Court: Trustee Can Recover Ponzi Investor's Principal And Profits
In a rare move, a Connecticut Bankruptcy court has approved a court-appointed bankruptcy trustee's efforts to recover not only the false profits from a group of Ponzi investors, but also those investors' invested principal due to their lack of good faith in making those investments. The decision by U.S. Bankruptcy Judge Albert S. Dabrowski is notable in that it marks a rare occasion that a Ponzi investor was ordered to surrender his profits and invested principal based on a finding that the investor lacked the requisite good faith to allow retention of the initial investment. The decision is a welcomed development for the defrauded investors in Michael S. Goldberg, LLC ("MSG"), which raised more than $100 million from hundreds of investors who were promised a 20% - 25% profit every 60 to 90 days but which turned out to be a massive Ponzi scheme that resulted in tens of millions of dollars in losses.
Background
MSG was operated by Michael S. Goldberg, a Connecticut man who promised extraordinary returns to potential investors purportedly derived through the resale of diamonds and distressed assets from JP Morgan Chase. Goldberg told potential investors that their investment was risk-free, as Chase had promised to refund the purchase price of any asset that could not be resold. In addition, Goldberg told some investors that he would pay any tax obligations arising from the investment. Investors were drawn to the scheme not only through word-of-mouth, but also through other investors who were paid a "finder's fee" for recruiting new investors. In total, more than 350 investors entrusted over $100 million to Goldberg. After the scheme collapsed and was revealed to be a Ponzi scheme, Goldberg filed bankruptcy and was later sentenced to a 10-year prison term. Authorities estimated total losses to investors of at least $30 million.
Clawback Action
After MSG's bankruptcy filing, James Berman was appointed as Chapter 7 trustee over MSG and tasked with recovering assets for victims. In that context, Berman filed multiple actions against parties that he contended wrongly received distributions from MSG, including early investors Edward Malley ("Malley") and his wife Tracey Malley ("T. Malley") (Malley and T. Malley are collectively referred to as the "Malleys"), Scott LaBonte, Deborah Bianca, and several entities controlled by LaBonte and/or Malley (collectively, the "Defendants"). Edward Malley was an investor investor in MHG, having met Goldberg in 2004 and subsequently investing roughly $1.3 million of his own money as well as money pooled from dozens of other investors during the time period of July 2005 to September 2008. After Malley began acting as a "feeder" for other investors, he stopped investing his own funds and withdrew nearly $1.9 million from payments he received from MHG as a return on his investment. Through an account managed by a colleague's law firm, Malley caused nearly $4 million in investments to be made with MHG.
Between July 2008 and November 2009, more than $12 million was transferred from MHG to the law firm account designated by Malley which represented returns on the investments made by the Malleys and other third parties that had invested through the Malleys. These distributions represented exorbitant returns for the Malleys and their investors; for example, T. Malley's initial $50,000 investment resulted in over $1 million of subsequent profits. LaBonte also made significant investments with Goldberg through Malley on behalf of himself and other third parties, and ultimately received more than $7 million in distributions on account of those investments.
Berman brought claims against the Defendants under certain provisions of the Bankruptcy Code and Connecticut law providing for the recovery of fraudulent transfers made by MHG. Both allow the trustee to recover transfers made by the debtor with the actual or constructive intent to hinder, delay, or defraud the debtor's creditors. A creditor may then attempt to avoid rescission of a transfer by demonstrating both that the transfer was received in good faith and that the creditor provided value to the debtor. The Court set forth a two-part inquiry that a transferee must satisfy to demonstrate good faith: first, using an objective reasonable man standard, whether or not the transferee had information putting it on inquiry notice of the debtor's insolvency or fraudulent purpose; and second, once on inquiry notice, whether the transferee conducted a diligent investigation. With respect to value, courts typically find that a transferee can give value in the form of a preexisting claim against a transferor up to the amount of their invested principal; accordingly, a transferee cannot give value for transfers in excess of their investment.
