- Member Services
- Member Search
- TBA Member Benefits
- Government Affairs Update
- Law Practice Management
- Legal Links
- Local Rules of Court
- Opinion Search
- Tennessee Rules of Professional Conduct
- Update Information
- Celebrate Pro Bono
- Government Affairs Update
- Law Student Outreach
- Leadership Law
- Public Education
- TBA Academy
- Tennessee High School Mock Trial
- TBA Mentoring Program
- Tennessee Youth Courts
- TBA Groups
- ABA Resource Committee
- Attorney Well Being Committee
- Access to Justice Committee
- CLE Committee
- Committee on Racial and Ethnic Diversity
- Committee on the Judiciary
- Ethics and Professional Responsibility
- Governmental Affairs Committee
- Leadership Law
- Legal-Medical Relations Committee
- Long Range Planning
- Mentoring Committee
- Public Education Committee
- Tennessee Bar Journal Editorial Board
- Unauthorized Practice of Law
- Special Committee on Law Practice by Foreign Lawyers
- Leadership Law Alumni
- Tennessee Legal Organizations
- Young Lawyers Division
- YLD Fellows
- TBALL Class of 2014
- Access to Justice
- Access to Justice Committee
- Attorney Web Pages
- Celebrate Pro Bono
- Corporate Counsel Pro Bono Initiative
- Corporate Council Pro Bono Initiative Award Nomination
- Apply for a Corporate Council Pro Bono Initiative Grant
- CCPBI Sponsorship Information
- 2014 CCPBI Award Winners
- 2013 CCPBI Award Winners
- 2012 CCPBI Award Winners
- 2011 CCPBI Award Winners
- 2010 CCPBI Award Winners
- 2009 CCPBI Award Winners
- 2008 CCPBI Award Winners
- Disaster Relief Resources
- Finding an Attorney
- Hometown Support: Legal Help For Our Military
- I Want to Do Pro Bono
- Justice for All
- Member Search
- The TBA
Follow the Money
The trustee uses 'claw backs' to retrieve certain payments of principal and profits paid by the schemer to investors during the two-year period prior to the filing of the bankruptcy petition.
Massive Ponzi schemes have crumbled in recent years, leaving thousands of victims seeking both answers and compensation for losses mounting in the billions. A federal bankruptcy case may ensue to sell what is left of the schemer's assets, recoup claims owed to the estate, and distribute assets in a fair and equitable process. Sometimes the victims themselves initiate the bankruptcy process by filing an involuntary petition against the schemer, which enables a court-appointed trustee to halt the schemer from further dissipating the estate. Investors hope that the bankruptcy trustee will find a "pot of gold" that will fully compensate them for their lost investments and earnings. Assuming that savings supported the schemer's opulent lifestyle, investors may optimistically assume that the trustee will find this "pot of gold" in a sizeable bank account, perhaps in the Caymans or in another foreign location. However, the stunning reality is that the trustee usually does not find a pot of gold in the Caymans; instead the elusive "pot of gold" is in the pockets of the innocent victims who invested with the schemer. The trustee uses broad avoidance powers under the federal Bankruptcy Code, popularly referred to as "claw backs," to retrieve certain payments of principal and profits paid by the schemer to investors during the two-year period prior to the filing of the bankruptcy petition. The Bankruptcy Code allows the trustee to go even further back in time by applying the state fraudulent conveyance statute. In Tennessee, the Uniform Fraudulent Transfer Act, allows the trustee to reach back four years. These assets " in the hands of the victims " are typically the largest source of claims for the bankruptcy estate. How does the federal Bankruptcy Code apply to victims of a Ponzi scheme and is this framework fair? How should an attorney advise a client who is nervous about a suspicious investment or after a fraud has been detected? This article will explore these issues in the context of bankruptcy cases, including the Robert W. McLean bankruptcy case, involving hundreds of trusting friends and successful business people in Tennessee in a $50 million scheme.
