Often in the aftermath of a Ponzi scheme once the dust has settled and a Receiver or Trustee has taken stock of the remnants of what was once touted as a guaranteed and safe investment opportunity, the focus shifts to what assets could potentially be recovered for the benefit of defrauded victims. One of the most common recovery mechanisms is to attempt to "clawback" any amounts transferred to investors in excess of their original investment - often called "false profits." But in rare situations, investors have been targeted for the return of their entire principal investment based on allegations that they allegedly lacked good faith when they received that principal amount. Recently, a federal appeals court determined that the receiver overseeing R. Allen Stanford's failed $7 billion Ponzi scheme was entitled to recover a Stanford investor's entire $80 million principal investment because the victim failed to act in good faith. The decision is notable not only because of its rarity but also because the SEC initially opposed the Stanford receiver's plans to target certain investors' principal investments.
Stanford's Scheme and the Receiver's Appointment
"Everybody who got money from Stanford has two things in common: One, they don't want to give it back. Two, they claim they're completely innocent and had no idea anything untoward was going on,"
- Janvey attorney Kevin M. Sadler
Stanford's scheme advised clients from 113 countries to purchase more than $7 billion in certificates of deposit from the Stanford International Bank ("SIB") in Antigua. The SEC instituted civil proceedings in February 2009, and a receiver, Ralph Janvey, was appointed to marshal assets for victims. Criminal charges were brought later that year, and Stanford is currently serving a 110-year prison sentence for what is considered one of the largest Ponzi schemes in history.
Following his appointment, Janvey filed numerous clawback lawsuits against victims and other third parties that he contended wrongfully received illicit scheme proceeds. The suits, brought under Texas's passage of the Uniform Fraudulent Transfer Act ("TUFTA"), alleged that the transfers to the investors were made with the actual or constructive intent to hinder, delay, or defraud, and that equity requires that those profits be returned to the receivership where they may be distributed in a pro rata fashion to those less-fortunate investors. Proceeding under a theory of actual intent to hinder, delay, or defraud, which can be satisfied through the finding that the perpetrator operated a Ponzi scheme, shifts the burden to the clawback defendant to demonstrate both that they showed good faith and provided reasonably equivalent value for the transfers.
In analyzing reasonably equivalent value, courts have made a distinction in analyzing whether the transfer encompassed an investor's principal investment or profits in addition to that investment. Courts have found that an investor can provide reasonably equivalent value for any amount up to that investor's principal investment because the return of those funds extinguishes that victim's claim for return of their principal. Of course, an investor must still demonstrate good faith in receiving those transfers in order to satisfy their defense under TUFTA. However, courts have found that an investor cannot provide reasonably equivalent value for their receipt of distributions in excess of their original investment - often called "false profits" because they are typically funds from other investors - and courts routinely allow recovery of those false profits under TUFTA or other theories.
Janvey's decision to file clawback suits was unique in that the SEC opposed any clawback suits seeking to recover an investor's partial or full principal investment. After Janvey indicated in his April 2009 Report that such efforts could potentially recoup more than $300 million in transfers, the SEC filed an Emergency Motion seeking to modify the Order Appointing Receiver to prohibit Janvey from pursuing clawback actions against innocent investors because those suits "contravene[d] Commission practice and [was] supported by neither logic nor the law." Like the courts' analysis of clawback suits, the SEC also drew a distinction between suits seeking false profits - which it supported - and suits targeting "innocent" investors for the return of principal - which it did not support. The Court ultimately denied the SEC's motion and allowed Janvey's suits to go forward.
The Clawback Suit
Gary D. Magness and his related entities (collectively, "Magness) were one of Stanford's largest U.S. investors, purchasing $79 million in Stanford CDs between December 2004 and October 2006 - several years before the scheme's collapse. Following a July 2008 Bloomberg report that the SEC was investigating Stanford, Magness's investment committee decided at an October 2008 meeting to seek, at a minimum, the accumulated interest owing on Magness's investment. Magness has maintained that this decision was not due to the Bloomberg report but rather because of his own mounting liquidity issues in the run-up to the financial crisis.
