TelexFree Trustee Says "Compelling Evidence of Fraud," Seeks Appointment Of Independent Trustee

 Given the facts alleged in the SEC Case, TelexFree appears to be engaged in a classic Ponzi scheme.

- Tracy Hope Davis, U.S. Trustee 

The United States trustee overseeing the bankruptcy cases of TelexFree, LLC, TelexFree, Inc., and TelexFree Financial, Inc. (collectively, "TelexFree") has filed a motion seeking the appointment of a Chapter 11 Trustee based on "compelling evidence of fraud, dishonesty and gross mismanagement of the affairs of [TelexFree]."  Tracy Hope Davis, the U.S. Bankruptcy Trustee for the region in which TelexFree's bankruptcy petitions were filed, filed a Motion For Order Directing the Appointment of a Chapter 11 Trustee Pursuant to §1104 (a) (the "Motion") today, arguing that "for the Debtors' investors and creditors seeking financial accountability, it is in their interests for an independent fiduciary to be appointed forthwith."

Pursuant to Federal Bankruptcy rules, while the appointment of independent trustees is common practice in bankruptcy petitions under other Chapters, a Chapter 11 bankruptcy typically only includes a U.S. Trustee associated with the Department of Justice. The reasoning behind this is that, in a Chapter 11 bankruptcy where the petitioning entity(ies) seek to continue doing business and eventually emerge from bankruptcy, the filing entity is best equipped to oversee day-to-day operations and thus would assume the majority of the duties of an independent trustee.  

However, as Ponzitracker noted in an article several days ago, the appointment of an independent trustee is specifically contemplated in a Chapter 11 case under 11 U.S.C. 1104, which provides that a case trustee may be appointed:

for cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management, either before or after the commencement of the case, or similar cause, but not including the number of holders of securities of the debtor or the amount of assets or liabilities of the debtor.

The Motion specifically cites Section 1104, noting that "the appointment of a Chapter 11 trustee would clearly be in the interests of the creditors of this estate" in light of the pending civil actions by the Securities and Exchange Commission and the Massachusetts Securities Division ("MSD").  The Motion notes that "the pyramid has collapsed," and also recounts the discovery of nearly $38 million in cashier's checks in the possession of TelexFree's interim CFO during a raid of the company's Massachusetts headquarters.  The Motion also thoroughly summarizes the pertinent facts alleged in the complaints filed by the Commission and the MSD.

The Motion argues that cause for the appointment of a Chapter 11 trustee is clearly established by the "fraudulent and dishonest acts committed by the principals and the officers of [TelexFree]."  Fraud is also evident by the very nature of Ponzi schemes, which are "fraudulent by definition." Donell v. Kowell, 533 F.3d 762, 767 n2 (9th Cir. 2008).  Under the definition of a Ponzi scheme as set forth by a recent Ohio Bankruptcy Court, the Motion concludes that:

Given the facts alleged in the SEC case, TelexFree appears to be engaged in a classic Ponzi scheme.

Finally, the Motion dismisses TelexFree's recent appointment of a CFO and CEO, arguing that these appointments do not negate past or protect against future fraudulent acts of the Debtors' board members James Merrill and Carlos Wanzeler.  The Motion expresses doubt that the CFO and CEO truly have control or are independent of former management, and suggests "it is more likely than not that anyone handpicked by [Merrill and Wanzeler] to manage their wholly owned companies will be another cohort."

Should a trustee be appointed, their duties are set forth in Section 1106.  These duties include the filing of a statement of investigation, as soon as practicable, that includes "any fact ascertained pertaining to fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debtor..."  Additionally, the trustee may recommend the conversion of the case to another Chapter under the Bankruptcy Code, including a liquidation under Chapter 7.  

TelexFree will have an opportunity to respond to the Motion pursuant to Court rules.

PatrickPretty also has coverage of the Motion.