The Robert W. Mclean Ponzi Scheme
McLean was a Murfreesboro resident who crafted an excellent reputation as a broker, generous giver, and music patron. McLean worked as a broker until the late 1980s when he began day-trading. McLean was unsuccessful on most days and he suffered substantial losses in the late 1980s. Despite these losses, McLean began accepting other people's money " primarily from friends and former fraternity brothers " in exchange for unsecured promissory notes. By using promissory notes, McLean was able to avoid regulatory oversight. "Investors" accepted notes from McLean based on McLean's reputation, appearance of success and the sweet deal that accompanied the notes (many exceeded a 20-percent return per year). McLean hid his losses from prior investors by persuading new investors to loan him money. McLean paid a high and steady rate of interest, with no mention of compensation for his services. He would tell investors the accounts were pooled in futures trading, while simultaneously evading details about his "proprietary" strategy. McLean even told some investors the strategy would "go away" if he explained it. He kept his operations tightly controlled with one small office and one outside CPA. McLean never provided a prospectus to investors; however, if requested, he would send a bogus Statement of Account. His business grew through trust and by keeping his investors happy with high and steady returns.
In the meantime, McLean began using investor money to sustain a lavish lifestyle (five homes, including a beach house in Destin, Fla., and a home at Center Hill Lake), to make generous donations to his favorite charities, including Middle Tennessee State University and the Country Music Hall of Fame, and to pay for expenses and tuition of some favored college students. Over the years, McLean allegedly donated close to $1 million to students and acquaintances to pay living expenses and tuition. He contributed more than $900,000 to MTSU to support academics and athletics. He donated prized instruments and cash to purchase instruments worth approximately $1.5 million to the Country Music Hall of Fame, including two guitars owned by Johnny Cash, a 1925 Bill Monroe mandolin, and a 1923 Maybelle Carter guitar. Several people invested with McLean because of his philanthropic activities and high community standing. However, this generosity was made possible only through the "investments" of his clients. In the four years prior to the collapse of his scheme, McLean had virtually no income from any business and his sole source of cash was from enticing "investors" to loan him money. Ultimately, McLean used the investments coming from people who trusted him to pay interest on other investors' loans and to fund charities that were important to him.
The Sinking Ship. By 2002, McLean knew his situation was dire. He made little income from his investments " he ceased day-trading, closed his brokerage accounts, and deposited almost all of the funds received from investors into one of his personal bank accounts. When asked why he continued to borrow from individuals despite knowing that the scheme would fail, McLean told the bankruptcy trustee that he could not bear to let their notes go into default. He thought that if he could only keep the interest payments current a little longer, he could figure out something to bring in enough money to make these people whole. McLean also told the trustee that he felt that he was in a boat, away from the shore, and as time went by, the shore kept getting further away.
In the spring of 2007, one of McLean's large lenders, Mr. Vanetta, demanded $400,000 to pay taxes. After McLean delayed several times, Vanetta got nervous and hired professional investigators. Vanetta met with McLean and took a picture with his cell phone of a purported brokerage account statement. Investigators discovered the account had been closed for several years. McLean began defaulting on other investors' notes. Even as he was defaulting, he was convincing others to loan him money. Several lawsuits were filed in various courts to freeze McLean's bank accounts. Three investors retained a bankruptcy attorney to file an involuntary petition in federal bankruptcy court. A Chapter 7 filing was made in July 2007 in the United States Bankruptcy Court for the Middle District of Tennessee and Robert H. Waldschmidt was appointed the Chapter 7 trustee. All other proceedings came to a halt because of the bankruptcy automatic stay and a meeting of creditors was scheduled for Sept. 26, 2007. Waldschmidt met with McLean to discuss the hearing. McLean was worried that the lenders at the meeting might threaten him physically and he asked if there would be security. He even had Waldschmidt take him to the location where the meeting was to be held. The day before the hearing where he would be confronted by family and friends, McLean took his own life. Waldschmidt continued with the scheduled meeting of creditors and explained what he knew " that there was no "pot of gold" and, with about $50 million in claims, there would not be enough assets to meet all the claims of the creditors.
Ponzi Schemes and Federal Bankruptcy Law
The bankruptcy judge determined that McLean was operating a "Ponzi" scheme for the four years prior to the bankruptcy filing. McLean had no ability to repay the obligations and made no efforts to earn income from 2002 onward. How does a court determine the existence of a Ponzi scheme? While courts do not have a consistent definition, many courts look to a number of factors to determine if a Ponzi scheme existed. For example, in a case involving promissory notes used by an accountant to perpetuate her scheme for more than 10 years in Ohio, the In re Taubman court described a Ponzi scheme as a "fraudulent investment arrangement in which returns to investors are not obtained from any underlying business venture but are taken from monies received from new investors." The court continued "[t]ypically, investors are promised high rates of return [citation omitted], and initial investors obtain a greater amount of money from the ponzi scheme than those who join the ponzi scheme later. As a result of the absence of sufficient, or any, assets able to generate funds necessary to pay the promised returns, the success of such a scheme guarantees its demise because the operator must attract more and more funds ..."