After Magness's financial advisor approached Stanford's issuing bank for a redemption, Magness ultimately received approximately $88.2 million in cash later that month as purported "loans" repaid by the accrued interest and principal investment. This amount included approximately $8.5 million in purported profits on Magness's CD investment. Stanford was charged by the SEC several months later.
Janvey sued Magness to recover all $88.2 million he had received before SIB's collapse. Magness subsequently returned the $8.5 million he had received in "false profits" following the Court's award of partial summary judgment to the Receiver for those transfers. The case ultimately went to a jury to decide whether Magness had received the returns constituting his principal investment in good faith. The jury decided that Magness had inquiry notice that Stanford's bank was engaged in a Ponzi scheme, but not actual notice. Inquiry notice was defined in the jury instructions as:
[K]nowledge of facts relating to the transaction at issue that would have excited the suspicions of a reasonable person and led that person to investigate.
In what would be the focus of appellate efforts, the jury also concluded that any investigation by Magness would have been futile. The jury instructions defined a futile investigation as when:
a diligent inquiry would not have revealed to a reasonable person that Stanford was running a Ponzi scheme.
Notwithstanding the jury verdict, The Receiver asked the lower court to enter judgment in his favor and argued that the jury's finding of inquiry notice defeated Magness's good faith defense under TUFTA. The court denied that motion, finding the Receiver was only entitled to recover Magness's $8.5 million in false profits, and the Receiver appealed that Order to the Fifth Circuit.
The Receiver's main argument on appeal was that the trial court had impermissibly created a "futility exception" to TUFTA's good faith defense. That futility exception derives from bankruptcy law where courts interpreting the Bankruptcy Code's fraudulent transfer provision (11 U.S.C. 548(c)) have allowed a transferee to rebut a finding of inquiry notice by demonstrating that the complexity of the fraudulent scheme would have rendered any investigation futile. Despite TUFTA's silence on the topic, the district court held that a transferee with inquiry notice must conduct a diligent investigation into the facts giving rise to the inquiry notice or otherwise that any investigation would have been futile.
The Fifth Circuit noted that the Texas Supreme Court had not addressed whether or not TUFTA's good faith provision requires a diligent investigation or corresponding futility exception. In reviewing other relevant and persuasive decisions, the Fifth Circuit noted that:
in fact, no court has considered extending TUFTA good faith to a transferee on inquiry notice who later shows an investigation would have been futile.
Even though TUFTA was based on the Bankruptcy Code's fraudulent transfer provision under Section 548, the Fifth Circuit noted that it had previously declined to rely on that provision to interpret good faith under TUFTA. This, the Court reasoned, was supported by the absence in Section 548 or its legislative history of any definition of good faith as well as the lack of clear consensus from other courts as to the application of a good faith defense or the corresponding availability of a futility exception under Section 548. In declining to find the availability of a futility exception to TUFTA's good faith requirement, the Fifth Circuit concluded that
No prior court considering TUFTA good faith has applied a futility exception to this exception, and we decline to hold that the Supreme Court of Texas would do so.
Assuming that the Fifth Circuit's decision withstands any appellate scrutiny, the holding presents potentially enormous ramifications in Ponzi scheme jurisprudence. In essence, the decision allows a trustee or receiver to point to a news article or other red flag and then argue that any principal redemptions subsequent to that event were done on inquiry notice and thus deprive that transferee of the good faith defense. This is important because the vast majority of investors in a Ponzi scheme are not fortunate enough to receive enough distributions to exceed their principal investment and previously would not typically have been subject to a receiver's scrutiny or clawback efforts. The potential for principal distributions to now be within a receiver's grasp upon the existence of a certain event placing any recipients on inquiry notice greatly expands both the potential number of clawback targets as well as the ultimate size of the receiver's recoveries.
A copy of the Fifth Circuit's decision is below:
Janvey v Magness by on Scribd