INSIGHT: Stanford Ponzi Scheme Ruling Limits Defenses to Fraudulent Transfer Actions

April 3, 2019, 8:01 AM

The Fifth Circuit’s Jan. 9 ruling regarding a lawsuit arising out of R. Allen Stanford’s $7 billion Ponzi scheme makes it more difficult for recipients of allegedly fraudulent transfers to demonstrate a good faith defense.

The defendent, GMAG LLC, invested $79 million in Stanford’s fake certificates of deposit. After learning of the Securities and Exchange Commission’s investigation of Stanford, GMAG redeemed its investment, receiving $87.5 million in cash from Stanford.

The court, in Janvey v. GMAG LLC, held that a recipient who has inquiry notice of the debtor’s insolvency or fraud must diligently investigate the debtor’s circumstances before accepting the payment even if the investigation would have been futile. Failing to do so precludes the good-faith defense to fraudulent transfer claims.

Thus, the court rejected the so-called “futility exception” to the requirement of good faith in fraudulent transfer law. While the court’s analysis is logical and follows largely an existing line of precedent, the result is shocking.

Following this ruling, investors should remain vigilant and protect themselves. They must be sure not to ignore red flags, continue to participate, take money, and hope for the best.

If they come across information that raises questions, they should demand answers. At best, investors will confirm their original investment decision. At worst, they will uncover a problem but be in a position to take action to protect their rights. In either case, they will have satisfied the requirements of good faith under the Bankruptcy Code and the Uniform Fraudulent Transfer Act.

Distressing Result

Typically, in Ponzi cases like Stanford’s, the receiver can recover only the investor’s “profit” (here, the $8.5 million in interest) but not the return of the investor’s principal. This is particularly true where the investor, as appears to have been the case for GMAG, did not have a role in the fraud.

GMAG serves a reminder that fraudulent transfer law can be harsh even to the (mostly) innocent.

GMAG’s definition of good faith can create significant difficulties for investors in complicated frauds. During the course of the fraud, the fraudster will go to great lengths to make everything appear to be reasonable, safe, and legitimate.

For example, Bernie Madoff built an infrastructure to generate fake account statements and trade confirmations based on actual market data. It took the authorities decades to catch up with him.

The same was true for Stanford, Thomas Petters ($3.7 billion Ponzi scheme), and any of a host of other felons. So long as payment is forthcoming, an investor has no real incentive to look too closely. And, in the case of a complex fraud, it is unlikely that the type of investigation that even a sophisticated investor could undertake would uncover the truth.

Yet, when the fraud is revealed and hindsight is fully active, it can be relatively easy for a trustee or receiver seeking funds to point out numerous red flags that should have required an investigation. Without the leavening of the futility exception, these investors will not be able to establish good faith and face having to return all of the payments that they received, not just those in excess of the amounts invested in the scheme.

Acting in Good Faith

Fraudulent transfer law—both the Bankruptcy Code (11 U.S.C. § 548(c)) and the Uniform Fraudulent Transfer Act (§ 8(a))—provides recipients of allegedly fraudulent transfers with an affirmative defense of good faith. A recipient acts in good faith if he accepts a payment without knowledge of facts sufficient to cause a reasonable person to inquire into the debtor’s insolvency or fraud.

A recipient on inquiry notice also can establish good faith by investigating the debtor. The “futility exception,” which the Fifth Circuit rejected in GMAG, is a third way of showing good faith. Under the exception, a recipient on inquiry notice can establish good faith by proving that a reasonable investigation would not have uncovered the debtor’s misconduct, i.e., an investigation would have been futile.

Red Flags

Despite the presence of some red flags, GMAG did not investigate Stanford or the source of the payments it received. The receiver sued under Texas’ version of the UFTA to recover the entire $87.5 million payment, which included repayment of GMAG’s $79 million investment as well as $8.5 million in “interest.”

After a jury trial, the trial court held that GMAG accepted the payments in good faith—despite being on inquiry notice and failing to investigate—because an investigation would have been futile given the breadth and scope of Stanford’s fraud.

The Fifth Circuit disagreed, holding that: “Regardless of the intricate nature of a fraud or scheme, failing to inquire when on inquiry notice does not indicate good faith.” (GMAG, slip op. at 9-10.) The appeals court reversed the trial court and rendered judgment for the receiver, requiring GMAG to return not only its $8.5 million in interest, but also $79 million representing the return of its principal.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Michael Napoli is a partner in Akerman LLP’s Fraud and Recovery Practice Group. Resident in Dallas, Napoli acts as a receiver and counsel to receivers in cases involving complex frauds.

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