Other factors that may point to a scheme include misappropriation of funds to support the flamboyant lifestyle of the Ponzi operator, high returns in relation to the investor's low risk, and admission or conviction of the operator. While Ponzi schemes can take various forms, they are doomed to fail from the beginning because there is no real business behind them and they promise unrealistic rates of return.
Once the Ponzi scheme collapses, creditors may file individual lawsuits against the schemer, petition a state court for the appointment of a receiver to liquidate the schemer's assets, or file for relief under the federal Bankruptcy Code. In a bankruptcy case, the bankruptcy trustee is then responsible for collecting assets to pay defrauded investors and other creditors. The common problem as demonstrated by the McLean case is that the schemer has few assets left to satisfy the claims. In perpetuating the scheme, the schemer has transferred the assets to other investors, used the funds for personal expenses, and perhaps made generous donations to charities to enhance his image and reputation as a trusted and successful advisor.
What claims can the trustee pursue to retrieve assets into the estate? The largest claims of a collapsed Ponzi scheme are likely in the hands of the investors themselves " the monies that the schemer paid to the investors as earnings and as redemptions of principal. For example, in a collapsed scheme involving the Bennett Funding Group Inc., the bankruptcy trustee filed more than 10,000 lawsuits against the former investors seeking recovery of $100 million. In the McLean case, the trustee filed suit against more than 50 investors, including the investors who filed the involuntary petition. Under certain conditions, the trustee is permitted to recover payments to investors as either fraudulent transfers or voidable preferences. The trustee recovers these funds into the bankruptcy estate and then is able to equitably and ratably distribute the funds to all of the creditors.
The federal Bankruptcy Code and case law grants bankruptcy trustees extensive powers in collecting assets for fair distribution to all investors and other creditors. In general, courts across the country have interpreted the federal Bankruptcy Code broadly as permitting the recovery of profits from victims who received more than they invested in the scheme (net winners), regardless of the investor's knowledge or innocence of the schemer's wrongdoing. In addition, many courts have allowed the trustee to recover principal when the investor had actual knowledge of the fraud or when the investor failed to meet the good faith standard of a reasonable investor. As indicated by Waldschmidt, the trustee in the McLean case, equality requires that payments be returned to one pot and distributed equitably on a pro-rata basis.
Consider an illustration: Suppose that Investor A gave $1 million to a schemer two years prior to the scheme's collapse and was paid earnings of $300,000 in the year prior to its collapse. Investor B invested $2 million one month prior to the scheme's collapse. Suppose further that investors will be paid only 10 cents on the dollar for their claims against the estate. Is it fair for Investor A to keep all of the earnings paid within one year prior to the collapse ($300,000) and receive a $100,000 distribution on his investment, while Investor B will receive only a $200,000 distribution on his $2 million investment? The Bankruptcy Code provisions suggest that this would not be a fair result because the transfer of the $300,000 to Investor A by the schemer was made with the actual intent to defraud creditors.
Clawing Back "Fraudulent Transfers." Two provisions in the Bankruptcy Code are critical to the trustee's powers to recover assets into the bankruptcy estate of a schemer:
- The Fraudulent Transfer Provision: This allows a trustee to recover principal and interest for two years or longer under state law (four years in Tennessee) when there is actual fraud (the debtor made a transfer with the actual intent to hinder, delay or defraud any creditor) or when there is constructive fraud (the debtor received less than a reasonably equivalent value in exchange for such transfer and was either insolvent on that date, the property remaining was an unreasonably small capital, or the transfer was to an insider).
- Voidable preference provision: This allows the trustee to recover any transfer of the debtor's property (1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt the debtor owed before the transfer was made; (3) made while the debtor was insolvent; (4) made on or within 90 days before the date of the filing of the petition; and (5) that enables such creditor to receive more than he would have received in a liquidation.
