Kathy Bazoian Phelps
Senior Counsel in Ponzi Scheme Litigation
and Bankruptcy Matters

Kathy is a senior business trial attorney with more than 25 years experience prosecuting and defending claims for clients involved in Ponzi scheme matters and in bankruptcy proceedings. Kathy’s practice includes recovering assets for clients in complex fraud cases on under standard fee and alternative fee arrangements. Kathy also serves as a mediator in bankruptcy matters, in complex business disputes, and in matters requiring an expert on fraud or Ponzi schemes.

Kathy’s Clients in Ponzi Scheme Cases and Bankruptcy Matters
Equity Receivers
Bankruptcy Trustees
High Net Worth Investors
Debtors in Bankruptcy
Secured and Unsecured Creditors

Friday, June 29, 2012

The Ponzi Perpetrator’s Art Dealer? The Endless Scope of Clawback Claims

Posted by Kathy Bazoian Phelps

Sheila Gowan, the trustee of Dreier, LLP (“DLLP”), has filed a fraudulent transfer action against Marc Dreier’s personal art advisor. Gowan asserts that Marc Dreier caused DLLP to make a series of transfers to the defendant totaling $1,940,915.00 for Mark Dreier’s personal obligations and that DLLP received no consideration for these transfers. The Trustee asserts that Dreier retained the defendant to advise him on his art purchases for his personal collection and that DLLP was not a party to any agreement with the defendant.

The Trustee’s complaint asserts a claim for avoidance and recovery of the payment as constructive fraudulent transfers under 11 U.S.C. § 548(a)(1)(b) and § 550 on the theory that DLLP did not receive any value from the defendant’s services in exchange for the money DLLP paid to the defendant. The complaint also objects to the defendant's proof of claim under § 502(d), which requires the court to disallow a claim filed by a party from whom property is recoverable under §§548 or 550.

It will be interesting to see what defenses the defendant asserts to this claim. Undoubtedly, the Trustee will have little difficulty in proving her case-in-chief. Presumably, the Trustee has the DLLP checks payable to and negotiated by the defendant, so the Trustee’s case will be complete when she establishes either: (1) that DLLP was insolvent at the time of the transfers; (2) that the transfers left DLLP with unreasonably small capital; or (3) that DLLP intended to incur or believed that it would incur debts beyond its ability to pay as such debts matured.

The defendant may assert a good faith value defense under § 548(c), but even that will be challenging for her. While she may have acted in good faith and without knowledge or notice of Dreier’s fraud, that is not enough. The defense will only help her to the extent that her services provided value to DLLP, and that may be tough for her to prove since the services rendered by the defendant were allegedly for the benefit of Dreier individually and not for DLLP.

This case highlights the difference between preferences and fraudulent transfers from the perspective of the transferee. The Trustee does not allege that the defendant did anything wrong or out of the ordinary course of the defendant's business. Unfortunately for the defendant, however, there is no ordinary course defense for fraudulent transfer claims as there is in a preference action. See 11 U.S.C. § 547(c)(2).

A fraudulent transfer claim has a different objective than a preference claim, where the ordinary course of business makes a difference. The purpose of the ordinary course exception in preference actions is “to leave undisturbed normal financial relations, because it does not detract from the general policy of the preference section to discourage unusual action by either the debtor or [its] creditors during the debtor's slide into bankruptcy.” Lawson v. Ford Motor Co. (In re Roblin Indus., Inc.) 78 F.30 (2d Cir. 1996).

In constructive fraudulent transfer actions such as the Trustee’s claims against the defendant, however, the purpose and perspective is different. Fraudulent transfer law considers liability from the perspective of the financial condition of the debtor to ensure that the debtor hasn’t given away its property with no return value being provided in exchange. Whether the transaction is ordinary or unusual, therefore, not an issue.

The defendant may be out of luck in this case, even though all she did was accept payment for the services she provided. In the fraudulent transfer context, however, defendants are stuck with the option of demonstrating both good faith and value, and if the money came from an entity different from the entity that received the value, the value element of the defense cannot likely be established.

Gowan’s suit was filed in the United States Bankruptcy Court for the Southern District of New York. (Adversary Proceeding No. 12-01717)

A complete discussion of fraudulent transfer claims, preference claims, and the defenses to them may be found in The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes (LexisNexis 2012).