Analysis
The Court began its analysis by evaluating whether the trustee had adequately demonstrated MHG's actual or constructive intent to hinder, delay, or defraud its creditors in making the transfers to Defendants. The Court found this analysis unnecessary, as the parties' stipulation that MHG had been a "pure" Ponzi scheme allowed it to assume the existence of an actual fraudulent intent based on the invocation of the Ponzi scheme presumption. Under the Ponzi scheme presumption, which has been applied nearly universally by courts around the country, the existence of a Ponzi scheme - which is itself premised on the fraudulent operation of a scheme that cannot last forever and is indeed destined to fail - conclusively demonstrates the fraudulent intent of a transferor. Thus, the Court found that the trustee had carried his burden, and the burden then shifted to the Defendants to demonstrate the existence of good faith and value.
1. Were Defendants On Notice Of MHG's Insolvency Or Fraudulent Purpose?
The trustee alleged that numerous red flags were on notice to the Defendants that precluded any finding of good faith in the receipt of transfers from MHG. In evaluating this, the Court used an August 2014 investor bulletin published by the SEC identifying ten potential investment red flags as a benchmark. These red flags consisted of:
(1) promises of high returns with little or no risk; (2) unregistered or unlicensed investment professionals; (3) aggressive sales tactics; (4) problems with sales documents (sloppy documents containing typographical, spelling or other errors); (5) no net worth or income requirements for investors; (6), no one other than the salesman appearing to be involved in the deal; (7) sham or virtual offices; (8) the company not being in good standing in the state where it is incorporated or formed; (9) unsolicited investment offers, often coming from a trusted friend, co-worker or family member and (10), suspicious or unverifiable biographies of managers or promoters.
As the Court observed, "courts have often used these and other 'red flags' to identify those situations where a reasonably prudent investor in a Ponzi scheme would have been put on inquiry notice."
In applying the ten 'red flags' to the present situation, the Court listed numerous factual circumstances that led it to conclude that:
all of the “Red Flags” were in evidence to varying degrees in the manner by which the Debtors conducted their business operations.
This included the "extraordinarily" high returns, assurances of little or no risk, the promises to pay the transferees' tax obligations (despite never asking for those transferees' social security numbers), and the lack of registration of Goldberg's company, grammatical errors in offering documents. The Court also highlighted the fact that, despite the Malleys' self-professed investment experience, they never met with any attorneys or accountants representing Goldberg or MHG nor did they request or receive any financial or tax documents. As the Court concluded, "It is apparent here that the Malleys’ chose to remain willfully ignorant of the facts which would have alerted them to the Debtors fraudulent purpose." Also noteworthy as to the Malleys was their transfer of over $250,000 to their personal accounts after they learned of Goldberg's arrest for operating a Ponzi scheme. As to LaBonte, the Court referenced a previous order sanctioning LaBonte for the destruction of evidence, and also noted that LaBonte was privy to the same information which supported a lack of good faith on behalf of the Malleys. As the Court poignantly observed,
Thus, LaBonte, as with Malley, was not just an investor but became a participant in the fraud itself. By adding to the pot in placing other peoples’ money with the Debtors, he and Malley were both extending the ability of the Debtors to keep the Ponzi scheme going and at the same time increasing the likelihood that their own investments would be repaid.
The Court also imputed LaBonte's lack of good faith to entities for which he served as the managing member "because they are charged with the same knowledge as that possessed by LaBonte."
2. Did Defendants Conduct A Diligent Investigation After Being On Notice Of MHG's Insolvency Or Fraudulent Purpose?
Having demonstrated that Defendants were clearly on notice of information which should have prompted them to conduct a diligent investigation, the Court next turned to whether such a diligent investigation had, in fact, been made. The Court answered this question with a resounding "no." First, the Court observed that the Defendants stood to make "staggering" returns that could be jeopardized if they were to investigate the propriety of MHG. Additionally, despite meeting with Goldberg on numerous occasions, neither Malley nor LaBonte ever requested to speak with MHG's accountants or attorneys nor did they raise the issue with their own professionals. While T. Malley sought to excuse her failure to act on the basis that she was relying on her husband, the Court noted that
“Given that good faith is determined using an objective standard and that no reasonable person would have proceeded in a manner similar to the defendants without completing the requisite due diligence, “[the investor’s] excuse that ‘he didn't know better’ merely establishes ignorance, not good faith.”
Concluding that Defendants had failed to establish either of the two elements of a good faith defense, the Court found that it was not necessary to examine whether Defendants had provided value in exchange for the transfers.
Each of the Defendants was found liable for the total amount they received from the scheme, as well as pre- and post-judgment interest.
The Order is below: