Minnesota Supreme Court Rejects The Ponzi Scheme Presumption: Lenders Claw Back Some Of Their Own Rights

Apr 17 2015 | 9:23am ET

By Steve G. Stevanovich & Tobias S. Keller

Lenders can be forgiven if they feel exposed in insolvency matters.  Trustees, receivers, and other fiduciaries invariably find theories to pursue “deep pockets” to fund creditors’ losses, whether in the form of “lender liability” claims or allegations of collusion with failed businesses.  One such theory holds that if a lender advances money to an entity that is running a Ponzi scheme, the lender must as a matter of law disgorge everything it recovered on its loans other than principal; this is true in spite of the fact that the statutes appear to exempt from liability transfers made for fair value, specifically including “satisfaction .. of a … debt of the debtor.”  All the same, under the judicially-created “Ponzi Scheme Presumption”, facts relating to the loan – for instance, that it was supported by appropriate underwriting and diligence, made at rates that are indisputably market rates, or paid down in accordance with contract terms – become entirely irrelevant. 

While there is no reason that the policy rationale underlying the Ponzi Scheme Presumption (that is, lenders should not “profit” from loans made to Ponzi schemes) should be limited to particular types of defendants, the Ponzi Scheme Presumption has been applied almost exclusively to lenders and investors.  Stated differently, lawsuits to recover “profits” from vendors, lessors, or employees are so rare as to be extraordinary.  This notwithstanding, in cases now pending in Minnesota, trial courts have ruled that lenders are liable for fees and interest received on their loans, without further inquiry, based entirely on the Ponzi Scheme Presumption.

In its decision of February 18, 2015, Finn v. Alliance Bank, the Minnesota Supreme Court conclusively put an end to the Ponzi Scheme Presumption in Minnesota.  In the underlying appeal, First United Funding was a lender offering to other lenders participation interests in its loans.  It turned out that some of the participations purchased by third-party lenders were, in fact, utterly unsupported by an underlying loan.  In order to preserve the illusion that First United’s lending business was legitimate and profitable, the fraudulently-obtained participation interests were repaid – not from a loan, but from proceeds of other participations.  In this way, First United was running a classic Ponzi-scheme:  Lenders buying new participations were unwittingly providing the cash First United needed to pay off lenders that had themselves unwittingly purchased participations in loans that did not, in fact, exist.

The First United fraud collapsed in September 2009 and, ultimately, a receiver brought suit to recover payments received by the lenders that had purchased participations.  The trial court allowed the receiver to proceed based on the Ponzi Scheme Presumption, which it described as a rule providing that “the profits that good-faith investors enjoy in connection with a Ponzi scheme are recoverable as fraudulent transfers.”    It ultimately granted the summary judgments in favor of the receiver.  The lenders took the matter up on appeal and ended up in the Minnesota Supreme Court.

In Finn, the Minnesota Supreme Court noted that the fraudulent transfer laws on which the receiver was relying were intended to prevent borrowers from placing assets “otherwise available for payment of their debts out of the reach of their creditors.”  It observed that the Ponzi Scheme Presumption was actually comprised of “three separate presumptions”:  (i) debtors in Ponzi scheme cases can be presumed to have acted with “fraudulent intent”; (ii) debtors engaged in Ponzi schemes are insolvent at the outset “and become more insolvent with each investor payment”; and, finally, (iii) “any transfer from a Ponzi scheme [is] not for reasonably equivalent value.”  From a statutory standpoint, the court was unpersuaded that there was any basis to allow a presumption to supplant actual evidence.  It noted that other courts struggled to define the scope of the phrase “Ponzi scheme” and, rather pointedly, observed that “the word ‘Ponzi’ does not appear in the Minnesota Statutes, and [the Minnesota Uniform Fraudulent Transfer Act] does not address ‘schemes.’”

