September 9, 2013

When an SEC Equity Receiver may, and may not, Use the “Ponzi Presumption” in Fraudulent Transfer Cases

Charles Ponzi’s scheme through which he convinced investors to lend him money which he promised to repay at high interest rates, was completely unsupported from its inception by any assets or legitimate business.  High rates of return were promised to investors, and those returns were financed exclusively from funds raised from new investors.  The payment of these high returns allowed Ponzi to attract new investors. This type of classic Ponzi scheme is insolvent and fraudulent from its inception.  An equity receiver appointed in such a classic case enjoys the “Ponzi presumption,” an evidentiary presumption that establishes, solely on the basis that the perpetrator was operating a Ponzi scheme, that the perpetrator’s transfers during the course of the scheme were made with actual intent to hinder, delay or defraud creditors.  This presumption shifts the
burden of proving the legitimacy and good faith of the transfer to the defendant.

However, throughout the years, other fraudulent schemes which are nevertheless backed in part by some assets or a legitimate business have exhibited characteristics of a Ponzi scheme.   In these cases, is the equity receiver entitled to the same “Ponzi presumption” which applies in classic Ponzi cases?  The United States District Court for the District of Utah has held that an equity receiver in a non-classic Ponzi case cannot avail himself of the Ponzi presumption. Securities and Exchange Commission v. Management Solutions, Inc. et al, 2:11-cv-1165BSJ, Doc. 1215 (D. Utah August 22, 2013). 

In Management Solutions, the receiver filed a number of ancillary actions seeking to recover monies transferred by Management Solutions, Inc. (“MSI”) to various investors.  Seeking to rely on the “Ponzi
presumption” to establish that the transfers were made with actual intent to hinder, delay or defraud creditors, the receiver filed a Motion for Findings Regarding the Existence and Start Date of an Alleged Ponzi Scheme and for Approval to Pool Claims and Assets for administrative purposes of the
receivership.  Several of the defendants targeted in the Motion objected to the relief sought.

In determining the receiver’s request, Judge Bruce Jenkins provided an in-depth examination of the history of Ponzi schemes and their historical treatment by the courts.  Judge Jenkins examined the case law from the various circuits addressing the elements necessary to establish the existence of a Ponzi scheme.  From that examination, Judge Jenkins noted that “courts around the country have defined a Ponzi scheme in various ways.”  However, he also concluded that all of the definitions have a common base:  “a Ponzi scheme is a fraudulent investment scheme in which ‘returns to investors are not financed through the success of the underlying business venture, but are taken from principal sums of newly attracted investments,’” citing In re Independent Clearing House Co., 41 B.R. 985, 994 n. 12 (Bankr. D. Utah 1984). 

Judge Jenkins noted that the facts in the MSI case established that MSI was not operating a classic Ponzi scheme because its business operations included substantial real estate business operations which generated substantial revenues.  Because MSI engaged in legitimate business operations, Judge Jenkins found that its scheme was not a “classic” Ponzi scheme in the nature of that run by Charles
Ponzi.  Consequently, in assessing the receiver’s Motion, Judge Jenkins held that, in order to establish that a fraudulent investment scheme is a Ponzi scheme, a receiver must establish by a preponderance of the evidence two things:  (1) that returns to earlier investors were paid by funds from later
investors and (2) that returns to investors could not be paid by the underlying legitimate business venture. 

Judge Jenkins held that the Ponzi presumption is appropriate in classic cases, where the scheme is “fraudulent from the beginning, with no assets other than investor contributions, no legitimate business, commingled investment funds, and preferential transfers to early investors from the
contributions of subsequent investors.” However, he ruled that use of the presumption in cases where the perpetrator’s operations include legitimate business functions but also represent some characteristics of a Ponzi scheme is inappropriate and might actually penalize innocent conduct.  The
court stated that the Ponzi presumption is “but a tool.  It is not a shortcut or substitute for proof.  In the finding of Ponzi schemes, it is applicable where appropriate and if not, then proof of inappropriate activity on the part of a target, not the mere affixing of a label by the Receiver, is required.”  Judge Jenkins ended his Memorandum Opinion by stating that the Ponzi presumption should be of limited use and applied only in those cases “as blatant and as plain as the original Charles Ponzi case and the more recent Madoff case:  assetless and fraudulent from day one.”