Unwitting Transfers to Ponzi Schemes

Two recent decisions from the 5th and 8th U.S. Circuit Courts of Appeals could expand the fraudulent transfer exposure of unknowing third parties that provide goods, services or funding to companies operating Ponzi schemes.

The Golf Channel

The 5th Circuit's recent decision in Janvey v. The Golf Channel Inc., 1311305 (March 11, 2015), could leave many unknowing vendors and service providers in Ponzi scheme cases without a defense to fraudulent transfer claims by a trustee or receiver.

The decision arises from the multibillion dollar Ponzi scheme perpetrated by Allen Stanford. In 2009, the Securities and Exchange Commission filed a civil enforcement action in the Northern District of Texas, obtained a freeze of all assets of Stanford International Bank Ltd. and its affiliates, and requested the appointment of Ralph S. Janvey as receiver, which the district court granted.

Stanford had paid The Golf Channel Inc. $5.9 million for advertising and other promotional services. The receiver sued Golf Channel to recover the $5.9 million under the Texas Uniform Fraudulent Transfer Act. The act, which mirrors statutes in other states, allows creditors or receivers to avoid transfers made with actual intent to defraud creditors or by an insolvent entity that does not receive reasonably equivalent value in return.

The Texas act, like other states' statutes, provides a defense for transferees who receive funds in good faith and provide reasonably equivalent value in return. Golf Channel argued just that. The district court agreed and granted summary judgment in Golf Channel's favor. The 5th Circuit reversed, finding no evidence the advertising and promotional services provided value to Stanford's creditors and served only to "encourage investment" in the Ponzi scheme. The court reasoned that, under the Texas law, value is measured from the standpoint of creditors rather than that of an ordinary buyer in the marketplace and the primary consideration is the degree to which the transferor's net worth is preserved. Even though the services "may have been quite valuable to the creditors of a legitimate business, they have no value to the creditors of a Ponzi scheme." The court drew an analogy to the services of a broker who sold securities in a Ponzi scheme, citing Brown v. Warfield, 436 F.3d 551 (5th Cir. 2006). Accordingly, the 5th Circuit rendered judgment in the receiver's favor.

However, there are other cases in which transferees have successfully defended fraudulent transfer claims in Ponzi schemes by showing they provided value from the perspective of the market for their goods or services. See Orlick v. Kozyak (In re Fin. Federated Title & Trust Inc.), 309 F.3d 1325, 1332 (11th Cir. 2002); Balaber-Strauss v. Sixty-Five Brokers (In re Churchill Mortg. Investment Corp.), 256 B.R. 664, 67980 (Bankr. S.D.N.Y. 2000).

In fact, the Golf Channel decision runs contrary to a 5th Circuit decision holding that Section 548(c) of the Bankruptcy Code (which mirrors the Texas act) "looks at value from the perspective of the transferee: How much did the transferee 'give'? The concern here, quite properly, is for the transferee's side of the exchange, not the transferor's gain." Jimmy Swaggart Ministries v. Hays In re Hannover Corp.), 310 F.3d 796, 802 (5th Cir. 2002) (holding that call options purchased from the transferee had value even though the transferor, a fraudulent scheme, was unable to exercise them). In these decisions, the transferee's good faith as an unknowing provider of goods or services seems to outweigh the interest of preserving the net worth of the fraudulent scheme.

The Golf Channel decision could affect many types of vendors and service providers who unknowingly provide services to companies operating Ponzi schemes. Because Ponzi schemes rarely have any legitimate revenue producing operations, only those who provide tangible assets, goods or benefits which can subsequently be liquidated and distributed to creditors would be protected from fraudulent transfer liability. Landlords, professionals, vendors, utility companies and other service providers who lease space or provide other valuable services in the marketplace would have a difficult time showing they provided value to creditors of a Ponzi scheme. It remains to be seen whether other circuits accept this narrower view of value.

Ritchie Capital Management

The 8th Circuit case Ritchie Capital Management LLC v. Stoebner, 141154 (March 10, 2015), is likewise instructive. The decision arises from a multibillion dollar Ponzi and fraud case, in which Tom Petters, through a number of companies he controlled, purported to run a so called diverting business, where electronics were to be purchased in bulk and resold to major retailers at a substantial profit. In truth, the business was a sham, and the funds received originated exclusively from loans made to or investments in the Petters entities.

In early 2008, the Petters companies, including Polaroid Corporation, began experiencing substantial financial distress. In response, a Petters entity, Petters Group Worldwide (PGW), obtained a $31 million loan from Ritchie Capital Management LLC, ostensibly to pay off PGW and Polaroid debts. Petters personally guaranteed the loan, and represented to Ritchie that it was to be "backed by the entire Polaroid corporation[.]" Ritchie ultimately extended nearly $130 million in loans to Petters entities. Polaroid was not a signatory to any of the Ritchie loans and, while the initial loan to PGW was used to pay the debts of Polaroid, the proceeds of the loans were not directed to Polaroid.

As Ritchie began demanding collateral for its loans, and on the eve of the FBI raid that would halt the fraudulent scheme, Petters executed a trademark security agreement granting Ritchie liens on critical Polaroid trademarks. Polaroid was later placed into bankruptcy.

Polaroid, through its bankruptcy trustee, sued Ritchie to invalidate the agreement on the grounds that it constituted a fraudulent transfer. The trustee submitted a motion for summary judgment on the fraudulent transfer claim based on the so called Ponzi scheme presumption, which holds that transfers made in furtherance of a Ponzi scheme are presumed to have been made with intent to defraud creditors. The application of the Ponzi scheme presumption enables a creditor to bypass a more detailed "badges of fraud" analysis, where an affirmative showing of actual intent to defraud must be made. The bankruptcy court applied both the Ponzi scheme presumption and the traditional badges of fraud analysis, and determined that Petters executed the agreement with fraudulent intent. Ritchie appealed.

While the 8th Circuit acknowledged the Ponzi scheme presumption, it determined that it "need not ... [apply the Ponzi scheme presumption] ... because [it could] affirm the bankruptcy court's finding of actual fraudulent intent under the badges of fraud approach." It thus drew "no conclusions as to the validity or future applicability of the Ponzi scheme presumption in the Eighth Circuit." Notably, in applying its badges of fraud analysis, the 8th Circuit looked at the actual intent of the debtor Polaroid not PGW, because it was Polaroid (through Petters) which granted the liens which the trustee sought to avoid as fraudulent transfers. In other words, the fact that Polaroid was not a signatory to the Ritchie liens was irrelevant. What mattered was that "[b]ecause Petters unilaterally granted the[] liens on Polaroid's behalf, his intent was that of Polaroid." As such, and while the Ritchie loans may have benefitted PGW, "the viability of a parent company is not the type of value contemplated by the fraudulent transfer laws."

The Ritchie Capital Management decision does not resolve the issue of whether the Ponzi scheme presumption will be formally recognized in the 8th Circuit, which remains unclear. However, it does serve as a reminder to trustees, receivers and creditors pursuing fraudulent transfer claims that: (a) Even where a Ponzi scheme exists that might enable the application of the presumption, a more traditional badges of fraud approach should be considered, as it may be more palatable to a court; and (b) the intent of the transferor must be the focus of the inquiry, even where the transferor is a subsidiary of another entity, or an affiliate receives a benefit from the overall transaction.