Lenders Beware: The Ponzi Scheme Presumption Can Trap an Unwitting Lender

It is common for someone engaged in a Ponzi scheme to borrow money from a lender to support seemingly legitimate aspect of the business operations. A lender could unwittingly provide secured financing for the Ponzi borrower to acquire an office or equipment for operations. In this alert, we discuss how the discovery of a borrower’s Ponzi scheme might have an unexpected and adverse impact on such lenders.

The transfer-recovery (or claw back) statute that gives rise to the subject cause of action is Bankruptcy Code Section 548(a)(1)(A) (and similarly drafted state laws). The statute allows the trustee (or similarly situated party) to recover, as intentionally fraudulent (rather than constructively), any payment or transfer made by the debtor with “actual intent to hinder, delay, or defraud” creditors. Despite the statute’s implication that actual intent to hinder, delay or defraud must be proven, courts have long reasoned that debtors do not readily admit to intentional fraud and held that something short of the debtor’s admission will suffice. “Badges” of fraud (i.e., circumstantial evidence supporting fraudulent intent) have been developed as a substitute.

An even more powerful substitute and legal principle is the irrebuttable Ponzi scheme presumption. Not only does its application completely dispense with all inquiry into the debtor’s actual intent to hinder, delay or defraud, the presumption seems to ignore the differences that exist between payments made by the debtor to Ponzi scheme victims (whose money is used to perpetuate the Ponzi), and payments made to everyone else, including good faith lenders (whose money was not so clearly used to perpetuate the Ponzi). The recent decision in Jerrold S. Pressman, Debtor and Poshow Kirkland as Trustee of the Bright Conscience Trust vs. Rund (In re EPD Inv. Company, L.L.C.), NO. 22-55944 (9^THCir. 2024) illustrates the problems posed for non-victim creditors, including good faith lenders.

EPD filed for chapter 7, and the trustee commenced Ponzi scheme related litigation, including against John Kirkland, EPD’s legal counsel who made more than $2 million in secured loans to EPD prior to its collapse. The litigation was moved to the U.S. District Court because Kirkland did not file a proof of claim and exercised his right to a trial by jury (which does not happen in bankruptcy court). The jury returned a verdict that (a) EPD operated a Ponzi scheme, (b) EPD made payments to Kirkland with intent to hinder, delay or defraud creditors, and (c) Kirkland received payments from EPD in good faith and for reasonably equivalent value. The apparent upshot of the verdict is that all payments received by (or benefiting Kirkland), save the return of principal, are recoverable as intentionally fraudulent transfers.

On appeal, the Ninth Circuit (in a 2 to 1 decision) rejected the argument that “the district court misstated the law by including lenders as a possible class of victims of a Ponzi scheme,” reasoning that regardless of whether the loan terms were reasonable there “is no question that lenders can be victims of a Ponzi scheme as a matter of law,” and held the jury was properly instructed that lenders are “investors” in a Ponzi scheme, and otherwise affirmed application of the irrebuttable Ponzi scheme presumption to the Kirkland loan transactions. In re EPD Inv. Company, L.L.C. at III.B.

The dissent argued that the district court’s jury instructions improperly allowed the jury to infer EPD’s actual intent to defraud others by taking out and paying the Kirland loan, pointing to the fact that EPD engaged in substantial transactions and had assets, including substantial business investments which took this case out of the pure Ponzi scheme situation where the perpetrator has no legitimate operations. The appellant did not seek Supreme Court review.

OBSERVATIONS
The Ninth Circuit’s EPD Investment decision has implications for lenders who, in good faith, advance credit to a Ponzi scheme borrower debtor.

First, the Ponzi scheme presumption does not easily apply to a third-party lender (e.g., a bank) that unwittingly loaned funds to (and obtained collateral from) a borrower engaged in a Ponzi scheme. The purpose of the Ponzi scheme presumption is largely to ensure that victims (who typically invested based upon the borrower’s misrepresentations of quick and/or substantial profits) are treated the same so that no victim receives a greater return than others. In contrast, good faith lenders, especially those making loans based upon credible underwriting and receiving collateral, possess collateral to support non-payment of the loan, regardless of the cause, and traditionally are not looking for a quick, equity-type profit.

Second, there is no controlling authority a lender can use to overcome a claw back claim on a motion to dismiss, likely leaving the lender to argue that the trustee did not plausibly allege that the loan repayments were made in furtherance of the Ponzi scheme and asserting as an affirmative defense that the lender, in good faith, provided the borrower with value. This may ultimately necessitate an expensive trial that, even if successful, could result in the lender being required to return all payments other than those applied to principal.

Third, the fact that the loan at issue in EPD Investment was from the debtor’s attorney, not a true third-party commercial lender, may have factored into the jury’s decision and, given the pushback from the dissent, the Ninth Circuit’s decision as well. We expect lenders or similarly situated defendants to continue to push back (a) on the presumption being applied as an irrebuttable presumption against transferees other than investors and (b) on the idea that commercially reasonable third-party transactions can give rise to a Ponzi scheme finding in the first place.

Fourth, the Ponzi scheme presumption poses untested questions when a good faith lender forecloses on real estate (or other collateral) pledged by the Ponzi borrower as collateral, especially where the lender credit bids and takes ownership of the property. EPD Investment would seem to imply that the lender is at claw back risk for any portion of the debt, above the principal, that it used in its credit bid.

Fifth, if a lender credibly senses that its borrower may be engaged in a Ponzi scheme, it should consider applying payments received first to reduce principal, and then develop a strategy for promptly exiting the facility.

CONCLUSION
EPD Investment is a warning to lenders that despite (a) lending in good faith without knowledge of the Ponzi scheme, (b) advancing loan proceeds to the borrower, (c) not looking to make a quick and/or high return, and (d) transacting based upon traditional secured lending fundamentals, they are at risk. The irrebuttable Ponzi scheme presumption will apply, litigation costs will likely be material, and all payments other than principal payments are plausibly subject to recovery. Lenders should remain vigilant in their efforts to identify borrowers engaged in fraudulent activities. A lender suspecting a Ponzi scheme should take steps to protect against possible claw back claims, including applying payments to the principal and promptly developing a strategy for exiting the loan facility.

(This is another in our series of client alerts related to the intersection of bankruptcy and real estate.)