A copy of the Motion is below:

Trustee Motion

TelexFree Seeks Six-Week Extension To File Financial Information

Attorneys for TelexFree have filed a motion seeking court approval for a six-week extension to provide the required supplements to their bankruptcy filing, including financial disclosure statements, summaries of assets, and lists of creditors.  TelexFree, LLC, TelexFree Inc., and TelexFree Financial, Inc. (collectively, "TelexFree") filed for Chapter 11 bankruptcy protection last week shortly before state and federal regulators accused it of operating a massive pyramid and Ponzi scheme.  In a Motion for Extension filed yesterday, TelexFree argued that a six-week extension was necessary in light of the ongoing actions by the Massachusetts Securities Division and the Securities and Exchange Commission, as well as the company's alleged inability to access its corporate documents following a raid of its headquarters last week by federal authorities.

Federal Bankruptcy Rule 1007 sets forth a list of the required documents and schedules to be filed in connection with initiation of a Chapter 7, 9, 11, or 13 bankruptcy.  In addition to a bankruptcy petition, a debtor is also required to file:

• schedules of assets and liabilities;
• a schedule of current income and expenditures;
• a schedule of executory contracts and unexpired leases; and 
• a statement of financial affairs.

In addition, other required schedules include lists of creditors holding secured and unsecured claims, personal and real property holdings, and executory contracts and expired leases.

In the initial filings made by TelexFree, none of these required schedules were included.  These schedules contain information, such as current assets and income, that will be crucial to determining whether TelexFree will be permitted to move forward with a Chapter 11 reorganization or if it is instead ordered to proceed with a Chapter 7 liquidation.  Indeed, one of the threshold requirements for receiving approval to proceed with a Chapter 11 bankruptcy is that creditors must receive more than they would receive under a Chapter 7 liquidation.  The bankruptcy court issued a Notice of Incomplete and/or Deficient Filing on April 14, 2014, and ordered that all of the missing schedules were to be filed no later than 14 days after the initial filing date of April 13, 2014.

In the Motion to Extend filed April 21, 2014 (the "Motion"), TelexFree stated that the deadline to file the schedules is currently April 28, 2014 (when in reality the deadline is April 27, 2014 - 14 days after the petitions were filed on April 13, 2014).  It first noted that it had included a list of all known creditors in its bankruptcy petition - with the exception of "the complete list of Promoters, believed to exceed 700,000 parties."  With the Schedules currently due in less than one week, the Motion referenced several parallel actions that it argued warranted a six-week extension until June 16, 2014.  This included (1) the execution of federal government search warrants on TelexFree's Massachusetts office resulting in the inability to access complete records; and (2) the "significant time" TelexFree is spending to address complaints filed by the Massachusetts Securities Division and the Commission.  Indicating that these issues would prevent TelexFree from completing the Schedules within the statutorily-prescribed time, TelexFree requested an extension to June 16, 2014.  Oddly enough, it appears that TelexFree originally had planned to seek an extension until May 31, 2014 - as indicated by the date set forth in the proposed order that accompanied the Motion.

While the exact reasons for the Motion are unknown, it is likely that TelexFree did not anticipate the swift response their bankruptcy filing would provoke from the Massachusetts Securities Division and the Commission, which have served only to magnify the spotlight currently on the company.  In addition, federal authorities executed a search warrant on TelexFree's Massachusetts office the same day.  The information required to be filed in the Schedules is certainly likely to garner an intense amount of scrutiny, and TelexFree lawyers may feel that a six-week extension may be sufficient breathing room to deal with the competing actions and ensure that any figures eventually submitted are accurate.

Yesterday, TelexFree filed an ex parte motion to shorten the time requirement to schedule a hearing on the Motion, and requested that the Motion be added to the list of motions currently scheduled for hearing on May 2, 2014.  

A copy of the Motion is below:

Motion to Extend

Zeek Receiver Slams Lawyers' Efforts To Redirect Claim Distributions

The court-appointed receiver overseeing efforts to recover funds for victims of the $600 million ZeekRewards Ponzi scheme has again reserved strong words for efforts by certain victims' lawyers to have distributions sent to their law offices, rather than directly to victims, saying that it "ought not to be the responsibility of the Receiver to act as the Movants’ attorneys’ collection agent."  The Receiver, Kenneth D. Bell, filed his Reply in Opposition to a Motion for Clarification And/or Reconsideration filed by a group of several hundred scheme victims.  While Bell initially characterized the efforts to compel the mailing of distribution checks to victims' attorneys as "at least questionable" back in January, he used stronger words in his Reply, arguing that the victims' attorneys were simply "unable to let go of their pecuniary interests."

