United States: No Decision From Eighth Circuit On Validity Of Ponzi Scheme Presumption

Last Updated: May 29 2015
Article by Dan T. Moss

In Ritchie Capital Mgmt., LLC v. Stoebner, 779 F.3d 857 (8th Cir. 2015), the U.S. Court of Appeals for the Eighth Circuit affirmed a bankruptcy court's decision that transfers of trademark patents were avoidable under section 548(a)(1)(A) of the Bankruptcy Code and Minnesota state law because they were made with the intent to defraud creditors. On a motion for summary judgment, the bankruptcy court had determined that transfers effected as part of a massive, multibillion-dollar Ponzi scheme satisfied both the "Ponzi scheme presumption" of fraud and the more general "badges of fraud" analysis. On appeal, the Eighth Circuit affirmed the rulings below on the basis of the badges of fraud analysis. The court did not find it necessary to address the validity of the Ponzi scheme presumption, writing that "[w]e . . . draw no conclusions as to the validity or future applicability of the Ponzi scheme presumption in the Eighth Circuit."

Avoidance Powers and Proving Fraudulent Intent

Section 548(a)(1) of the Bankruptcy Code authorizes a trustee or debtor-in-possession ("DIP") to avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor within the two years preceding a bankruptcy filing if: (i) the transfer was made, or the obligation was incurred, "with actual intent to hinder, delay, or defraud" any creditor; or (ii) the debtor received "less than a reasonably equivalent value in exchange for such transfer or obligation" and was, after the transfer, insolvent, undercapitalized, or unable to pay its debts as such debts matured.

Transfers or obligations may also be avoided under analogous state laws by operation of section 544(b)(1) of the Bankruptcy Code, which empowers a trustee or DIP to "avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim" against the debtor. Examples of such laws are the versions of the Uniform Fraudulent Transfer Act ("UFTA") and the Uniform Fraudulent Conveyance Act ("UFCA") adopted by most states. Like section 548(a)(1), both the UFTA and the UFCA provide for the avoidance of intentionally and constructively fraudulent transfers or obligations.

Proving actual intent to defraud under either section 548 or state law can be difficult. Many courts therefore permit plaintiffs to rely on "badges of fraud," a concept developed and applied by English courts since the reign of Queen Elizabeth I, to support a case for avoidance based on actual intent to hinder, delay, or defraud creditors. In general terms, badges of fraud are "circumstances so commonly associated with fraudulent transfers that their presence gives rise to an inference of intent." In re Sharp Intern. Corp., 403 F.3d 43, 56 (2d Cir. 2005). While there is no exhaustive catalog of badges of fraud, courts typically look for, among other things, "a close relationship between the parties to the alleged fraudulent transaction; a questionable transfer not in the usual course of business, inadequacy of consideration; . . . and retention of control of the property by the transferor after the conveyance." Id. (internal citations omitted); see also HBE Leasing Corp. v. Frank, 48 F.3d 623, 639 (2d Cir. 1995) ("Actual fraudulent intent . . . may be inferred from the circumstances surrounding the transaction, including the relationship among the parties and the secrecy, haste, or unusualness of the transaction"). Once the trustee or DIP establishes the existence of several badges of fraud, the trustee or DIP is entitled to a presumption of fraudulent intent. The burden then shifts to the transferee "to prove some legitimate supervening purpose for the transfers at issue." Kelly v. Armstrong, 141 F.3d 799, 802 (8th Cir. 1998) (citation omitted).

With respect to Ponzi schemes, several courts have decided that "transfers made in furtherance of the scheme are presumed to have been made with the intent to defraud for purposes of recovering the payments under § 548(a)." Perkins v. Haines, 661 F.3d 623, 626 (11th Cir. 2011); accord Wing v. Dockstader, 2012 BL 140244 (10th Cir. 2012); Donell v. Kowell, 533 F.3d 762 (9th Cir. 2008); Warfield v. Byron, 436 F.3d 551 (5th Cir. 2006); see also In re DBSI, Inc., 476 B.R. 413, 422 (Bankr. D. Del. 2012) (" 'all payments made by a debtor in furtherance of a Ponzi scheme are made with actual fraudulent intent' ") (citation omitted). To trigger this presumption, a plaintiff must establish that a Ponzi scheme exists and that the transfers were made in furtherance of the scheme. See In re Manhattan Inv. Fund Ltd., 397 B.R. 1 (S.D.N.Y. 2007).

