Charities: Proper Clawback Targets in Ponzi Scheme Cases?

To gain valuable recognition, Ponzi perpetrators often make handsome contributions to charities. But those contributions create political difficulties for the trustees and receivers in evaluating whether to seek the return of those contributions on fraudulent transfer theories for the benefit of the defrauded investors whose money was used to make the contributions.  On the one hand, who wants to sue a do-good charity?  On the other hand, how to explain the refusal to seek the return of investor funds that were paid to bring attention and recognition to the wrongdoer? 

            Trustees, receivers, and courts vary in their analyses of these fraudulent transfers, depending on whether the claim is for an actual or constructive fraudulent transfer.  Additionally, the results are further confused if the transfer was made to a religious organization because of the Religious Freedom Restoration Act ("RFRA").   The cases are split on the impact of RFRA on fraudulent transfer claims against religious organizations under the Bankruptcy Code.  Some cases find no impact, while others find that RFRA does preclude fraudulent transfer claims against religious organizations under the Bankruptcy Code.  See The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes by Kathy Bazoian Phelps and Hon. Steven Rhodes at  § 3.02[5].

Even in cases involving non-religious charities, however, the avoidance of contributions is problematic, as demonstrated recently by The American Cancer Society v. Cook, 2012 U.S. App. LEXIS 5769 (5th Cir. Mar. 20, 2012).  In the fraudulent scheme of Giant Operating, Inc. and its related entities and individuals, the SEC-appointed receiver, Karen L. Cook, sought to recover $240,000 that the perpetrators paid to The American Cancer Society.  Cook asserted theories of fraudulent transfer and constructive trust, and argued that the perpetrators' actual fraud justified disgorgement of the contributions. 

            The district court relied on the Ponzi presumption, as permitted by the Fifth Circuit in Warfield v. Byron, 436 F.3d 551, 558-59 (5th Cir. 2006), and found that the payments to The American Cancer Society were recoverable as fraudulent transfers.  It found that because defendants were operating a "Ponzi-like scheme," the debtors' transfers to the charity were "presumptively made with fraudulent intent."  SEC v. Harris, 2010 U.S. Dist. LEXIS 99118  (N.D. Tex. Sept. 7, 2010), Magistrate's report and recommendation adopted, 2010 U.S. Dist. LEXIS 99146 (N.D. Tex., Sept. 22, 2010).  For a discussion of the Ponzi presumption, see The Ponzi Book at § 2.03[1][a].

            However, the Fifth Circuit reversed, holding that the evidence did not support a "Ponzi scheme finding."  Writing for the court, Judge Edith Jones held that the receiver's affidavit was conclusory and insufficient.  Judge Jones described the evidence that Cook presented as follows:

Cook attested that (1) investor funds constituted virtually all of Giant's revenue; (2) those funds were commingled and used for personal and unauthorized expenses; (3) Giant did not operate a profitable business outside of money received from new investors; (4) investor funds were used to pay "returns" to some investors; and (5) Giant used some of its funds to procure new investors. Thus, the affidavit concluded, "Giant was a fraudulent Ponzi-type scheme." Attached to the affidavit were three exhibits that purported to support her conclusions.

The exhibits included the following: a summary of Giant's profitability, a list of payments made by Giant Operating to DSSC, and what appears to be a checkbook registry of an account of DSSC at Comerica Bank.

Then, in the key holding, Judge Jones held, "Nothing in these documents demonstrates that investor funds were used to issue 'returns' to other investors - a sine qua non of any Ponzi scheme."

 Judge Jones further noted, "at oral argument, Cook's counsel failed to identify in those exhibits any instance in which a single payment was made to an investor. The absence of even a single investor 'payout' - which would be, by its nature, easy to show - convinces us the district court erred in placing determinative weight on Cook's declaration that Giant operated as a Ponzi scheme."  The American Cancer Society v. Cook, at *7. For a discussion of the factors to establish the existence of a Ponzi scheme, see The Ponzi Book at § 2.03[1][b].

            Cook also sought recovery of the funds on a theory of constructive trust "on ACS's assets, arguing that the funds at issue rightfully belong to the defrauded investors of Giant."  Id., at *11.  Judge Jones noted that this remedy is entrusted to the discretion of the court, but stated:

In this case, the equities militate against a constructive trust on Giant's charitable contributions to ACS. As noted above, there is no evidence that Giant's contributions furthered any fraudulent scheme or were otherwise made with intent to defraud investors.

It must also be noted that Cook's original motion for turnover also asserted a constructive fraudulent transfer claim on the basis that the perpetrators received no reasonably equivalent value for their contributions and that they were insolvent. However, neither the magistrate, the district judge, nor Judge Jones dealt with this claim. Under such a claim, the perpetrators' fraudulent intent would have been irrelevant, and the lack of reasonably equivalent value would have been clear. The Supreme Court has stated that: "The sine qua non of a charitable contribution is a transfer of money or property without adequate consideration."  United States v. Am. Bar Endowment, 477 U.S. 105, 118, 106 S. Ct. 2426, 2433, 91 L. Ed. 2d 89 (1986).  Unfortunately, the record of the case does not disclose how this important claim got lost.

For a discussion of the case law on whether charitable contributions are avoidable as constructive fraudulent transfers, see The Ponzi Book at § 3.02[5].

            This is case could have gone either way.  The district court, reviewing the evidence, decided that avoiding the contributions to the ACS was appropriate in the context of what it concluded was a Ponzi-like scheme.  The Fifth Circuit, however, found the evidence insufficient and declined to exercise equitable powers to take the contributions away from the charity. 

Kathy Bazoian Phelps is the co-author of The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes available for purchase at www.lexisnexis.com/ponzibook. More information about The Ponzi Book can be found at www.theponzibook.com.

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