The Minnesota Supreme Court then considered each of the three separate presumptions as applied in the Finn cases.  With respect to fraudulent intent, it conceded that the trial court could make a “rational inference” that First United made any particular transfer with fraudulent intent, but observed “there is no statutory justification for relieving the Receiver of its burden” to present persuasive evidence of fraudulent intent.  Similarly, on the question of insolvency, the court made a rather obvious observation:  Even though the United States Supreme Court found that the debtor was insolvent in a Ponzi scheme before it, that decision “does not stand for the broader proposition” that “every Ponzi scheme is necessarily insolvent from its inception, without regard” to the particular facts of that case.  “Accordingly”, said the Minnesota Supreme Court, “we reject the second component of the Ponzi-scheme presumption.”

The Minnesota Supreme Court reserved its most thorough commentary for the third presumption – that the operator of a Ponzi scheme “cannot receive reasonably equivalent value for the ‘interest’ or ‘profits’ it pays to investors.”  The Minnesota Supreme Court rejected this argument directly and unambiguously.  Coming full circle, it noted that fraudulent transfer laws were intended only to keep a debtor from depleting its assets – not paying legitimate obligations.  Citing one of its decisions from 1927, the Minnesota Supreme Court reminded the litigants that

[p]ayment of an honest debt is not fraudulent under the general statutes against fraudulent conveyances, although it operates as a preference; the rule being that a preference by an insolvent debtor of one of his creditors can be avoided only by appropriate proceedings under the bankruptcy law . . . and is not open to attack in an action brought by another creditor.

The receiver protested that this was not fair.  He argued that if the Ponzi Scheme Presumption was not imposed, it would allow “some creditors to profit at the expense of others.”  The court’s response was curt:  “[t]hat is not relevant here.”  Other cases had already established that it is not unlawful for a creditor to receive its due, even if by doing so it has the “incidental effect of preventing [another creditor] from collecting his debt.”

Based on the foregoing, the Minnesota Supreme Court reversed each of the lower court decisions applying the Ponzi Scheme Presumption and, as to one aspect of the case, directed summary judgment in favor of a lender.  It held that the loan was legitimate and that the lender was entitled not only to recovery of the purchase price on its participation interest but the contractual return for which it bargained.

The court’s decision in Finn is not a windfall for lenders.  Rather, it inserts some fairness into the litigation of the so-called “clawback actions” brought by fiduciaries appointed in collapsed Ponzi schemes.  By doing away with the Ponzi Scheme Presumption and the shortcuts that it offered, it requires fiduciaries to show (and allows lenders to challenge) that the contractual returns received by lenders do not constitute “reasonably equivalent value.”  There may be instances in which a fiduciary can prove without the benefit of the Ponzi Scheme Presumption that lenders’ recovery of their loans according to contract terms provided more than reasonably equivalent value for the borrower’s use of a lender’s capital.  But without the benefit of the Ponzi Scheme Presumption, the vast majority of lenders – who charge and receive market rates for their capital – should be able to keep the proceeds of their loans. 

Perhaps one day a Minnesota legislator will propose and obtain the passage a law requiring that losses in a Ponzi scheme may be paid out of lenders’ recoveries.  For the time being, however, the Finn decision makes it clear that Minnesota courts cannot invoke the Ponzi Scheme Presumption to subsidize cases by avoiding otherwise legal, contractual payments to a lender.

Steve G. Stevanovich is the Founder and President of Epsilon Investment Management LLC and Westford Asset Management LLC and has 30 years of experience in international investment management. He has a BA in Economics from the University of Chicago and an MBA from the University of Chicago Graduate School of Business, and currently serves as a trustee for the University of Chicago.  Some of the Epsilon and Westford funds are being sued for $3.2 billion in Kelley v. Westford Special Situations Master Fund, L.P. (In re Petters Companies, Inc.) in the United States Bankruptcy Court for the District of Minnesota in connection with loans made by those funds.  He also appeared as an amicus party in the Finn case.

Tobias S. Keller is the Managing Partner of Keller & Benvenutti LLP, a law firm based in San Francisco that concentrates its practice in the areas of insolvency and restructuring.  He is a graduate of Harvard College and Stanford Law School.  His firm represents the Epsilon and Westford funds in various matters including the Petters matter and appeared on behalf of Epsilon and Westford in the Finn case.


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