Tuesday, June 26, 2012

Hedge Fund Liability for Inadequate Due Diligence

Posted by Kathy Bazoian Phelps
Due diligence is not just for the buyer, auditor, or investor anymore. It is for everyone, including the hedge fund investing in sub-hedge funds. One court recently found a hedge fund liable for failing to conduct adequate due diligence and then misrepresenting to its investors the amount of due diligence that it actually conducted. Schwarz v. ThinkStrategy Capital Management LLC, 2012 U.S. Dist. LEXIS 79453 (S.D.N.Y. May 31, 2012)
Investors in a hedge fund, ThinkStrategy Capital Management LLC, sued ThinkStrategy and its sole member/managing director, Chetan Kapur, for misrepresenting the amount of due diligence they conducted in the other hedge funds in which they were investing (the “sub-hedge funds”). The plaintiff investors brought claims under New York state law for fraud, negligent misrepresentation, and breach of fiduciary duty against ThinkStrategy and its director.
Many of the sub-hedge funds into which the defendants poured the investors’ funds were fraudulent, causing the investors to suffer losses. The investors alleged that had the “sparse due diligence practices been truthfully disclosed to them, they would never have invested” with the defendants. Additionally, the investors alleged that the defendants concealed problems from them after they had invested which, if disclosed, would have caused the investors to immediately redeem their investments.
The court found for plaintiffs and awarded them $3,068,483, which was the total amount of plaintiffs' investment, net of redemptions that the investors had received.
So what did ThinkStrategy do wrong that led to liability? In summary, the court found that “ThinkStrategy's due diligence was cursory and that this diligence entailed virtually no independent verification of representations made to it by prospective sub-funds.” The decision runs through all kinds of misrepresentations that were made about the due diligence that was done, and the court found that the due diligence conducted by ThinkStrategy did not conform to industry standards. The court found that the four central misrepresentations were that the defendants: “(1) conducted background and reference checks on prospective sub-fund managers; (2) performed in-person interviews of sub-fund managers; (3) invested only in audited sub-funds; and (4) invested only in sub-funds with reputable service providers.”
The testimony revealed that “industry-standard due diligence on these funds would have revealed various red flags and irregularities that would have precluded a rational manager from investing client funds in them.”
The problem here was that ThinkStrategy represented that it was doing substantial due diligence. In reality, it wasn’t. And, as it turns out, seven of the twenty funds that ThinkStrategy invested in were fraudulent.
The court found that the defendants were liable for common law fraud.
The evidence established that Kapur made knowingly false representations to plaintiffs about a variety of subjects. . . The Court also readily finds that these statements were made for the purpose of inducing plaintiffs to rely, by investing in the TS Fund, and that plaintiffs did justifiably rely on those statements. The Court also finds that these false representations caused injury to plaintiffs: The Court fully credits plaintiffs' testimony that, but for these representations, they would not have invested in the TS Fund.
The court also found that the defendants were liable for negligent misrepresentation.
The defendants undeniably had a duty, as a result of their fiduciary role towards the [investors], to give them correct information. Defendants made false representations to the [investors], as set out at length above. The information in question (as to ThinkStrategy's due diligence practices generally, and also as to whether the TS Fund had invested in Bayou) was known by defendants to be desired by the [investors] for a serious purpose. The [investors] intended to rely and act upon the information supplied by the defendants. And, the [investors] reasonably relied on the false and incomplete information supplied by the defendants to their detriment.
The court additionally found that the defendants were liable for breach of fiduciary duty.

The plaintiffs had entrusted their savings to ThinkStrategy and Kapur, and defendants had a duty not only to handle plaintiffs' money with due care but also to make sure that any representations made to plaintiffs with regard to ThinkStrategy's investment of their funds were followed through on . . . . Here, that duty was breached when defendants failed to follow through on various false and misleading representations to plaintiffs, chronicled above, and when defendants failed to correct those representations. For the same reasons as discussed above, defendants' false statements and representations caused damages to plaintiffs, by inducing them to invest money with ThinkStrategy which was later lost, and by leading them not to exercise their right to redeem their investments. The Court therefore finds for plaintiffs on their claim for breach of fiduciary duty.

