The Rise and Fall of the Ponzi Scheme Presumption Minnesota case law has undermined its application to state fraudulent transfer claims

For many years, the evidentiary shortcuts associated with the so-called “Ponzi scheme presumption” reduced the pleading burden on a trustee with respect to claims seeking to claw back proceeds of fraudulent conveyances. But more recent Minnesota case law has effectively ended that presumption. Going forward, it would seem that trustees and receivers asserting fraudulent transfer claims under state law will need to prove the express statutory elements.

By Christopher R. Morris and Jeffrey D. Klobucar

Image Credit: vasabii/iStockphoto

32 Bench&Bar of Minnesota s January 2018 www.mnbar.org raudulent financial schemes, it’s safe to say, While First United sold participation interests at ordinary mar- have been with us since the dawn of commerce. ket interest rates, some were over-sold, and others were based Common law and statutes have evolved to keep on fictitious loans. Though it created only a fraction of the pace and provide remedies to victims. Among the losses generated by more famous schemers such as Madoff and many forms of financial fraud, one of the most Petters, First United’s business generated claims that ultimate- publicized (and litigated) in the last century has ly reached the Minnesota Supreme Court, resulting in the first Fbeen the “Ponzi scheme”—in which investors and lenders are high-court decision in any state regarding application of the tricked into providing funds for a business venture claimed so-called “Ponzi-scheme presumption” to the state’s version of to be entirely legitimate, but which uses funds of subsequent the Uniform Fraudulent Transfer Act. investors to pay off early investors, creating the illusion of Before turning to the details of that case, we’ll explore how handsome profits. The Minnesota Supreme Court once defined the term “Ponzi scheme presumption” became a familiar part of a Ponzi scheme as a “fraudulent investment scheme in which the bankruptcy court lexicon, used by trustees and receivers to money contributed by later investors generates artificially high claw back payments or “profits” for allocation among compet- dividends or returns for the original investors, whose example ing creditors. attracts even larger investments… usually without any… revenue-producing activity other than the continual raising of A brief history of Minnesota fraudulent new funds.”1 conveyance law The concept of paying off early investors through funds The statute now known as the Minnesota Uniform Voidable from new investors was present in the fiction of Charles Dick- Transactions Act (MUVTA), Minn. Stat. §513.41 et seq., and ens dating back to the 19th century.2 Nearly 100 years later, its predecessors—the Minnesota Uniform Fraudulent Transfers the moniker “Ponzi scheme” arose from the notorious use Act (MUFTA) (formerly Minn. Stat. § 513.44 et seq.)3 and of that device by Boston businessman Charles Ponzi in the prior fraudulent conveyance statute—were enacted to give the 1920s. Ponzi lured investors by promising to double creditors a direct remedy against a debtor who secretes away their money in 90 days through the purchase and sale of assets to hinder, delay, or defraud its creditors.4 Specifically, international postal-reply coupons, collecting more than the statute provides that transfers are subject to avoidance $8 million from 30,000 investors in seven months before if the debtor made them “with actual intent to hinder, delay, the scheme collapsed. At the onset of the Great Recession, or defraud any creditor of the debtor,” or “without receiving 2008 proved to be a banner year for Ponzi schemes: Bernie a reasonably equivalent value in exchange for the transfer or Madoff was arrested for the largest investor fraud in history, obligation.”5 Even if fraudulent intent on the part of the debtor while here in Minnesota Thomas Petters was charged for transferor is proven, the transferee still is not liable if it acted in conducting a multi-billion dollar scheme that bilked inves- good faith and accepted a reasonably equivalent value.6 tors over a 13-year period. The modern MUVTA is modeled after the Uniform Fraud- While such schemes may be destined for ultimate fail- ulent Transfer Act.7 The Uniform Act stems from the Statute ure, even when mixed with legitimate business activities, of 13 Elizabeth, which was enacted to invalidate “covinous efforts at this form of investment fraud persist. Inevitably, and fraudulent transfers designed to delay, hinder, or defraud once investment slows down, the scheme collapses as creditors and others.”8 Likewise, the purpose of MUVTA is to the promoter is unable to continue paying the prom- prevent debtors from putting property that is available for pay- ised returns, and once the reputation for such returns ment of their debts beyond the reach of their creditors.9 is unsupportable by testimonials, the spigot of new investment runs dry. Sometimes market forces (for Birth of the Ponzi scheme presumption example, economic downturns) cause investors to Bankruptcy courts must act with efficiency in administer- withdraw funds, leading to a liquidity crisis for ing the unwinding of failed business enterprises. There are the schemer. While the most famous example limits on the courts’ and the parties’ resources, of course, and in modern times is that of Bernie Madoff— a limit on how much time and expense can be incurred liti- chronicled in Diana B. Henriques’s book The gating disputes, particularly when such cases involve a mas- Wizard of Lies and a subsequent HBO movie sive fraudulent scheme and myriad creditors victimized by the starring Robert De Niro—Minnesota has debtor’s misconduct. While the Bankruptcy Code allows for also seen its fair share of criminal Ponzi preferential payments to creditors in the months immediately scheme activity beyond the Petters case. prior to a bankruptcy filing to be undone fairly easily, trustees Among the many lesser-known are often inspired to go back years rather than months to claw financial frauds in Minnesota was back what might fairly be considered ill-gotten gains, to more the Ponzi scheme perpetrated by equitably allocate payments among large groups of creditors, a Lakeville man who victimized and to maximize the estate. Pursuant to a bankruptcy trustee’s banks. Corey Johnston ran a strong-arm powers,10 it has at its disposal the ability to utilize business known as First United state-law fraudulent transfer statutes, which permit a look- Funding, which from 2002 back period substantially larger than that afforded under other through 2009 originated sections of the Bankruptcy Code. (For example, MUVTA has commercial loans and sold a six-year statute of limitations from the discovery of the fraud- participation interests ulent transfer, whereas the fraudulent conveyance section of in the loans to banks. the Bankruptcy Code permits only a two-year look-back.11)