A Ponzi scheme investor who receives more from the debtor than he or she invests is considered a "net winner." The payments received by a net winner can be classified as (a) a return of principal, and (b) the fictitious profit on that principal. Whether the trustee can recoup both principal and fictitious profits generally depends on the theory of recovery " actual fraud or constructive fraud. A trustee who seeks to recover under the theory of actual fraud may seek to recover both principal payments and fictitious profits earned by the investor because there is a presumed intent to defraud in a Ponzi scheme. The investor may be able to avoid the return of principal if he or she can prove a "good faith" defense. Several courts, including the Sixth Circuit, will make a presumption that the debtor actually intended to defraud investors if the court determines that a Ponzi scheme existed as a matter of law. Thus, a trustee who can prove the existence of a Ponzi scheme will have an easier time recovering both principal and profits from the victims. Many times the existence of a Ponzi scheme is uncontested because the schemer has pled guilty to criminal charges.
A trustee who seeks recovery under the theory of constructive fraud is limited to recouping fictitious profits earned by the investor, unless the investor subjectively knew of the fraud. These profits are calculated over the life of the investment. For example, assume investor A invested $100,000 in 1990 and received $15,000 each year for 20 years (with a total of $60,000 received in the four years prior to bankruptcy). Investor B invested $100,000 in 2010 and received $15,000 in 2010. Assume neither investor subjectively knows of the fraud and the scheme collapses at the end of 2010, followed by a bankruptcy petition. For investor A (a net winner), the first $100,000 would be a return of principal and $200,000 would be considered earnings; the trustee can recover the $60,000 received in the four years prior to bankruptcy under either an actual fraud or a constructive fraud theory. For investor B (a net loser), the trustee can recover $15,000 under an actual fraud theory (unless the investor can prove a good faith defense discussed in the next section) but cannot recover any amount under the constructive fraud theory because investor B is a net loser.
Why are fictitious profits subject to recovery, but not principal, under a constructive fraud action? Almost all courts that have considered the issue under state or federal law have determined that a debtor does not receive reasonably equivalent value or fair consideration for payments received as fictitious profits. On the other hand, the investment made by the investor to a Ponzi operator is obtained by fraud. Thus, the investor has a claim of restitution to recover this investment. When the schemer repays principal to the investor, the exchange is for value because the schemer is actually repaying debt owed to the investor under the law by virtue of the schemer's fraud. According to several courts, the investor has a claim of restitution only if the investor acted in good faith and without subjective knowledge of the fraud. If the investor did know of the fraud, the trustee may recover both principal and fictitious profits, even under a constructive fraud theory. The good faith defense will be explored next.
Reasonable Investor/Good Faith Defense. Investors who can mount the difficult task of showing a "good faith defense" may not have to return principal payments in an action for actual fraud.
When sued under an actual fraud theory for the return of principal, an investor may assert a good faith defense. Section 548(c) of the Code establishes the good faith defense to a transferee who takes for value and in good faith. The Bankruptcy Code does not define "good faith." Courts have reached a consensus that good faith is measured by an objective, reasonable investor standard, and not by the subjective knowledge of the investor. The courts apply a two-part test. This two-part test was explained in great detail in the matter of In re Bayou Group LLC, et. al. involving a Chapter 11 proceeding in the Southern District of New York after the 2005 collapse of the Bayou hedge fund empire. The two-part inquiry considers (1) whether there were any "red flags" which should have put the investor on inquiry notice of a debtor's fraudulent purpose and alerted an objective potential investor that some further investigation of the person or the investment was prudent; and (2) if such "red flags" were present, whether the investor performed an adequate amount of due diligence to resolve any questions or issues about the investment. According to the Bayou court, the purpose of the due diligence is not necessarily to unveil the details of the fraud, but to allay concerns raised by the red flags and prove the plausibility of the defendant's good faith reason for redemption. In short, the investor cannot put his or her head in the sand and then take advantage of the good faith defense.
In the Bayou court's opinion, the following settlements reached by the parties illustrated good faith defenses: (1) a redemption requested solely for funding the purchase of a home, (2) a request to fund expenses of a newborn child and private school tuition of an older child, and (3) University of Tennessee Medical Group Pension Plan's request, upon advice of auditors and counsel, to redeem funds to comply with ERISA.