The court went further to find that the managing director of ThinkStrategy was individually liable for these torts.
When a corporate officer commissions a tort through misfeasance or malfeasance (as opposed to a mere failure to act), that officer may be held individually liable "regardless of whether the officer acted on behalf of the corporation in the course of official duties and regardless of whether the corporate veil is pierced."
The court rejected the defendants’ defense that the Offering Memorandum contained disclaimers that put investors on notice not to rely on statements or representations made, along with the defense that plaintiffs did not demonstrate loss causation as part of the breach of fiduciary duty claim.
The only good news for the defendants was that the court declined to impose punitive damages, noting that:
[A]lthough the evidence revealed dismaying misconduct by Kapur, amply justifying liability for fraud, negligent misrepresentation, and breach of fiduciary duty, it did not, in the Court's view, meet the higher bar of moral culpability required under New York law for the imposition of punitive damages. There was no evidence presented, for example, that Kapur absconded with plaintiffs' money. On the contrary, the evidence suggests that he, too, was decimated by the collapse of the sub-funds, and there is no evidence that Kapur knew of their wrongful machinations, as opposed to his being a gullible, negligent, and inept investor. Thus, although the Court easily finds that defendants engaged in tortious, callous, and unprofessional behavior, plaintiffs have not proven that defendants' conduct reaches the level of gross, willful, or wanton fraud necessary to justify imposition of punitive damages.
A thorough discussion of claims for fraud, negligent misrepresentation, and breach of fiduciary duty may be found in The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes (LexisNexis 2012) by Kathy Bazoian Phelps and Hon. Steven Rhodes.

Sunday, June 17, 2012

Is the “Ponzi Scheme Presumption” Expanding into New Territory?

Posted by Kathy Bazoian Phelps

Most courts endorse and affirm the use of the “Ponzi scheme presumption” against recipients of transfers from the Ponzi debtor. These courts hold that, in an actual fraudulent transfer case, the transferor’s fraudulent intent is presumed if the trustee establishes that the transferor was perpetrating a Ponzi scheme and that the transfer was made within the scope of the scheme. See, e.g., Wing v. Dockstader, 2012 U.S. App. LEXIS 11390 (10th Cir. June 6, 2012); Perkins v. Haines, 661 F.3d 623 (11th Cir. 2011); Donell v. Kowell, 533 F.3d 762 (9th Cir. 2008); SEC v. Res. Dev. Int’l, LLC, 487 F.3d 295, 301 (5th Cir. 2007).

The rationale for the broad brush application of a presumption of actual intent in a Ponzi scheme is that “transfers made in the course of a Ponzi scheme could have been made for no purpose other than to hinder, delay or defraud creditors.” Bear, Stearns Sec. Corp. v. Gredd (In re Manhattan Inv. Fund, Ltd.), 397 B.R. 1, 8 (S.D.N.Y. 2007). Such a presumption can be a powerful tool in a Ponzi scheme case, as it eliminates the need to prove actual intent to hinder, delay or defraud by the more customary “badges of fraud” analysis that uses circumstantial evidence.

Some courts have questioned the broad scope of the Ponzi scheme presumption. As one court put it, “The Ponzi scheme presumption must have some limitations, lest it swallow every transfer made by a debtor, whether or not such transfer has anything to do with the debtor’s Ponzi scheme.” Kapila v. Phillips Buick- Pontiac-GMC Truck, Inc. (In re ATM Financial Services, LLC), Bankr. LEXIS 2394, at *17-18 (Bankr. M.D. Fla. June 24, 2011). The ATM Financial court found that the presumption applies only to transfers made in furtherance of the Ponzi scheme.

A recent case, however, moves in the opposition direction and has expanded the application of the Ponzi scheme presumption in a significant way. In Stoebner v. Ritchie Capital Management, L.L.C. (In re Polaroid Corp.), 2012 Bankr. LEXIS 1926 (Bankr. D. Minn. April 30, 2012), the court applied the presumption of intent to defraud to a transferor who was not even directly involved in a Ponzi scheme.

The decision arose out of the Petters Ponzi scheme group of cases. Petters had granted a security interest to the defendants in his capacity as chairman of Polaroid, and the trustee sought to avoid that transfer as an actual fraudulent transfer. Polaroid was not, however, directly involved in Petters’ Ponzi scheme. Rather, Petters ran his scheme through Petters Company, Inc., and other entities. Nevertheless, the court held that the presumption did apply to the transfer made by Polaroid. The court reasoned:

[Petters’] intent is attributed to the Polaroid Corporation as transferor, because he controlled that artificial entity. And the point of the Trustee's theory is that Tom Petters also controlled the whole structure centering around PCI, through which the Ponzi scheme had been transacted to the detriment of its final victims.
* * *
The Trustee’s expanded conception of the presumption is premised on common control within a larger structure. When this is the governing consideration, the automatic inference of fraudulent intent is made when the person in common control effects the transfer by the entity extrinsic to the Ponzi scheme, but in order to further the scheme as it has been maintained through the central entity.

Id. at *48-50 (emphasis in original and footnote omitted).