www.mnbar.org January 2018 s Bench&Bar of Minnesota 33 The Minnesota Supreme Court ruled that the MUFTA does not include a presumption that allows Ponzi scheme victims to bypass the proof requirements for a fraud claim.

From this context arose a judicially who were “said to have received only claims.15 That decision is consistent with created rule that became known as the a modest end-of-year bonus” and who established Minnesota law, which dic- “Ponzi-scheme presumption.” Bank- were not alleged to have engaged in any tates that a payment to one creditor to ruptcy courts adopted the presumption sort of wrongdoing.14 the detriment of another, or the prefer- as an evidentiary shortcut—reducing the ence of one creditor over another, is not pleading burden on a trustee with respect Beginning of the end for the enough to make the transfer avoidable to claims seeking to claw back proceeds Ponzi scheme presumption under non-bankruptcy law. It was also of fraudulent conveyances, and compli- While the massive and ongoing Pet- consistent with decisions from a hand- cating the defendant-transferee’s abil- ters litigation venued in the Minnesota ful of federal courts that had previously ity to establish its defenses. In a typical Bankruptcy Court continued, a relatively ruled that the Ponzi scheme presumption fraudulent transfer claim, the plaintiff unknown lawsuit was commenced in contradicted the plain language of the must plead and prove the existence of the Dakota County District Court by a Uniform Fraudulent Transfer Act.16 “badges of fraud” that are identified spe- receiver seeking to wind up the business On petition by the trustee, the Min- cifically by statute and used to determine of the Ponzi scheme perpetrated by John- nesota Supreme Court accepted review, whether a transfer was made in violation ston through First United. Johnston was and ruled that the MUFTA does not of the creditor’s rights. The plaintiff must charged by the U.S. Attorney and pled include a presumption that allows Ponzi demonstrate that the debtor was insol- guilty to bank fraud. The receiver of First scheme victims to bypass the proof re- vent at the time of the transfer and that United, Patrick Finn, pursued state law quirements for a fraud claim. Writing for the transfer was not made in exchange claims in an attempt to claw back interest the Court, Justice Stras reasoned that for reasonably equivalent value. It is on on loan participations received by vari- the Minnesota statute “does not contain these evidentiary points that the pre- ous banks dating back to the early 2000s. a provision allowing a court to presume sumption most often rested. The Ponzi The receiver alleged that First United anything based on the mere existence of presumption effectively assumed that a “forged borrowers’ signatures, cut and a Ponzi scheme.” The word “Ponzi” does debtor engaged in such a churn could pasted or otherwise appended borrow- not appear in the Minnesota statute and not be solvent and could not be effecting ers’ signatures… and altered bank state- the statute does not address “schemes.” transfers for reasonably equivalent value, ments and other financial documents” in In short, the Court ruled the Minne- as no actual value existed by definition. order to sell participations in loans that sota statute (an example of the Uni- That is, “any acts taken in furtherance of did not exist and participation interests form Fraudulent Transfer Act) does not [a] Ponzi scheme” constitute fraudulent that exceeded the actual loan amounts. contain a provision allowing a court to transfers because “the Ponzi scheme is by The district court entered summary presume fraudulent intent based on the definition fraudulent.”12 As sometimes judgment in favor of the receiver against existence of a Ponzi scheme. applied, the Ponzi presumption provided two bank defendants, based on applica- Justice Stras further noted that a shortcut to establish a fraudulent trans- tion of the Ponzi scheme presumption. fraudulent transfer laws were intended fer as a matter of law by the mere show- One of the banks appealed, arguing that only to keep the debtor from depleting ing that the transferor was involved in a until the recent decisions stemming from its assets—not paying legitimate obliga- fraudulent Ponzi scheme. the Petters Ponzi scheme, no other court in tions. Quoting a decision dating back to The presumption was most often used the 8th Circuit had ever applied the Ponzi the 1920s, when the term Ponzi scheme in cases where the transferor promised scheme presumption as a device for fact- was popularized, the Finn court observed: and delivered exorbitant returns on in- finding, and emphasizing factual differ- “Payment of an honest debt is not fraud- vestments, but engaged in little or no ences in the particular First United loans ulent under the general statutes against legitimate business activity.13 The pre- at issue, for which there did exist an ac- fraudulent conveyances, although it op- sumption expanded into Minnesota in tual borrower who was repaying the loan. erates as a preference.”17 the context of such a case—Petters— The court of appeals reversed the where the trustee brought fraudulent district court judgment, and declined to Continued fall: Court decisions transfer claims against a variety of inves- fully apply the Ponzi scheme presumption subsequent to Finn tors, including churches and charitable in light of the evidence that the bank re- The Finn decision had an immediate organizations. But the Minnesota Bank- ceived payments in good faith and for impact on the ongoing Petters bankruptcy ruptcy Court found these complaints to reasonably equivalent value—a defense litigation, related to the trustee’s efforts to be viable even against former employees to the receiver’s fraudulent transfer claw back “profits” from Petters investors