The dispute arose in December 2013, after the Receiver filed his Motion for an Order Approving Distribution Procedures and Certain Other Related Relief ("Motion").  The Motion sought court approval for distribution procedures that included, among other things, a provision that payments would be made directly to victims.  Of the nearly-200,000 individuals that submitted claims for the Receiver's determination, an objection was filed by a small subset of approximately 740 victims which had previously entered into a contingency agreement with a Louisiana law firm (the "Louisiana Firm") for the purpose of filing a class action lawsuit - a lawsuit that was later halted by a federal court and deemed "ill-timed."  In his response to that objection, the Receiver observed that

whether or not the fee agreement would permit Movants’ counsel to claim a large contingent fee (as much as 25%) for simply providing administrative assistance in filing a claim through the Receiver’s claim portal is uncertain.

There are substantial potential fees at stake.  Considering that the average claim amount was approximately $3,100, and the fact that the Louisiana Firm claimed 740 clients, this would represent an average per-claim fee of $775, and a cumulative total fee of over half a million dollars for simply assisting victims in filling out a claim form.  (Obviously, the number could fluctuate based on the actual dollar amounts of the claims of the 740 victims.)

On April 1, 2014, the Court approved the Receiver's Motion in all aspects.  Several days later, the Louisiana Firm filed a Motion for Clarification and/or Reconsideration, which, in the Receiver's words, "again challeng[es] the Court’s decision by seeking to change the approved distribution process to require the Receiver to aid the Movants’ attorneys in collecting their attorneys’ fees from the Movants."  Characterizing the reason for the motion as the Louisiana Law Firm's inability "to let go of their pecuniary interests," the Receiver explained that he sought to make payments directly to victims to prevent duplicative payments, to ensure aggregate net winners do not receive distributions by using multiple addresses, and even ensuring that the Receiver does not unwittingly violate the Department of Treasury’s Office of Foreign Assets Control’s (OFAC) regulations.  While observing that his plan "may not assist Movants’ attorneys’ efforts to collect their fees," he argued that no clarification of the Order was necessary.  

A copy of the Receiver's Reply is below (h/t ASDUpdates):

Zeek Doc 202

What's Next For TelexFree Victims?

Last week was a busy week for TelexFree.  After filing for bankruptcy protection on Monday in a Nevada bankruptcy court, state and federal securities regulators filed civil actions accusing the company of operating a massive pyramid and Ponzi scheme that, by one estimate, may have raised $1 billion from investors worldwide.  That same day, federal agents from the FBI and the Department of Homeland Security raided the company's headquarters in Marlborough, Massachusetts, which later drew headlines after authorities discovered TelexFree's Chief Financial Officer attempting to remove $38 million in cashier's checks from the offices. (The company later claimed there was no nefarious purpose behind this effort.)  

Now, one week after TelexFree's bankruptcy filing and as reality begins to set in to an estimated 700,000 company "affiliates," the focus turns to the next steps.  This includes not only the various pending court and regulatory proceedings, but also the future of those "affiliates" that made substantial investments based on promises of extravagant returns.  

Court Proceedings

Currently, there are three pending court proceedings that interested parties should consider following.  The first is a Chapter 11 bankruptcy proceeding pending in the District of Nevada Bankruptcy Court (the "Bankruptcy Case").  The second and third are civil actions pending in Massachusetts: one, an administrative action filed by the Enforcement Section of the Massachusetts Securities Division (the "Massachusetts Case"), and the other an enforcement action filed by the Securities and Exchange Commission pending in U.S. District Court (the "SEC Case") (collectively, the "Civil Cases").  There are no current pending criminal cases, although it has been reported that criminal authorities were involved in the search warrant executed on the company;s headquarters last week.