As explained by the Bayou court, lack of good faith for bankruptcy purposes under the fraudulent transfer provision does not mean the investor acted with bad faith or bad intent. It means that the investor was put on inquiry notice. For example, the Bayou court rejected the good faith defense of CSG, an investment advisory firm based in Memphis, not because CSG acted in bad faith, but because CSG became concerned about how the Bayou fund calculated net asset values (NAVs). When Bayou management refused CSG's requests for documentation, CSG recommended to its clients that they redeem their investments. CSG was actually prudent in its inquiry after the calculation of NAVs became suspect. CSG tried to protect its clients by recommending that they redeem their funds because of concerns. However, the "good faith" defense required that the concerns of the fraud be allayed. Since CSG's concerns were not allayed and the knowledge of CSG was imputed to the clients, the good faith defense failed for these investors. One could argue that CSG and its clients were punished for reclaiming funds after they recognized the suspicious smell of fraud.
In another adversary proceeding in the Bayou matter, the trustee argued that advice of the new general counsel to Sterling Stamos showed that the defendants lacked good faith. Sterling Stamos was a "fund of funds" that invested a total of $15.7 million in Bayou hedge funds. Sterling Stamos received a copy of a legal complaint filed by Westervelt, a former partner of the Bayou management entity, alleging that he was fired after investigating purported SEC violations and other improprieties by the CEO. Sterling Stamos decided to increase its due diligence and ordered two investigative reports. Apparently undeterred by these reports, Sterling Stamos invested an additional $14 million between December 2004 and early February 2005. A new general counsel joined Sterling Stamos on Feb. 7, 2005. By Feb. 9, 2005, after reviewing the files and meeting with Bayou's CEO, the new general counsel advised the partners that his hunch was to redeem the Bayou investments. Peter Stamos decided to redeem the entire investment on Feb. 11, 2005. The judge refused the motions for summary judgment by both parties, holding that the trier of fact would have to decide whether to accept Peter Stamos' "good faith" explanation that the redemption
was based solely on concerns other than red flags.
McLean's Business Model & Investor Good Faith. In the McLean case, Waldschmidt, the trustee, cited the Bayou case in his brief in support of his motion for summary judgment against the seven investors who asserted a good faith defense and refused to settle. Waldschmidt argued that there were many "red flags," including high rates of return (in most cases exceeding Tennessee's usury statute), McLean & Co. was not registered as a business, the company did not have a business model, McLean's business affairs were completely secretive, McLean maintained a high lifestyle with no explanation of how he made money and no provision for compensation, the arrangements were structured as loans with simple promissory notes, there was no documentation about the investments or earnings, and there was no independent investigation of the business. When the investors who asserted good faith defenses failed to produce evidence of due diligence for their affirmative defense, the Bankruptcy Court granted the trustee's motion for summary judgment, avoided the transfers made to the investors by McLean, and disallowed the investors' claims against the estate.
Conclusion/Advising the Client
In sum, when a Ponzi scheme collapses and a bankruptcy petition is filed, the bankruptcy trustee may seek recovery of assets into the estate by suing investors under either (or both) the fraudulent transfer or voidable preference provisions. Voidable preferences are limited to transfers made by the debtor in the 90 days prior to the filing of the bankruptcy petition. Fraudulent transfers are more potent because the trustee can claw back payments under one of two theories (actual fraud or constructive fraud) to recover payments for a longer look-back period (up to four years in Tennessee). If the bankruptcy judge determines that a Ponzi scheme existed, the intent to defraud is conclusively presumed in the Sixth Circuit and the trustee can recover principal received by the investor during the prior four-year period unless the investor can prove good faith.
Prevailing under the good faith defense will be a difficult task for the investor, not only because the burden of proof rests on the investor, but also because the courts have fashioned a circuitous test that requires the investor to prove that he or she performed due diligence if "red flags" were present and that any concerns about possible fraud were dispelled by this due diligence. The chart below illustrates the trustee's avoidance powers, the investor's level of knowledge and the result if the objective two-part test is applied. From a fairness standpoint in analyzing the chart, it is difficult to see why investors in category 2 (investors who knew there were red flags, but due diligence allayed concerns) should be treated more favorably than investors in categories 4 (red flags/no due diligence) and 5 (red flags/due diligence did not allay concerns). Indeed, the Bayou court allowed an exception for investors in category 4 to show that, even though they did not conduct due diligence, they requested a redemption for a reason other than concern about a potential fraud. Category 5 (red flags/due diligence did not allay concerns) is more problematic because the investor recognized red flags, conducted due diligence that did not relieve the concerns, and then demanded a redemption. Arguably, the due diligence for the investor in category 5 was more effective than that of investors in category 4 " yet, category 4 investors fare better if the Bayou exception is applied. The fairest treatment may be to allow the trustee to recover if objective red flags are present, regardless of due diligence.
