, the good faith of the transferee is irrelevant in a constructive fraudulent transfer suit. The transferee can defend the suit by showing he provided value in exchange for the transfer, regardless of the transferee's good faith.
Investors that received distributions from a collapsed Ponzi scheme and are then sued to recover the distribution are behind the eight ball from outset of the suit due to the presumption that transfers made by a Ponzi scheme were made with actual intent to hinder, delay and defraud creditors, and are thus presumed to be fraudulent transfers. While investors' defenses are limited, however, they are not all eliminated. After a debtor makes out a prima facie case of actual or constructive fraudulent conveyance, a transferee nevertheless may avoid rescission of a transfer under Section 548(c) of the Bankruptcy Code under the following circumstances:
a transferee … of such a transfer … that takes for value and in good faith … may retain any interest transferred … to the extent that such transferee … gave value to the debtor in exchange for such transfer or obligation.10
Most state law fraudulent transfer statutes have a similar defense.11 Under this defense, a transferee must prove two elements: (i) that transferee took the transfer for value and (ii) in good faith.12 It is generally accepted, in the Ponzi scheme context, that an investor's principal investment gave value to the debtor.13 In addition, investors have tort claims for rescission against the fraudulent debtor to recover all of their initial investment based on fraudulent inducement.14 However, any transfers received by an investor in excess of its principal investment in the Ponzi scheme are generally deemed not to have been taken for value.15
The theory is that the creditors of the fraudulent scheme did not receive any benefit from payment of fictitious profits and thus, no value was given. Accordingly, the defense that an investor took a transfer for value and in good faith will only protect against the avoidance and recovery of the investor's principal investment. The defense is not available to prevent the recovery of distributions in excess of the principal investment.
Many courts have applied a much lower standard than actual knowledge for determining whether an investor in a Ponzi scheme lacked good faith. These courts have found that if a hypothetical reasonable investor would have known or should have known that there were some irregularities with the fraudulent fund, and failed to conduct a diligent inquiry, then the investor would not be able to claim good faith as a defense to a fraudulent transfer. Three decisions over the last few years, all involving prominent Ponzi schemes, highlight the varied approaches that courts have taken to determine if an investor took a transfer from a Ponzi scheme in good faith.
Interpreting the meaning of “good faith” as a defense to a fraudulent transfer claim under the Bankruptcy Code, Judge Gardephe of the District Court for the Southern District of New York held that “good faith” was an objective standard that considered whether transferee knew or should have known about the debtor transferor's fraud at the time of the transfer.21 “The good faith test under Section 548(c) is generally presented as a two-step inquiry…[t]he first question typically posed is whether the transferee had information that put it on inquiry notice that the transferor was insolvent or that the transfer might be made with a fraudulent purpose.”22
Once a transferee has been put on inquiry notice of either the transferor's possible insolvency or of the possibly fraudulent purpose of the transfer, the second requirement transferee must satisfy a “diligent investigation” requirement.23 To satisfy the “diligent investigation” requirement, the transferee must demonstrate that it “conducted a diligent investigation of the facts that put it on inquiry notice,” or that a “‘diligent inquiry would [not] have discovered the fraudulent purpose’ of the transfer” or the transferor's insolvency.24
“An objective, reasonable investor standard applies to both the inquiry notice and the diligent investigation components of the good faith test.”25 “Under this objective test, courts look to what the transferee objectively ‘knew or should have known’ in questions of good faith, rather than examining what the transferee actually knew from a subjective standpoint.”26 While the court applied an objective standard, the Court noted that knowledge of any infirmity or suggestion of fraud or insolvency involving the transferor was not sufficient, there must be information suggesting insolvency or a fraudulent purpose in making a transfer that triggers inquiry notice.27
After the scheme collapsed, the trustee overseeing the bankruptcy of Dreier LLP filed a complaint against Westford Asset Management and several other affiliated hedge funds seeking to avoid and recover transfers totaling over $137 million as fraudulent conveyances. Westford and the affiliated hedge funds asserted as a defense that they had received the transfers for value and in good faith.29
Addressing the issue of good faith, the court stated: “Good faith focuses on the transferee's knowledge of the transferor's fraudulent intent, and is lacking where the transferee knew, or should have known, that he was not trading normally, but that on the contrary, the purpose of the trade, so far as the debtor was concerned, was the defrauding of his creditors.”30
The court further explained that “conscious turning away” involves more than mere negligence but asks the question: “did the grantee make a choice between not knowing and finding out the truth; or were the circumstances such that he was not faced with that choice?”32 While the “conscious turning away” standard is a subjective test, it does not wholly eliminate the relevance of objective evidence of knowledge. “What a reasonable person knew or should have known may show circumstantially what the defendant knew or should have known.”33
While noting that a “securities investor has no inherent duty to inquire about his stockbroker, and SIPA creates no such duty,” the court found that “[i]f an investor, nonetheless, intentionally chooses to blind himself to the “red flags” that suggest a high probability of fraud, his “willful blindness” to the truth is tantamount to a lack of good faith.”37 Explaining further, Judge Rakoff stated: “if, simply confronted with suspicious circumstances, [the investor] fails to launch an investigation of his broker's internal practices—and how could he do so anyway?—his lack of due diligence cannot be equated with a lack of good faith, at least so far as section 548(c) is concerned as applied in the context of a SIPA trusteeship.”38
The easy answer is that the manager should liquidate his investment as soon as possible. First, there is always the possibility that the investment is not in fact a fraud, or that the fraud is not a Ponzi scheme giving rise to the presumption that a transfer out of the scheme is a intentional fraudulent transfer. Even if the investment turns out to be a Ponzi scheme, there is always the slim possibility the liquidating trustee will not pursue recovery of the redemption. And even if a trustee or other creditors do ultimately pursue recovery of the redemption as a fraudulent conveyance, it is highly likely that the investment manager will be able to negotiate a settlement of the suit for less than the full amount of the redemption in light of the costs and uncertainty of litigating a claim to judgment.
On the other hand, if the manager doesn't withdraw the investment when he suspects there could be fraud or worse yet, a Ponzi scheme, then the entire investment is subject to being lost due to the fraud. Moreover, the manager likely has a fiduciary duty to his investors if he has some notion that the investment could be lost due to fraud. In the end, the choice seems relatively clear. Either the manager doesn't withdraw the investment and the investment is lost due to the fraud, or the manager withdraws the investment and risks having to give some of it back sometime later in a claw-back suit.
To protect against this risk, investors should also take care to thoroughly investigate and vet new investments, particularly those that seem to offer higher returns than might be expected for a particular investment. One factor some courts have considered in determining whether a reasonable investor should have known of a fraud is whether an investment offers significantly higher than market returns. In those instances, investors should conduct a diligent investigation of the investment to determine how the investment generates higher returns. If an investor had some inkling that there may have been fraud or some other infirmity in an investment at the time the investment was initially made, but went forward with the investment anyway without conducting a thorough investigation, it may be difficult for the investor to argue that he was acting in good faith when he took a transfer from the fraudulent scheme.
If investment managers suspect that one of their investments may be subject to a fraud, or if they are concerned they may be subject to a fraudulent transfer suit, managers should contact experienced counsel for advice.
Andrew E. Weissman is an associate in the Bankruptcy and Corporate Restructuring Group of Drinker Biddle & Reath LLP. He represents creditors, debtors and indenture trustees in all aspects of Chapter 11 proceedings and out-of-court restructurings. He also regularly represents lenders, trustees and borrowers in structured finance and securitization transactions.
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