Restructuring

Contributed by Will Hueske
When a debtor in bankruptcy has operated, or been an instrument of, a Ponzi scheme, the appointed trustee may institute fraudulent transfer actions seeking to avoid and recover payments made in furtherance of the scheme.  Defendants in these actions (the parties to whom such fraudulent transfers were allegedly made by the debtor prepetition) often attempt to block the attempted “clawbacks” by contending that they received their returns from the debtor in good faith and without any knowledge of the debtor’s “nefarious” operations, and that they gave “value” to the debtor in the form of initial and subsequent investments.  Courts are beginning to examine how these standard defenses to a fraudulent transfer recovery may be applied in Ponzi cases.
We previously wrote about a similar issue faced by the United States District Court for the Southern District of New York in connection with the Madoff liquidation in Picard v. Katz.  There, the district court examined to what extent the trustee could avoid certain transfers made with the actual intent to defraud present and future creditors.  In the district court’s view, the availability of a good faith defense turned on whether the monies sought to be clawed back were the defendants’ (i.e., the Madoff Securities customers) principal or profits.  The court concluded that the principal invested by the defendants gave value to the debtors, but the profits, by contrast, presumptively exceeded any value that might have been given. Of course, these conclusions were not absolute; the court also reasoned that a trustee might be able to recover principal invested in a Ponzi scheme if he or she could demonstrate “willful blindness” on the part of the investor, and the investor/fraudulent transfer defendant might be able to keep its profits if it could show it gave value for the profits in excess of its principal.
In Perkins v. Haines, 661 F.3d 623 (11th Cir. 2011), the Eleventh Circuit recently considered the issue and drew conclusions similar to that of the court in Picard.  In Perkins, the trustee brought an adversary proceeding seeking to avoid and recover certain fraudulent transfers made to equity investors who had invested in the underlying Ponzi scheme.  The defendant-investors alleged, as an affirmative defense under section 548(c) of the Bankruptcy Code, that they acted in good faith and that the transfers were made to them “for value,” value being defined in section 548(d)(2)(A) of the Bankruptcy Code as including “satisfaction or securing of a present or antecedent debt of the debtor.” The question of whether this defense entitles investors in a Ponzi scheme to keep all of the payments made to them by the debtor in connection with the scheme was one of first impression for the Eleventh Circuit.
First, the court found that transfers made in furtherance of a Ponzi scheme are presumed to be actually fraudulent—that is, made with actual intent to defraud—under section 548 of the Bankruptcy Code.  Thus, all of the transfers made to the defendant-investors were presumed to be fraudulent. Second, the Eleventh Circuit held that, where an investor has paid into a Ponzi scheme operated by a debtor, the general rule is that the defrauded investor is recognized as having given “value” to the extent of the principal invested for purposes of the section 548(c) affirmative defense.  The court reasoned that, at the time of the initial investment in a Ponzi scheme, a tort action for fraud accrues against the operator of the scheme for the amount of the investment.  Return of that initial investment by the debtor represents payment of value on an antecedent debt, owed to the investor by virtue of the fraud claim, and therefore cannot be recovered by the trustee.  The court, however, found that any amount in excess of the initial investment distributed to the investor, such as for fictitious “profits” or other forms of return on investment, are deemed not to have been given for value and may be recovered, as they exceed the amount of the fraud claim.
An interesting wrinkle in the facts of this case was that the defendant-investors held equity interests in the debtor.  The initial investments here consisted of purchases of equity interests in limited partnerships, rather than direct investments of cash into a fund or the like.  The trustee argued that, because the transfers to the investors were made to redeem their worthless equity investments in an insolvent entity, they were not made “for value” and could be recovered entirely.  The Eleventh Circuit held, however, that the form of the investment—either as a direct payment giving rise to a debt claim, or an equity investment as was the case here—is irrelevant to application of the rule, but that, where the substance of the transaction reveals an investor defrauded into participating in a Ponzi scheme, their initial investment, regardless of kind, will be considered made “for value,” and immune from recovery by the trustee.  While the court agreed that, in non-Ponzi cases, transfers to stockholders by an insolvent entity in exchange for the stockholders’ investment in the entity are fully recoverable as fraudulent transfers, those cases are distinguishable because the initial investment was not the product of fraud and could not be the basis for an antecedent debt.  In Ponzi schemes, however, the initial fraudulent inducement of the investor, regardless of the form of the investment, may give rise to an antecedent debt in the form of a tort claim against the debtor, and in that event, return of the initial investment could be regarded as made for “value” and deemed not to be recoverable.  As courts become increasingly forced to navigate the intersection of  Ponzi schemes and fraudulent transfers, Perkins and Picard provide a valuable road-map as to courts’ view on the distinction between principal and profits.