In Perkins v. Haines, et al, No. 10-10683 (11th Cir. October 27, 2011) (click here for .pdf of opinion), the 11th Circuit took a direct appeal of the Bankruptcy Court’s order concerning the "value" defense in fraudulent transfer proceedings.

The basic facts are as follows.  International Management Associates, LLC and related entities were operated as a Ponzi scheme by Kirk Wright).  "Wright used the Debtors to operate a fraudulent Ponzi scheme whereby capital contributions made to the Debtors by later equity investors were used to repay earlier investors more than their investments were actually worth, as well as fictitious profits."

Perkins, the Trustee, filed adversary proceedings against several defendants for the recovery of fraudulent transfers.Each of the defendants in the appeal were individuals who made a capital contribution through a limited liability company agreement, limited partnership agreement or subscription agreement.  Each of the defendants received transfers consisting a return of capital and/or "profits" from their investment.

The general rule for fraudulent transfers in a Ponzi Scheme case is that the transferee has an immediate claim for fraud against the debtor at the time of the original investment.  A recovery of the transferee’s initial investment, therefore, is treated as a release of the claim against the debtor, and provides the transferee with an affirmative defense in an action to recover the fraudulent transfer. The defense is not available for transfers over and above the initial investment, or "profits," and a trustee can normally recover those transfers.

Most of the cases involving Ponzi schemes and adversary proceedings to recover fraudulent conveyances involve loans or investments to the debtors.  In the cases on appeal, the defendants were equity holders in debtors.

The Trustee argued that the affirmative defense should not be available to the defendants because the transfers operated to redeem their worthless equity interests and were not made in satisfaction of a debt.  

The Trustee hangs his hat on a line of cases holding that transfers to redeem an equity investment in an insolvent entity (initially made free of fraud) cannot constitute a transfer “for value.” See e.g., Consove v. Cohen (In re Roco Corp.), 701 F.2d 978, 982 (1st Cir. 1983); Schafer v. Hammond, 456 F.2d 15, 17-18 (10th Cir. 1972); Lytle v. Andrews, 34 F.2d 252 (8th Cir. 1929); M.V. Moore & Co. v. Gilmore, 216 F. 99, 100-01 (4th Cir. 1914). In each of these decisions, investors exchanged shares of stock for other security interests, notes, or real property, all at a time when the corporations were insolvent. The courts held that the exchanges constituted fraudulent transfers because the stock returned to the corporations as part of the exchange was, at that time, virtually worthless due to the corporate insolvency. As such, the corporations received “less than a reasonably equivalent value.” See Roco Corp., 701 F.2d at 982; Schafer, 456 F.2d at 16-18; Lytle, 34 F.2d at 253-54.


The Circuit panel disagreed. None of the cases cited by the Trustee involved Ponzi schemes.  Rather, they involved insolvent corporations paying off equity holders at the expense of creditors. 

In sum, the Trustee asks the court to focus solely on the form of the investment to the exclusion of all other factors, and to ignore the realities of how Ponzi schemes operate. As the bankruptcy court correctly noted, however, no court to date has applied this form over substance rule in fraudulent transfer actions involving Ponzi schemes. More specifically, no court has distinguished between equity investments and debt-based claims when applying the general rule to fraudulent transfer actions arising out of a Ponzi scheme. To the contrary, the Ninth Circuit – the only court of appeals to address this issue to date – applied the general rule to equity investors in a Ponzi scheme, and rejected any attempts to distinguish between the forms of the investment.[In re AFI Holding, Inc.,525 F.3d 700, 704 (9th Cir. 2008)]…

 The [AFI] court emphasized that the limited partners in AFI Holding “were defrauded into their limited partnership role by the operator of the Ponzi scheme.” 525 F.3d at 708. The AFI debtors operated the Ponzi scheme before McKenzie made his principal investment, and the Ponzi scheme continued to exist well before any transfers were made back to him. Accordingly, McKenzie “acquired a restitution claim at the time he bought into [the] Ponzi scheme, . . . [and] [i]t is this restitution claim, in toto, that McKenzie exchanged when AFI returned McKenzie’s principal ‘investment’ amount.” 525 F.3d at 708.“Although circumstances of the exchange were cloaked in terms of a partnership interest, [we have looked] beyond the ‘form’ to the ‘substance’ of the transaction.” Id. Whether the debtor was insolvent at the time was irrelevant. The fact that McKenzie and the other investors held equity interests was also of no moment. The general rule applies in a Ponzi scheme setting regardless of whether good faith investors have an equity interest in, or some other form of claim against, the legal entity constituting the instrument of the fraud. We agree with that analysis and the result.

Virtually identical facts are presented in this case. The Trustee agrees that the investor defendants purchased limited partnerships from the Debtors at a time when the Ponzi scheme was already in operation and a claim for fraud or restitution was created in favor of the investors based on the Debtors’ fraudulent activity. Under AFI Holding and the general rule, later transfers from the Debtors up to the amount of the investment satisfied the investor defendants’ restitution or fraud claims and provided value to the Debtors. 

[emphasis in bold added].  The Bankruptcy Court’s denial of summary judgment to the Trustee was therefore affirmed.


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