Civil Cases

Both the Massachusetts Case and the SEC Case are enforcement actions premised on alleged violations of state and federal securities laws.  As civil regulatory actions, the purpose of these proceedings is purely remedial -- each seeks injunctive relief prohibiting future violations of securities laws by the TelexFree entities (and in the SEC Case, by TelexFree principals and top promoters), civil penalties, and disgorgement of ill-gotten gains from the violative conduct.  The respective defendants will be entitled to varying forms of discovery (likely more in the SEC Case due to the administrative nature of the Massachusetts Case), and will then likely file dispositive motions seeking a court order finding in their favor without the necessity of trial.  If necessary, a trial could be held. Notably, neither the Massachusetts Case nor the SEC Case includes a request for the appointment of a receiver to secure and marshal assets; rather, as explained below, the consensus seems to be that responsibility for the recovery of assets is properly in the realm of the Bankruptcy Case.

Bankruptcy Case

While the Civil Cases contain a somewhat predictable path to finality, the Bankruptcy Case is not as certain.  On April 14, 2014, TelexFree Inc., TelexFree LLC, and TelexFree Financial, Inc. (collectively, "TelexFree") each filed voluntary bankruptcy petitions under Chapter 11 of the U.S. Bankruptcy Code.  Under a Chapter 11 proceeding, the filing entity seeks to continue operating during and bankruptcy and ultimately emerge from bankruptcy after restructuring various aspects of the business, including debts.  In comparison, a Chapter 7 bankruptcy involves the cessation of operations and a complete liquidation of a business, with the proceeds being distributed to company creditors.  

In the press release announcing its bankruptcy, TelexFree cited "certain operational challenges," and indicated it intended to "restructure its debt obligations."  In a subsequent bankruptcy filing, the company sought approval from the Bankruptcy Court to reject "all agreements between the debtors and the promoters under both the Original Comp Plan and the Revised Comp Plan."  According to the Commission, this included at least $174 million in compensation demands submitted by "promoters" after the company drastically revamped its compensation plan.

Of note, while bankruptcy filings under other Chapters, including a Chapter 7 or Chapter 13 bankruptcy, includes the appointment of an independent trustee, a Chapter 11 bankruptcy typically features only a U.S. Trustee associated with the Department of Justice.  This is explained by the theory that the debtor, which is seeking bankruptcy protection not to liquidate but rather to continue operations, is best equipped to oversee day-to-day operations and is thus tasked with the duties of a case trustee.  However, pursuant to 11 U.S.C. 1104, the court may order the appointment of a case trustee:

for cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management, either before or after the commencement of the case, or similar cause, but not including the number of holders of securities of the debtor or the amount of assets or liabilities of the debtor.

According to Kathy Bazoian Phelps, a California attorney with significant experience in Ponzi scheme bankruptcy cases and the author of The Ponzi Book, "the first step is to see what both the assets and liabilities of the debtor entities are, which is information that will be included on the Schedules and Statement of Financial Affairs to be filed in two weeks."  This information is important, because this information will ultimately influence the Bankruptcy Court's decision whether a Chapter 11 bankruptcy - rather than a Chapter 7 - is ultimately approved.  According to Phelps, a successful reorganization under Chapter 11 requires that "the companies will need to generate profits from a legitimate business operation that are sufficient to pay the creditors more than they would receive in a Chapter 7 liquidation."  

The allegations in the Massachusetts Case and SEC Case could pose a problem to this determination.  As Phelps observed, "The Massachusetts regulatory action [and subsequent SEC Case] has labeled the businesses as a pyramid or Ponzi scheme, calling into question whether there are legitimate business operations sufficient to fund a plan of reorganization."  Indeed, the Commission alleged that TelexFree had only approximately $1.3 million in VoIP sales revenue from August 2012 to March 2014 - approximately 1% of the $1.1 billion in accrued obligations to "promoters."  Factoring in the other allegations, including that (i) TelexFree transferred over $30 million to company principals and promoters, and (ii) tens of millions of investor funds remain unaccounted for, this could be a difficult showing for TelexFree.  Thus, one of the main issues decided in the interim will be whether the company will be permitted to reorganize or forced to liquidate.