Illustration of Trustee's 'Claw Back' Powers
|Assume a Ponzi scheme collapses and bankruptcy is filed on 12/31/2010. Assume Investor A invested $100,000 and requested a full redemption plus $50,000 earnings on 4/1/10||Trustee can avoid||Bankruptcy Code Provision||Comments/Defense||"Innocence" of investor|
|1. when there were no red flags and investor did not know of fraud||$50,000 (profits)||Actual Fraud under 11 U.S.C. § 548(a)(1)(A) and 548(c)||Investor can successfully assert good faith defense||Subjectively Innocent/no reason to suspect fraud|
|2. when investor did not know of fraud but there were red flags; investor did conduct due diligence but concerns were allayed||$50,000 (profits)||Actual Fraud under 11 U.S.C. § 548(a)(1)(A) and 548(c)||Investor can successfully assert good faith defense||Subjectively Innocent/no reason to suspect fraud because concerns allayed|
|3. when the investor did not subjectively know of the fraud||$50,000 (profits)||Actual Fraud under 11 U.S.C. § 548(a)(1)(A) or Constructive Fraud under 11 U.S.C. § 548(a)(1)(B)||Subjectively Innocent/ unimportant whether investor should have suspected fraud|
|4. when investor did not know of the fraud but there were red flags; investor did not conduct due diligence||$150,000 (profits and principal)||Actual Fraud under 11 U.S.C. § 548(a)(1)(A) and 548(c)||Investor's good faith defense will likely fail unless Bayou exception is applied (preponderance of objective evidence that redemption was not due to any red flags)||Subjectively Innocent/should have conducted due diligence|
|5. when investor did not know of the fraud but there were red flags; investor did conduct due diligence but concerns were not allayed||$150,000 (profits and principal)||Actual Fraud under 11 U.S.C. § 548(a)(1)(A) and 548(c)||Investor's good faith defense will likely fail||Subjectively Innocent/ did not receive payments in "good faith" according to court decisions|
|6. when the investor did know of the fraud||$150,000 (profits and principal)||Constructive Fraud under 11 U.S.C. § 548(a)(1)(B)||Not innocent|
|7. Regardless of red flags or knowledge, investor received payments of the $150,000, within 90 days of bankruptcy||$150,000 (all payments - outside of ordinary course)||Voidable Preference under 11 U.S.C. § 547||Objective good faith is not a defense.||Subjectively Innocent/ unimportant whether investor should have known of fraud|
On the other hand, the results of the objective test are harsh, allowing the trustee to unwind transactions that occurred up to four years earlier, even when the investor did not subjectively know of the fraud. Many investors may have spent the money or may suffer great hardship in repaying funds to the bankruptcy estate. While it is true that nothing is fair about the losses incurred in a Ponzi scheme, one could argue it is just as fair to leave the victims as they are on the date of the petition rather than re-allocating the funds to the way they existed four years earlier. To achieve this end, the defendant who lacked objective good faith would have to persuade the bankruptcy court to adopt a subjective standard.
How does the attorney advise a client who seeks due diligence on a current investment? The best case is to conduct due diligence and to find no red flags. However, attorneys are especially adept at finding red flags. It seems probable that an expert hired by a bankruptcy trustee will detect red flags. If there were red flags, the investor must show he or she conducted a diligent inquiry that allayed any concerns of fraud. Unfortunately, if the consensus view from other bankruptcy cases is applied, a client may be penalized by demanding a redemption after due diligence fails to allay concerns. Obviously, a client who suspects fraud will want to demand redemption of their investment in any event. If the scheme lasts for more than four years, the innocent investor in Tennessee should be able to retain the redemption of principal. If not, attorneys should advise their clients about the "claw back" potential and warn them to keep their redemptions liquid in the event of a lawsuit by a trustee.
- Ponzi schemes are named after Charles Ponzi, who swindled 40,000 Bostonians in the early 1900s by promising a 50-percent return in 45 days in postal reply coupons. See Cunningham v. Brown, 265 U.S. 1, 44 S.Ct.424 (1924).