34 Bench&Bar of Minnesota s January 2018 www.mnbar.org going back six years or more, through Conclusion Notes the MUFTA or other state laws.18 Ruling Despite the spectacular failures of 1 In re Murrin, 821 N.W.2d 195, 197 n.1 (Minn. on motions presented after the Finn Bernie Madoff, Tom Petters, and others, 2012) (citing Black’s Law Dictionary 1198 decision, the Petters court concluded that it seems likely that fraudsters will contin- (8th ed. 2004)). while the Finn court had categorically ue to replicate Charles Ponzi’s business 2 Charles Dickens, The Life and Adventures rejected all three components of a Ponzi model, and thus, efforts to unwind such of Martin Chuzzlewit, 1842. Chuzzlewit’s scheme presumption, the plaintiff may schemes in order to compensate creditors nephew, Jonas, joins with Montague Tigg still plead and prove intent with the and victims will persist. Going forward, in an insurance scam. As Tigg describes the aid of an inference, by bringing forward however, it would seem that rather than scheme to Jonas: “we grant annuities on the enough evidence of fraud in surrounding asking courts to create new evidentiary very lowest and most advantageous terms circumstances, consistent with the badges shortcuts applied to commonly known known in the money market; and the old of fraud approach specifically provided in frauds such as Ponzi schemes, trustees ladies and gentlemen down in the country, the Uniform Fraudulent Transfer Act.19 and receivers asserting fraudulent trans- buy’em. Ha, ha, ha! And we pay’em too – One year after the Finn ruling, a sec- fer claims under state law will need to perhaps. Ha, ha ha!... Then there are the ond state high court—the Texas Supreme prove the express statutory elements. Life Insurances without loans: the common Court—considered the Ponzi scheme pre- Absent the Ponzi scheme presumption, policies. Very profitable, very comfortable. sumption and came to a similar conclusion claw-back attempts through state law Money down, you know; repeated every year; regarding its applicability. That case arose claims may be limited largely to business- capital fun!” from the infamous Allen Stanford Ponzi es that received extraordinary returns or 3 Many of the citations below refer to cases de- scheme, which sold fraudulent high-yield had reason to suspect the existence of cided during the period of the MUFTA, and certificates of deposit to unwary investors, the criminal scheme. Such claims should references to that statute are maintained— and a claim by the related receiver that not typically extend to ordinary business though they likely apply equally to MUVTA the Golf Channel should disgorge trans- transactions, such as a bank receiving a as well. fers of nearly $6 million spent on televi- market interest rate on a loan, a radio 4 See In re Butler, 552 N.W.2d 226, 232 (Minn. sion advertisements. Although litigation station selling advertising, or an electri- 1996). was venued in the federal courts, the cian providing maintenance work at a 5 Minn. Stat. §513.44(a); see also Minn. Stat. 5th Circuit certified the following ques- fraudster’s office, even though all these §513.45(a) (specifically addressing fraudulent tion regarding the Texas version of the service providers could be considered as transfers to present creditors). Uniform Fraudulent Transfer Act to the furthering, in some fashion, the ongoing 6 Minn. Stat. §513.48(a). Texas Supreme Court: “Considering the business of a Ponzi schemer. s 7 Butler, 552 N.W.2d. at 231. definition of ‘value’ in section 24.004(a) 8 Id. (quotations omitted). of [TUFTA], the definition of ‘reasonably 9 Kummet v. Thielen, 210 Minn. 