Currently, several preliminary TelexFree motions are pending before the Bankruptcy Court, including the motion seeking court approval for the company to "reject" all agreements (and resulting compensation obligations) with "promoters" under the former compensation plans.  The Bankruptcy Court has asked for objections from interested parties, including the SEC and Massachusetts regulators, by April 21, 2014, and a hearing is scheduled for May 2, 2014.

Asset Recovery

One of the primary concerns posed by those interested parties is the extent and likelihood of any compensation for losses.  Unfortunately, it is much too early to offer an informed answer to that question. Several factors will influence whether that question may be answered in the affirmative or negative.  The first factor, logically, is the existence of assets.  As Phelps alluded to earlier, various financial statements and schedules must accompany a bankruptcy petition within two weeks of the initial filing, and the assets disclosed on those statements will provide a glimpse into the "operational challenges" facing TelexFree. The second factor is the form of bankruptcy ultimately employed by the Court - will TelexFree seek to set aside certain assets and/or a portion of future revenues under a court-approved reorganization plan, or will the companies be forced to liquidate all assets.

What Can Victims Do?

Unfortunately, neither the Civil Cases or the Bankruptcy Case are expected to have an immediate resolution; rather, it is likely that the cases (and recovery efforts) could take several years.  While this may be difficult for some to fathom, the reality is that such a a duration is likely due to the complexity of the alleged scheme, the worldwide nature of the business, and the sheer number of victims.  It is anticipated that simply gaining an understanding of TelexFree's true operations could be a complicated task that could take several weeks, if not months.

One step that those affected parties can take today is to begin gathering all evidence of their relationship and investment with TelexFree.  This includes agreements, negotiated checks and credit card statements, and bank statements showing any deposits and/or withdrawals.  This information will be necessary, if not required, in connection with submitting claims to the Bankruptcy Court.

Regarding claims, each interested party will most likely have the opportunity to submit Proof of Claim Forms to the Bankruptcy Court to properly document their entitlement to any earmarked funds.  Perhaps the most crucial guidance surrounding these claims is that attention must be paid to the deadlines imposed by the Court for submission of Proof of Claim forms and any other documents - untimely or tardy claims fare a much less chance of being approved than a timely claim.  A copy of a blank Proof of Claim Form is embedded below and downloadable here.  While the filing of a Proof of Claim may not be required if the case proceeds as a Chapter 11 proceeding and the particular debt is listed in the correct amount in the schedules filed with the Court, the submission of a Proof of Claim may still be advised.

All interested parties are advised to pay close attention to the proceedings.  Some other sites that have been covering TelexFree in detail include BehindMLM, PatrickPretty, ASD Updates, and MLM Help Desk.

A copy of the Proof of Claim Form is below:

04-2013 b10 Form Court Version

TelexFree Asks Bankruptcy Court To Eliminate Promoter Obligations

On the date it filed bankruptcy in a Nevada federal court, and just days before Massachusetts regulators and the Securities and Exchange Commission accused the company of being a massive pyramid and Ponzi scheme that had raised at least hundreds of millions of dollars from investors worldwide, TelexFree LLC filed a rather innocuous-sounding motion to "Authorize the Debtors to Reject Certain Executory Contracts Nunc Pro Tunc As Of The Petition Date."  Cloaked in bankruptcy parlance, the title of the motion holds little meaning to the estimated hundreds of thousands of "promoters" that, until recently, were promised lucrative returns for placing daily advertisements and recruiting new investors.  

However, a casual read of the Motion makes clear that the company accused by regulators of being an "egregious" pyramid scheme seeks now to use the Bankruptcy Court's power to eliminate the obligation to pay accrued compensation likely totaling hundreds of millions of dollars to "promoters" - under the theory that elimination of these obligations will allow the company to "ultimately prove successful and profitable."  Ironically, one of the chief concerns cited by TelexFree related to questions "raised as to whether the Original Comp Plan is compliant with law, which jeopardized the Debtors' business."  