- Bernard Madoff, founder, chairman, and CEO of BLMIS, perpetuated perhaps the largest Ponzi scheme in history. More than 15,000 claimants are owed approximately $64.8 billion, according to the final BLMIS customer statements issued Nov. 30, 2008. See SIPC v. Bernard L. Madoff Inv. Sec. LLC (In re Bernard L. Madoff Inv. Sec. LLC), SIPA Liquidation No. 08-01789 (BRL), (Bankr. S.D.N.Y Mar. 1, 2010) (written opinion/memorandum granting trustee's determination of net equity), available at http://www.nysb.uscourts.gov/opinions/ brl/174497_1999_opinion.pdf. Many Tennessee schemes have made recent news. See, e.g., E. Thomas Wood, "One more Franklin schemer pleads guilty," NashvillePost.com, April 12, 2010, available at http://www.nashvillepost.com/news/2010/4/12/one_more_franklin_schemer_pl... E. Thomas Wood, "Many Unhappy Returns," Business TN (describing recent Tennessee schemes) available at http://businesstn.com/print/16528.
- In re Taubman, 160 B.R. 964 (Bankr. S.D. Ohio 1993); In re Bayou Group LLC, 396 B.R. 810, 844 (Bankr. S.D.N.Y. 2008); Jobin v. McKay, 84 F.3d 1330 (10th Cir. 1996); In re Agric. Research and Tech. Group Inc., 916 F.2d 528 (9th Cir. 1990). For the bankruptcy court filings in the Madoff matter, visit the trustee's website at http://www.madofftrustee.com.
- See Theo Emery, "Illusion of Success Gives Way to Suits and Suicide," N.Y. Times, Nov. 10, 2007 (three investors filed an involuntary petition against Robert W. McLean).
- The term "claw back" is not defined or used in the federal Bankruptcy Code but has been used in the media. In this article, this term is used to refer to the fraudulent transfer provision under 11 U.S.C. § 548 and the voidable preference provision under 11 U.S.C. § 547 of the Bankruptcy Code.
- 11 U.S.C. § 544(b).
- Tenn. Code. Ann. § 66-3-301 et seq.
- Tenn. Code. Ann. § 66-3-310.
- See Mark A. McDermott, "Ponzi Schemes and the Law of Fraudulent and Preferential Transfers," 72 Am. Bankr. L.J. 157,158 (1998). The trustee may also have other sizeable claims against charities that were recipients of the schemer's generous donations. See, e.g. "McLean trustee wants instruments returned," NashvillePost.com, Aug. 12, 2008, available at http:// www.nashvillepost.com/news/2008/8/12/ mclean_trustee_wants_prized_instruments_returned; Naomi Snyder, "MTSU settles with Mclean estate," Daily News Journal, June 14, 2008.
- See In re McLean, No. 07-05054-GP3-7 (Bankr. M.D.Tenn). The facts and rulings in the McLean matter are taken from various court filings in the PACER system for the Middle District of Tennessee. These filings include the Order granting summary judgment against remaining defendants (entered Dec. 19, 2009), Brief in support of trustee's motion for summary judgment, Order granting partial summary judgment on three issues (entered Jan. 28, 2009), Order Deeming Facts Admitted (entered Sept. 17, 2009), Affidavit of Jack F. Williams, JD, CIRA, CDBV, Expert Report (Aug. 17, 2009), and Affidavit of Robert H. Waldschmidt (Aug. 12, 2008). The actions to avoid fraudulent conveyance and preferential transfers against the seven defendants who did not settle with the trustee were consolidated for trial under Adv. No. 308-0175A. Since the PACER system charges a fee, this article will refer to links and articles in the public domain where known to the author. For links to the trustee's complaints to avoid transfers in the McLean matter, see E. Thomas Wood, et al., "McLean victims may owe million, trustee claims," NashvillePost.com, May 8, 2008, http:// www.nashvillepost.com/news/2008/5/8/ McLean_victims_may_owe_millions_trustee_claims.
- It is ironic that the deal would have "gone away" if McLean told investors he was scamming them in a Ponzi scheme.
- See E. Thomas Cook, "McLean trustee sues more fund recipients," NashvillePost.com, July 7, 2009, available at http://www.nashvillepost.com/news/2009/7/7/mclean_trustee_sues_more_fund.... A link to the trustee's complaint is provided in this article.