Simply stated, because Petters orchestrated the challenged transfer to further the Ponzi scheme, the Ponzi scheme presumption applied, even though the entity that made the transfer was not otherwise involved in the fraud. “The proof lies in a motivation: a manifest wish by the controlling person to prolong the imposture of the Ponzi scheme (thus ‘furthering’ it), by effecting the transfer by the controlled, related company.” Id. at * 51-52.

The court recognized that the creditors that were prejudiced by Polaroid’s grant of the security interest were not creditors or victims of the Ponzi scheme.  Still, it observed, “that does not mean the basic willingness to prejudice others’ rights is absent.”

In justifying its expanded use of the Ponzi scheme presumption, and noting that, “There is nothing untoward about using the presumption in this way,” the court in dicta attempted to leave a back door open to challenge the expanded use of the presumption. It stated, “The resulting inference, satisfying the intent requirement of the statute, can always be rebutted by hard proof of contrary intent, i.e., a credible motivation to make the transfer that is grounded in good economic reason, as to the transferor-entity.” Id. at *52 (citing Kelly v. Armstrong, 206 F.3d 794, 799, 801 (8th Cir. 2000)).

The problem with this invitation to challenge the expanded use of the Ponzi scheme presumption in dicta is that the cited case, Kelly v. Armstrong, is not a Ponzi case, and every other court addressing the Ponzi scheme presumption has held that it establishes actual fraudulent intent as a matter of law. See, e.g., Johnson v. Neilson (In re Slatkin), 525 F.3d 805, 814 (9th Cir. 2008); Hayes v. Palm Seedlings Partners-A (In re Agric. Research & Tech. Grp., Inc.), 916 F.2d 528, 534 (9th Cir. 1990); Gredd v. Bear, Stearns Sec. Corp. (In re Manhattan Inv. Fund, Ltd.), 359 B.R. 510, 517-18 (S.D.N.Y. 2007), aff’d in part and rev’d in part on other grounds sub nom. Bear, Sterns Sec. Corp. v. Gredd, 397 B.R. 1 (S.D.N.Y. 2007); Terry v. June, 432 F. Supp. 2d 635, 639 (W.D. Va. 2006); Picard v. Madoff (In re Bernard L. Madoff Inv. Sec. LLC), 2011 Bankr. LEXIS 3578, at *15 (Bankr. S.D.N.Y. Sept. 22, 2011); Bauman v. Bliese (In re McCarn’s Allstate Fin., Inc.), 326 B.R. 843, 850 (Bankr. M.D. Fla. 2005).

Despite that misstep, however, it seems likely that the court’s conclusion that the trustee can use the Ponzi scheme presumption in seeking to avoid Polaroid’s grant of a security interest to the defendants due to Petters’ intent to further his Ponzi scheme will withstand scrutiny on appeal. 

Wednesday, June 6, 2012

NY Times Column Criticizing Madoff Trustee Flawed on Many Levels

Posted by Kathy Bazoian Phelps

A recent New York Times article by Andrew Ross Sorkin severely and unfairly criticizes Irving Picard, the trustee for the Bernard L. Madoff Ponzi scheme. It states, “Mr. Picard has had much more success collecting money for himself and a dozen law firms and consultants than any victim of Mr. Madoff’s crime.” A copy of the article is attached here.

These remarks appear to be intended to inflame the public. Irving Picard is the neutral fiduciary charged with collecting funds for investors. He is not Bernie Madoff. Picard did not run a Ponzi scheme. The New York Times article makes sweeping, conclusory statements about Picard and his professionals, sensationalizing the compensation paid to them, without considering the facts, the law, or the process of unwinding a Ponzi scheme of this size and scope. I have no affiliation with Picard or his firm, although he did endorse a book that I co-authored, The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes (LexisNexis 2012). I do, however, have a strong familiarity with Ponzi cases and the work required to unravel them. As a rebuttal to the New York Times’ attempt to unfairly prejudice the public against the team charged with undoing Madoff’s epic fraud, I present the following insights into Ponzi schemes and the Madoff Ponzi scheme in particular.

First, the article states that Picard and his professionals have been paid $554 million and that the victims have only “actually received” $330 million. As written, this is quite misleading. Picard has actually recovered $9.1 billion. This is not a small number. The reason he hasn’t paid that to victims is that those funds are tied up in connection with pending appeals.

The professional fees paid to date are 6.1% of the recoveries. Picard himself has been paid $5.1 million, which is 0.06% of recoveries. This is for 3½ years of work. Is this really so outrageous? It’s a good thing he didn’t hire contingency counsel at the going rate of 40%. Those fees would have been a whopping $3.64 billion!