The Eighth Circuit had an opportunity to address these issues in Ritchie Capital.

Background

Ritchie Capital involved one of many disputes related to the multibillion-dollar Ponzi scheme perpetrated by Thomas Petters ("Petters"), founder of Petters Group Worldwide ("PGW"). In this case, Petters, as the sole board member of PGW, directed PGW in 2005 to purchase Polaroid Holding Company ("Polaroid"), successor to the once iconic photographic technology pioneer. Petters thus became the 100 percent beneficial owner of Polaroid, an otherwise legitimate, independent, stand-alone business. After PGW acquired Polaroid, Petters became the sole member and chairman of the Polaroid board. Polaroid's business operations continued after the acquisition without substantial change.

Approximately three years later, however, Petters' companies—including Polaroid—began to experience financial difficulties. To alleviate these problems, between February 2008 and May 2008, Petters obtained loans from various hedge funds affiliated with Ritchie Capital Management, LLC (collectively, "Ritchie") totaling approximately $160 million. Some of these funds were used to pay debts of PGW and Polaroid. Polaroid was never a signatory to any of these loans, and although some of the funds were used to repay some of Polaroid's debts, none of the proceeds from these loans went directly to Polaroid.

Petters was unable to service the loans. By September 2008, all the loans were past due, and Ritchie demanded collateral. In response, Petters proposed a Trademark Security Agreement ("TSA") whereby Ritchie would be granted liens on several Polaroid trademarks. Polaroid's CEO objected, claiming that the agreement would inhibit her ability to secure new capital for the company (the TSA's terms did allow Polaroid to obtain first-priority secured financing for up to $75 million, but this was not disclosed to the CEO). Notwithstanding this objection, Petters executed the TSA on Polaroid's behalf on September 19, 2008.

Five days later, the Federal Bureau of Investigation raided Petters' office and home, suspecting his involvement in a massive fraud. Shortly afterward, Ritchie accelerated the amounts due on all outstanding loans. Polaroid filed for chapter 11 protection on December 18, 2008, in the District of Minnesota. Petters was later convicted of mail fraud, wire fraud, and money laundering and was sentenced to 50 years in prison.

Polaroid commenced an adversary proceeding in February 2009 against Ritchie, alleging that the TSA was unenforceable because, among other things, the obligations created under the agreement were avoidable under section 548(a)(1)(A) of the Bankruptcy Code and Minnesota's version of the UFTA because they were both actually and constructively fraudulent. A bankruptcy trustee was substituted as the plaintiff in the litigation after Polaroid's chapter 11 case was converted to a chapter 7 liquidation in August 2009.

The bankruptcy court bifurcated the litigation to consider the actual and constructive fraud claims separately. In the first phase, the court considered a motion for partial summary judgment on the trustee's actual fraudulent transfer claims.

To establish fraudulent intent, the trustee relied on both the Ponzi scheme presumption and the traditional badges of fraud analysis. The bankruptcy court granted the trustee's partial summary judgment motion in part and denied it in part. See Stoebner v. Ritchie Capital Mgmt., LLC, 472 B.R. 22 (Bankr. D. Minn. 2012). The court granted the motion on the issue of actual fraud, to which the court applied both the Ponzi scheme presumption and the badges of fraud analysis.

The bankruptcy court considered Petters' "overarching level of control," concluding that, under either theory, Ritchie's liens resulted from actual fraudulent transfers and were therefore avoidable. Explaining that while the presumption of fraudulent intent could be rebutted by "probative, significant evidence that the transferor-debtor lacked the intent to take the transferred value away from contemporaneous or future creditors," the court ruled that Ritchie failed to meet the burden of production necessary to demonstrate nonfraudulent intent.

The bankruptcy court found that the following badges of fraud established actual intent: (1) the lack of reasonably equivalent value given in exchange for the transfer; (2) concealment of the transfer; (3) litigation or the threat of litigation by the transferee in the absence of the transfer; (4) the transfer of "substantially all" of the transferor's assets; and (5) orchestration of the transfer by the sole person in common control.

Ritchie appealed to the U.S. District Court for the District of Minnesota. Noting that the Eighth Circuit has not yet ruled on the application of the Ponzi scheme presumption to alleged fraudulent transfers, the district court affirmed the bankruptcy court's application of the Ponzi scheme presumption but expressly declined to address the badges of fraud analysis. See Ritchie Capital Mgmt., L.L.C. v. Stoebner, 2014 BL 420623 (D. Minn. Jan. 6, 2014). Ritchie then appealed to the Eighth Circuit.