- 160 B.R. 964 (S.D. Ohio 1993).
- Id. at 978.
- Expert Report of Jack F. Williams, In re McLean, supra Note 11 (Aug. 17, 2009).
- McDermott, supra note 10.
- Id. at 158.
- Emery, supra note 5.
- McDermott, supra note 10, at 158.
- Lisa Marchesoni, "55 investors with Robert McLean sued by trustee," The Murfreesboro Post, May 11, 2008.
- 11 U.S.C. § 548.
- 11 U.S.C. § 547.
- See McDermott, supra note 10, at 165.
- The trustee also sought to avoid interest payments as "false profits" under the actually fraudulent transfers under either the Bankruptcy Code or the Tennessee Uniform Fraudulent Transfer Act.
- See McDermott, supra note 10, at 160.
- In general, courts will not be bound by the parties' classification of payments as principal or earnings, but will calculate whether an investor is a net winner or net loser based on the amount of cash invested versus cash received over the life of the investment.
- McDermott, supra note 10, at 164. The trustee pursuing a constructive fraud theory under Section 548 of the Bankruptcy Code or under a state Uniform Fraudulent Transfer Act must prove that the debtor received less than reasonably equivalent value.
- McDermott, supra note 10, at 167.
- Tennessee's UFTA has a "good faith" provision. See Tenn. Code Ann. § 66-3-309(a). The expert in the McLean matter applied the same analysis for good faith under both the federal Bankruptcy Code and under Tennessee's Uniform Fraudulent Transfer Act.
- See, e.g., In re Bayou, supra note 4, at 844; Enron Corp. v. Avenue Special Situations Fund II, L.P. (In re Enron Corp.), 340 B.R. 180, 207 (Bankr. S.D.N.Y. 2006), rev'd on other grounds, 379 B.R. 425, 2007 WL 2446498 (Bankr. S.D.N.Y. 2006).
- See, e.g., In re Bayou, supra note 4 at 844; Jobin v. McKay (In re M & L Business Machine Co.), 84 F.3d 1330, 1338 (10th Cir. 1996), cert. denied, 117 S. Ct. 608 (1996) (citation omitted) (investor in Ponzi scheme should have known of the fraudulent intent); Warfield v. Byron, 436 F.3d 551, 560 (5th Cir. 2006) (investor in Ponzi scheme failed to look into the possible Ponzi scheme despite suspicious information).
- In re Bayou, supra note 4, at 848.
- Id. at 847.
- Id. at 871-872.
- Id. at 861-863.
- Brief in Support of Trustee's Motion for Summary Judgment, Waldschmidt v. Burge, et al. (In re McLean), Adv. No. 308-0171A, Case No. 07-05054-GP3-7 (M.D.Tenn.).
- Id. at 8-9.
- See In re Taubman, supra note 4. In the McLean matter, the court granted the trustee's motion for partial summary judgment, finding that (1) McLean operated a Ponzi scheme, (2) McLean did not have any legitimate income, and (3) McLean was insolvent for the four years prior to the filing or the bankruptcy petition.
- The Bayou court also carved out an exception for investors who were on inquiry notice but who did not conduct due diligence. The court allowed these investor to prove by a preponderance of objective evidence that the request for redemption was in fact the result of a good faith reason other than the investor's knowledge of "red flags." In re Bayou Group LLC, 396 B.R. at 848-849. The court then granted summary judgment to dismiss trustee's claims to recover redemption payments from DB Structured Products Inc., because the defendant showed that the redemption was motivated not by an anxiety concerning Bayou but solely because the Bayou investment was no longer required as a hedge under certain swap transactions.
SANDRA S. (SANDY) BENSON practiced law for more than 12 years before becoming assistant professor of business law at Middle Tennessee State University. She recently received the 2009 Max Block Award for the outstanding article in the category of informed comment for “Recognizing the Red Flags of a Ponzi Scheme: Will You Be Blamed for Not Heeding the Warning Signs?” published in the June 2009 issue of The CPA Journal, a publication of the New York State Society of CPAs. She may be contacted at (615) 848-3525. The author is grateful for the review and comments of Thomas H. Forrester, a member of the firm of Gullett, Sanford, Robinson & Martin PLLC. The views expressed herein are strictly those of the author and do not necessarily reflect those of the reviewer or the author’s employer.