Section 548 of the bankruptcy code authorizes a trustee, debtor, or other appropriate party to avoid actual and constructive fraudulent transfers that occurred prepetition. In order to prove that a transfer was an actual fraudulent transfer, the trustee (or another appropriate plaintiff) must prove that the debtor made the transfer “with actual intent to hinder, delay or defraud any entity to which to debtor was or became…indebted.” 11 U.S.C. §548(a)(1)(A). In order to prove that a transfer was a constructive fraudulent transfer, the trustee (or another appropriate plaintiff) may instead show that the debtor did not receive reasonably equivalent value and was insolvent at the time of the transfer. See 11 U.S.C. §548(a)(1)(B).
Plaintiffs asserting actual fraudulent transfer claims often rely on the so-called badges of fraud, but intent can still be difficult to prove. To make matters worse, these claims must often meet a heightened pleading standard pursuant to Federal Rule of Civil Procedure Rule 9(b).
In some cases, however, there is another way to prove intent. Courts around the country have found that if a trustee (or another appropriate plaintiff) proves that the debtor operated a Ponzi scheme, then that is sufficient to prove the debtor’s intent to defraud creditors. The basis for this presumption is that the mastermind responsible for operating a Ponzi scheme knows that the scheme will fall apart as soon as the pool of new investors inevitably runs dry.
In one recent decision, the Ninth Circuit described this presumption as both “long-standing” and “irrebuttable.” See In re EPD Inv. Co., LLC, 114 F.4th 1148, 1152 & 1157 (9th Cir. 2024). The Ninth Circuit also embraced a definition of “Ponzi scheme” that contains “two essential elements: (1) the funneling of money from new investors to pay old investors, and (2) no legitimate profit-making business opportunity exists for investors.” Id.at 1159.
Other courts have applied a four-factor test: “1) deposits were made by investors; 2) the Debtor conducted little or no legitimate business operations as represented to investors; 3) the purported business operation of the Debtor produced little or no profits or earnings; and 4) the source of payments to investors was from cash infused by new investors.” Sec. Inv. Prot. Corp., 603 B.R. 682, 689 (Bankr. S.D.N.Y.) (collecting cases). But the result is essentially the same: the term “Ponzi scheme” applies to “any sort of inherently fraudulent arrangement under which the debtor-transferor must utilize after-acquired investment funds to pay off previous investors in order to forestall disclosure of the fraud.” Id.
Allegations of a Ponzi scheme may also help a trustee plead or prove insolvency for the purposes of a constructive fraudulent conveyance claim. See In re DBSI, Inc., 447 B.R. 243, 248 (Bankr. D. Del. 2012). The reasoning is that because a Ponzi scheme relies on constant infusions of new cash in order to satisfy existing obligations, a Ponzi scheme can never be solvent.
Notably, the presumption may also be applied to other fraudulent schemes similar to Ponzi schemes (“Ponzi-like schemes”). See, e.g., In re Equip. Acquisition Res., Inc., 2012 WL 4755028, at *6 (Bankr. N.D. Ill. Sept. 28, 2012) (“[Debtor’s] leasing and financing transactions were a “Ponzi-like” scheme and, as such, establish [debtor’s] actual fraudulent intent.”).
Parties who wish to benefit from the Ponzi scheme presumption may follow the lead of the plan proponents in iCap Enterprises, Inc., Case No. 23-01243 (Bankr. E.D. Wash). In iCap, the plan proponents sought a finding from the bankruptcy court that the debtor operated a Ponzi scheme, and the court recently entered a confirmation order that contains this finding. The plan proponents sought this finding in part to benefit from the Ponzi scheme presumption when seeking to unwind prepetition transactions.
The plan proponents also sought this finding for other reasons. For example, this finding would help resolve disputes over intercompany and intercreditor claims, liens and causes of action. Furthermore, the plan proponents noted that the Ponzi scheme finding would allow victims to take advantage of special rules enacted by the Internal Revenue Service. These rules allow victims of Ponzi schemes to deduct losses for income tax purposes as theft losses instead of capital losses, thereby avoiding the cap on capital loss deductions.
As noted above, given the benefits of the Ponzi scheme presumption, and its many practical applications, creditors in bankruptcy cases involving fraud may seek similar findings as iCap Enterprises. This finding may be particularly helpful if the fraud is merely a Ponzi-like scheme, where application of the Ponzi scheme presumption may be more difficult to prove.
