Spring 2009 • Issue 32, page 17

Recent Ninth Circuit Rulings on Ponzi-Scheme Fraudulent Transfers

By Coleman, Thomas Henry*

So far this year, the United States Court of Appeals for the Ninth Circuit has generated three major opinions significantly defining the potential liabilities of investors in bankruptcies and receiverships resulting from Ponzi schemes, a common type of investment fraud1.

To reiterate the fundamentals of a Ponzi scheme, an archetypical con artist, one Charles Ponzi, raked in millions of dollars from numerous investors, supposedly putting their money to work and returning them handsome returns. Indeed, for a brief period, there were tidy “interest” payments to the investors, confirming their intelligence in placing trust in Mr. Ponzi. Unfortunately for the investors, Mr. Ponzi really didn’t use their funds as he had promised; instead of placing funds with profitable businesses, he helped himself to most of the money he got and distributed smoke-screen payments to the investors, lulling them into believing that all was well.

The entirety of the payments to Mr. Ponzi’s investors came to considerably less than the money they put in.2

The three recent Ninth Circuit rulings have decided several important Ponzi-scheme issues: (a)the lucky investors whose money has been repaid to them are not liable for repaid principal; (b)the same lucky investors will be liable for net profits realized by them; and (c)an investor’s pure heart does not win judicial sympathy.

In the 1990’s, Beverly Hills-based Advance Finance, Inc., (“AFI”) harvested millions of dollars from numerous members of the investing public, falsely representing that their money was going to be used in the factoring of accounts receivable.3 Over time, AFI factoring actually became unprofitable, but management fraudulently masked that fact from the investing public, continuing the appearance of “business as usual” and making payments to investors.

Eventually, AFI’s financial position worsened to the point where, in 2001, it voluntarily filed bankruptcy in Los Angeles, and a bankruptcy trustee was appointed. Later, the trustee filed numerous adversary proceedings against most of AFI’s investors, alleging that they were the recipients of actual fraudulent transfers—that is, that the management of the transferor intentionally had the company pay money to investors that did not represent actual factoring profits. See In re AFI Holding, Inc., 525 F.3d 700, 702 (9th Cir. 2008.)

The Bankruptcy Court granted summary judgments in favor of the bankruptcy trustee, adjudging that the investors were liable for all principal and interest that they had received from AFI. The theory on which the bankruptcy trustee had proceeded, and a primary component of the Bankruptcy Court’s summary judgment, was that AFI, as a Ponzi scheme vehicle, made an actual fraudulent transfer by paying money to an investor. This actual fraudulent transfer happened because of the fraudulent intent of the perpetrator of the Ponzi scheme, irrespective of the actual naiveté of the investor-transferee.4 Moreover, the Trustee theorized—and the Bankruptcy Court agreed—that the payment of money to an investor was just a return of “equity” in a worthless investment and hence of no fair equivalent value.

The United States District Court in Los Angeles reversed this Bankruptcy Court ruling, relying on the precedent of the Ninth Circuit opinion in In re United Energy Corp., 944 F.2d 589 (9th Cir.1991). The District Court reasoned that the repayment to the investor was in return for the partial or complete extinguishment of a restitution cause of action that the investor held against the perpetrator. Id. at 702.

The Trustee appealed, and the Ninth Circuit affirmed the District Court’s reversal. Id. at 701. In doing so, the Court stated that the investor exchanged his partnership interest for a proportionately reduced restitution claim.

Elaborating on the reason why there was an exchange of value, the Ninth Circuit Opinion states (Id. at 708):

The Trustee argues that the parties did not expressly exchange the restitution claim for the $89,824.18, and instead, AFI transferred the money on account of Mackenzie’s partnership interest. Although circumstances of the exchange were cloaked in terms of a partnership interest, we delve beyond the “form” to the “substance” of the transaction. See United Energy, 944 F.2d at 596.

The AFI Opinion did not let investors completely off the hook, however, because it also made clear that the bankruptcy trustee was entitled to recover the “profits” made by an investor in a Ponzi scheme. Id. at 709.

While the Panel in AFI, supra, determined that “profits” from the money put into a Ponzi scheme are recoverable, the Ninth Circuit did not in the AFI Opinion rule on the recoverability of pre-judgment interest. In re AFI Holding, Inc., 525 F3d at 709.

However, shortly thereafter, another Ninth Circuit decision decided that the Bankruptcy Court did have authority to award pre-judgment interest on the amount of “profit” recoverable from the investors. In re Slatkin, 525 F.3d 805, 820 (9th Cir. 2008), explained that under applicable California law (made applicable in the Federal Courts because of the Trustee’s reliance on CUFTA) the Bankruptcy Court may, in its discretion, award pre-judgment interest on an amount recovered under CUFTA.

California law on pre-judgment interest is as follows, CC ß 3288:

In an action for the breach of an obligation not arising from contract, and in every case of oppression, fraud, or malice, interest may be given, in the discretion of the jury. (Emphasis added)

The investors had demanded a trial by jury. However, no jury trial would take place, because the Bankruptcy Court granted summary judgment, and in doing so, used its discretion and awarded pre-judgment interest. Id. at 820. The investors argued that, because the Civil Code reserved the award of pre-judgment interest to the discretion of a jury, only a jury trial would suffice as a foundation for awarding pre-judgment interest.