302, 306, 298 equivalent value’ in section 24.004(d) of N.W. 245, 247 (1941). [TUFTA], and the comment in [UFTA] 10 See 11 U.S.C. §544. stating that ‘value’ is measured ‘from a CHRISTOPHER R. MORRIS is 11 See 11 U.S.C. §548 creditor’s viewpoint,’ what showing of a shareholder and officer at 12 E.g., In Re World Vision Entm’t, Inc., 275 B.R. ‘value’ under TUFTA is sufficient for a Bassford Remele, P.A., and 641, 656 (Bankr. M.D. Fla. 2002). transferee to prove the elements of the a past president of the Hen- 13 See, e.g., In re Polaroid Corp., 472 B.R. 22, 43 [good-faith] affirmative defense under nepin County Bar Associa- (Bankr. D. Minn. 2012) (a massive, multi- section 24.009(a) of [TUFTA]?”20 tion. He defends financial year scheme that offered, in one instance, The Texas court followed Minnesota’s institutions and firms against promised returns of “20% interest … 80% lead in Finn, noting that “Like the Minne- consumer and regulatory annualized … backed by the entire Polaroid sota Supreme Court… we discern nothing lawsuits and advises businesses on compliance corporation” for a non-existent loan); Donell, in TUFTA’s text suggesting the Legisla- with federal credit and collection laws. He also 533 F.3d 762, 767 (business promised returns ture intended a different value standard to defends attorneys, engineers, and other profes- of 20% for a non-existent scheme that apply in the Ponzi-scheme context.”21 Ap- sionals, and represents businesses and individu- involved purchasing accounts receivables of plying that principle to the circumstances als in commercial and employment disputes. Malaysian glove manufacturer). faced by the Golf Channel, the court [email protected] 14 In re Petters Co., 495 B.R. 887, 912 (Bankr. noted that the media-advertising services D. Minn. 2013). offered to Stanford’s business “had objec- JEFFREY D. KLOBUCAR is an 15 Finn v. Alliance Bank, 838 N.W.2d 585 tive value and utility from a reasonable attorney at Bassford Remele, (Minn. Ct. App. 2013). creditor’s perspective at the time of the P.A. who regularly repre- 16 See, e.g., In re Carrozella & Richardson, 286 transaction, regardless of Stanford’s finan- sents commercial creditors B.R. 480, 491 (D. Conn. 2002); cial solvency at the time.” Moreover, as in bankruptcy cases, as well In re Unified Commercial Capital, 260 B.R. services were provided, each payment had as in federal and state court 343, 354 (Bankr. W.D.N.Y. 2001). value “by extinguishing claims against the litigation. The scope of such 17 Thompson v. Schiek, 171 Minn. 284, 287, 213 estate for the value of those services.”22 litigation includes contract N.W. 911, 912 (1927). The court thus concluded that a business rights enforcement, including cases regarding 18 See Kelley v. Opportunity Fin., LLC, 550 B.R. can demonstrate it provided reasonably security agreements, and commercial leases 457 (Bankr. D. Minn. 2016). equivalent value for the money it was paid involving both real estate and personal property, 19 Kelley, 550 B.R. at 468; Minn. Stat. by showing that it performed under a law- commercial post-judgment collection matters, §513.44(b). ful arms-length contract for fair market including enforcement of judgment liens and 20 Janvey v. Golf Channel, Inc., 487 S.W.3d 560, value, provided consideration that had guaranties, and commercial garnishment actions. 564 (Tex. 2016). objective value at the time of the transac- He also has significant class-action and multi- 21 Id. at 581. tion, and made the exchange in the ordi- district litigation experience. 22 Id. at 581-582. nary course of business. [email protected] www.mnbar.org January 2018 s Bench&Bar of Minnesota 35