The Eighth Circuit's Ruling

A three-judge panel of the Eighth Circuit affirmed. At the outset of its discussion, the court explained that many courts have looked to badges of fraud in determining whether a transfer was made with intent to hinder, delay, or defraud creditors under section 548(a) of the Bankruptcy Code and that Minnesota's codification of the UFTA contains "a lengthy list" of factors or badges of fraud which a court may consider in deciding this issue. It further noted that many courts confronted with circumstances amounting to a Ponzi scheme, including courts in the Fifth, Sixth, Ninth, Tenth, and Eleventh Circuits, have bypassed the badges of fraud analysis and applied the Ponzi scheme presumption.

However, the Eighth Circuit panel emphasized, the Eighth Circuit has not yet ruled on the Ponzi scheme presumption, and the Minnesota Supreme Court recently rejected the presumption in Finn v. Allied Bank, 2015 BL 40772, *8 (Minn. Feb. 18, 2015). In Finn, the Minnesota Supreme Court wrote that "there is no statutory justification for relieving the Receiver of its burden of proving . . . fraudulent intent [which must] . . . be determined in light of the facts and circumstances of each case."

The Eighth Circuit panel concluded, however, that it need not take a position on this issue, noting merely that "[w]e thus draw no conclusions as to the validity or future applicability of the Ponzi scheme presumption in the Eighth Circuit."

Instead, the court affirmed the rulings below on the basis of its de novo review and approval of most of the bankruptcy court's badges of fraud analysis under Minnesota law. Among other things, the Eighth Circuit panel determined that:

  • In a case where multiple entities are involved, it is important to precisely identify whose intent is relevant to the consideration of fraudulent intent. Here, the Eighth Circuit focused on the intent of Polaroid, as directed and orchestrated by Petters.
  • Polaroid's trademarks were encumbered without any real benefit to Polaroid, which was not a party to the Ritchie loan agreements. Thus, the "lack of reasonably equivalent value" badge of fraud was present.
  • At the time the TSA was executed, Petters' Ponzi scheme was in a precarious financial position. Petters also was aware that Polaroid was in the zone of insolvency, given its inability to satisfy vendor payments. Although the liens granted by Polaroid to Ritchie were not granted to an insider per se, they were granted to Ritchie for the benefit of an insider, Petters. Thus, the "transfer for the benefit of an insider" badge of fraud was present.
  • It was undisputed that Polaroid had serious financial difficulties before the TSA was executed, which worsened afterward. Citing cases that look to unmanageable indebtedness in addition to insolvency, the Eighth Circuit panel found that the "insolvency of the debtor" badge of fraud was present.
  • Petters directed Polaroid to grant liens to Ritchie despite knowing that Polaroid's CEO feared that those liens would inhibit Polaroid's ability to raise much-needed capital. The Eighth Circuit found this relevant to discerning fraudulent intent irrespective of whether the CEO was aware of the new first-lien capital carve-out in the TSA.


On the basis of the existence of these badges of fraud, the Eighth Circuit found no fault with the bankruptcy court's conclusion that Polaroid, controlled solely by Petters, was presumed to have acted with the actual intent to defraud creditors when it granted liens to Ritchie under the TSA. The Eighth Circuit rejected Ritchie's argument that all the badges of fraud under Minnesota law were not established. According to the court, "[T]he law does not require the trustee to prove all of the badges [because] [o]nce a trustee establishes a confluence of several badges of fraud, the trustee is entitled to the presumption of fraudulent intent" (citations omitted).

However, this did not end the inquiry. Instead, it "merely shifted the burden to Ritchie to prove it took the liens in good faith and for value." The Eighth Circuit agreed with the bankruptcy court that Ritchie failed to satisfy this burden—a ruling, moreover, which Ritchie did not appeal.

Takeaway

Ritchie Capital may be a disappointment for those hoping that the Eighth Circuit would rule on the legitimacy of the Ponzi scheme presumption in the context of fraudulent transfer litigation. Even so, the court did not reject the validity of the presumption, and the court's flexible approach to establishing fraudulent intent leaves open the possibility that it might be receptive to the concept in a future case which does not involve the application of Minnesota law.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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