Second, let’s consider the size of the estate that Picard is administering. As noted, it is $9.1 billion in recoveries so far, with claims of about $17.3 billion in principal investments. Incredibly, the New York Times criticizes Picard for attempting to recover more than the lost principal, stating: “In the last several years, Mr. Picard has brought more than 1,000 cases seeking more than $100 billion on behalf of victims, despite acknowledging that only about $17.3 billion had actually been invested by customers.” Yes, Picard is trying to recover funds in excess of the investors’ principal investments. But clearly this is so that he can distribute recoveries to investors due to their lost expected profits, which could be as much as $65 billion.

Wouldn’t Madoff’s victim sharply criticize Picard if he decided to shut down recovery efforts when he had just enough to pay the investors’ principal claims, but not their lost profits? The investors lost the use of their money by investing with Madoff. Shouldn’t Picard at least try to get them some interest if there are recoveries available under law for that purpose? Is Picard to leave money on the table by not pursuing additional recoveries for defrauded investors just because it is costing a small fraction of those amounts to try to collect those amounts?

Third, the New York Times article adopts, without question or analysis, the lower court decisions dismissing some of Picard’s claims. But those decisions are presently on appeal. The issues on appeal are issues being raised by other trustees and receivers across the nation in other Ponzi cases, and many of them have been brought with great success. So let’s wait to see the outcome of these appeals before we judge Picard’s strategy.

Picard may or may not prevail in these appeals. Still, can we really condemn him for trying to recover money from financial institutions and others who he alleges knew or should have known about Madoff’s fraud and about the billions of dollars of fraudulent funds that passed in and out of their accounts? If Picard’s claims are dismissed on standing or in pari delicto grounds, he would be merely one of many frustrated trustees denied the opportunity to recover money for defrauded investors on arguably unfair technicalities, even in the face of clear liability.

Perhaps it is not Picard whom we should be criticizing, but rather the system that allows wrongdoers to escape liability while defrauded investors are left with potentially shattered lives. The issues of standing and in pari delicto are complex issues, and they have been applied very unevenly by courts across the country. Let’s not disparage Picard for trying to recover money for investors. Let’s instead examine and reconsider the statutory and case law that mandates these often inequitable results for defrauded investors.

Fourth, let’s put the Madoff case in perspective in relation to the rest of the world. A study prepared by the International Monetary Fund for 2011 shows that 130 of the ranked 182 countries in the world have a Gross Domestic Product greater than $9.1 billion. That means that Picard now manages funds in an amount greater than the GDP of about 30% of the world’s countries. If we look at the total potential size of this estate of $65 billion, then Picard is working in the territory of the top 64 countries in the world. So why all the criticism over Picard’s $850 hourly rate? CEOs of much smaller corporations are paid well over $5.1 million for just one year’s worth of work, and Picard has been working at this for well over 3 years now.

Finally, the full scope of the services that Picard and his professionals have provided is, frankly, overwhelming. Picard’s Sixth Interim Report filed last November reveals much about what Picard has been doing. A small window into the size of the Madoff case is found in a few interesting numbers from that report, as of September 30, 2011:
     -Picard received and reviewed 16,518 customer claims.
     -Picard and his professionals fielded more than 7,500 hotline calls from claimants and their representatives.
     -Picard filed 2,310 objections to claims.
     -In lieu of litigation and its expenses, Picard reached agreements with approximately 440 customers, recovering over $1.7 billion.
     -There is international investigation and litigation in over a dozen countries.

A copy of Picard’s report is attached here.  And this is just a snapshot of what Picard did during one reporting period.  This does not include the massive number of settlements and lawsuits that Picard and his professionals have handled successfully to date in achieving recoveries for Madoff’s victims.

The article concludes with this seemingly uneducated speculative remark:

Nobody is asking Mr. Picard or his legal team to do all this work pro bono.  But given the amount of money at stake and the epic size of the crime, one would hope that he would have pursued a more effective legal strategy that would have made a lot more money for the victims than the lawyers.
The reader is left asking the following questions:

          What is the concept for a “more effective legal strategy”?

          Will that “more effective legal strategy” recover funds for investors?

          Will that “more effective legal strategy” cost any money to implement?

Let’s remember that Picard is not the bad guy here.  He is the court-supervised fiduciary managing an estate the size of a small country with an army of necessary professionals to assist him navigate his way through the morass that Madoff left behind.