Background

The Motion was filed on April 13, 2014 - the same day that TelexFree and two of its affiliates filed for bankruptcy in the Nevada bankruptcy court.  While TelexFree's main business centered on the sale of its voice over internet protocol (“VoIP”) program, 99TelexFREE, the company also operated a passive investment program.  By the terms of the previous compensation plan, an investor making an initial investment of either $289 or $1,375 would be required to so spend several minutes per day in an "effortless" path to astronomical gains - at least 200% per year.  These massive returns quickly resulted in a scenario where obligations to promoters drastically outpaced company revenues - indeed, according to the Commission, this compensation program racked up more than $1.1 billion in obligations to promoters.

As the Commission recognized, the $1.1 billion in promoter obligations was 100x larger than the $1.1 million realized in revenue from the sale of 99TelexFREE.  In March 2014, TelexFree announced a drastic revamp to its compensation plan.  Rather than simply place a daily advertisement and earn $20 per week on a $289 investment, the new compensation plan effectively required the purchase or sale of five $49.90 VOIP packages in order to be eligible for a return.  As BehindMLM recognized, the compensation plan suddenly shifted from previously allowing the passive investment program to function independently of the VoIP product to now integrating the two programs and counting on the viability of the VoIP product as a standalone product.

The Motion

The Motion positions TelexFree as a "telecommunications business that uses multi-level marketing to assist in the distribution of voice over internet protocol telephone services."  Touting 99TelexFree, the Motion claims that customer usage increased each month since its introduction in 2012.  For the first time, the Motion disclosed that TelexFree has "over 700,000 promoters" worldwide, and referenced the recent discontinuation of its compensation plan in favor of a revised compensation plan.  However, the "discretionary" payments owing to promoters under the original compensation plan soon allegedly "became a substantial drain on the Company's liquidity," and the company soon ceased making those payments prior to filing bankruptcy.

Despite experiencing "exponential" growth in revenue (which it claimed was over $1 billion), TelexFree claimed that it filed Chapter 11 bankruptcy due to "substantial asserted liabilities" against the company due to previous compensation arrangements.  Citing its belief that the soon-to-be released TelexFree mobile app and other products would propel the company to profitability, the Motion sought court approval  to reject "all agreements between the debtors and the promoters under both the Original Comp Plan and the Revised Comp Plan."  According to the Commission, this included at least $174 million in requests for payment by promoters submitted after the change in the compensation plan.

Of note, the Motion takes great pains to characterize the relationships between the promoters and the company as contractual, reciting a number of obligations that each owed one another.  While the company's obligations primarily consisted of paying the promoters, the promoter's obligations were characterized as adhering to the rules, agreeing to receive messages in their inboxes, and providing true and accurate information - primarily passive obligations.

The likelihood of success for the Motion is unknown.  Indeed, a case cited to in the Motion specifically cautions that such a "business decision" should not be granted if the decision was the product of "bad faith, whim, or caprice." In re Trans World Airlines, Inc., 261 B.R. 103, 121 (Bankr. D. Del. 2001). One bankruptcy authority recently recognized the difficulty the company would face in trying to discharge its obligations to creditors, noting the Bankruptcy Code's prohibition under 11 U.S.C. 523 against the discharge of debts arising from the debtor's bad acts:

1) debts arising from fraud by the debtor as a fiduciary, embezzlement, or larceny; (2) debts obtained through false pretenses, false representations, or actual fraud; (3) consumer obligations – credit card debts and luxury goods – owed to a single creditor over a certain threshold; and (4) willful and malicious injury caused by debtor to another’s property.

While in a vacuum the request might not appear as questionable, the recent allegations by Massachusetts regulators and the Commission paint a picture of widespread fraud - indeed, the recently-appointed Chief Financial Officer of TelexFree was caught trying to leave the company's headquarters with nearly $40 million in cashier's checks after federal authorities raided the office.  Moreover, the Commission alleged that approximately $30 million has been transferred in the last 5 months to company principals and related entities.  

There has been no ruling as of yet on the Motion.

Ponzitracker coverage of TelexFree to-date is here.  

The Motion is below:

Motion to Reject Certain Exec Ks