Realistically, Ponzi scheme litigation against investors does not often actually go through a jury trial to a verdict. Therefore, as a practical matter, recovery of pre-judgment interest against “profit”-taking investors in California-based Ponzi schemes would usually be up to a Judge, rather than a jury.

Relying on California case law, the Slatkin Panel ruled that the trial Court could, on summary judgment proceedings, by itself award pre-judgment interest. Id. at 820.

The Slatkin Panel also determined that the investors fared no better under Federal law pertaining to pre-judgment interest, citing Osterneck v. Ernst & Whinney, 489 U.S. 169, 176, 109 S.Ct. 987, 103 L.Ed.2d 146 (1989).

The AFI and Slatkin decisions, supra, arose in bankruptcy cases. However, relief under CUFTA is also available in a non-bankruptcy setting.

In Donell v. Kowell, 533 F.3d 762 (9th Cir. 2008), the Court dealt with an SEC Receivership, where numerous actions in the United States District Court were brought under CUFTA to recover “profits” from Ponzi-scheme “investors”. The District Court had appointed James Donell as Receiver at the request of the SEC, which had filed a civil enforcement proceeding against J. T. Wallenbrock & Associates. The Ponzi scheme involved numerous sales of “notes” that were supposed to pay 20 per cent interest every 90 days.5 Several years after Kowell invested in the “notes”, the Receiver sought to recover the “profits” that Kowell had received on his “investment” in the “notes”—some $70,000.6

Kowell indignantly protested that he could not imagine that he might be legally required to turn over “profits” that he had obtained as a consequence of putting money into a business years ago.

The Receiver was not deterred and sued Kowell. The District Court ruled that, although the suit was brought in the Federal Court sitting in California, State law embodied in CUFTA applied and entered a Judgment against Kowell.7

The Ninth Circuit issued an affirming Opinion that provides a compendium of legal principles for receivers dealing with Ponzi-scheme/CUFTA litigation. The ruling on appeal was that (1) Kowell met the definition of “transferee” under CUFTA, (2) Federal securities laws did not preempt CUFTA, (3) applying CUFTA to recover Kowell’s “profits” was not inequitable and (4) Kowell was not entitled to offset his liability under CUFTA with paid income taxes, bank transfer fees and other expenses.

The Receiver did not dispute Kowell’s “good faith”. Consequently, the Opinion did not involve an in-depth analysis of the definition of “good faith” when applied under CUFTA. See Donell v. Kowell, supra, 533 F.3d at 771 (footnote 3). However, the Opinion did affirm that, to the extent that an investor receives back his initial investment—rather than “profits”—the legal surrender of his rescission claims automatically constitutes “reasonably equivalent value”.

Kowell’s lawyer raised many points on appeal, but his fundamental thrust was that CUFTA was simply not intended to apply to innocent investors in a Ponzi scheme. Id at 774. The Ninth Circuit’s response was as follows:

Kowell’s claim fails because the terms of the statute are abstract in order to protect defrauded creditors, no matter what form a Ponzi scheme or other financial fraud might take.

“In this case, we need not construe the terms particularly broadly in order to see that they apply quite clearly to Kowell. As we discussed above, when Kowell and the other innocent victims gave money to Wallenbrock, they were not actually investors, but rather tort creditors with a fraud claim for restitution equal to the amount they gave. See [In re] United Energy, 944 F.2d [589], at 595 [9th Cir. 1991].”

The AFI, Slatkin and Donell opinions provide important, and in certain respects, previously-unavailable guidance for bankruptcy trustees and receivers and their lawyers.

*The Law Offices of Thomas Henry Colman are located in Valencia, where Mr. Coleman specializes in receivership and financial law in Stand and Federal courts.

1 See United States Bankruptcy Code (11 U.S.C. 101, et seq.)
2 Over a couple of months, victims turned over to Mr. Ponzi’s company about $10,000,000 in 1919 dollars, in return for 90 day promissory notes that were to pay 150 per cent of each amount “loaned”. Though his company paid some interest to investors, insolvency rumors soon toppled the scheme, when investors suddenly withdrew about $6,000,000, emptying his coffers. Cunningham v. Brown, 265 U.S. 1, 44 S.Ct. 424, 68 L.Ed. 873 (1924)
3 “Factoring” involves the assignment, usually en masse, of businesses’ accounts receivable at a substantial discount. The factoring company makes money when it collects the assigned accounts receivable.
4 The Trustee relied on the Bankruptcy Code’s incorporation of the California Uniform Fraudulent Transfer Act (“CUFTA”), under 11 U.S.C. ß 544(b). The heart of CUFTA’s actual fraudulent-transfer cause of action is California Civil Code (“CC”) ß 3439.04(a). Under that section, “A transfer made or obligation incurred by a debtor is fraudulent as to a creditor, whether the creditor’s claim arose before or after the transfer was made or the obligation was incurred, if the debtor made the transfer or incurred the obligation” with actual intent to hinder, delay, or defraud any creditor of the debtor without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor either depleted its assets or could not timely pay its debts.
5 Under basic definitions found in the Securities Act of 1933 and the Securities Exchange Act of 1934, the so-called “notes” were deemed to be securities, invoking SEC jurisdiction.
6 The Receiver did, however, offer a quick compromise settlement if Kowell would pay 90 per cent of the Receiver’s demand.