How Ponzi Scheme Presumption Can Be Catastrophic for Lenders

How Ponzi Scheme Presumption Can Be Catastrophic for Lenders

A bankruptcy trustee can establish the existence of a Ponzi scheme. When they do this, the Ponzi scheme presumption applies. 

“According to the law, courts can infer that the intent of Ponzi scheme perpetrators is to defraud creditors. The courts can also infer that the intention was to delay or hinder creditors from all payments made,” says attorney Scott Silver of Securities Fraud Attorneys.

When you receive payments from perpetrators of Ponzi schemes, these payments can be clawed back. However, the recipient can keep payments applied to their exact investment in the scheme.

This article discusses the view of the law on Ponzi schemes and how the irrebuttable presumption of Ponzi schemes can be fatal for lenders:

How Ponzi Schemes Work

A person involved in Ponzi schemes may borrow money from a lender. The lender may assume this money will be used for a legitimate business, so the lender may give secured financing to the individual intending to run a Ponzi scheme.

The borrower may then use this money to get an office or acquire equipment for the Ponzi operations. 

What the Law Says on Proving Fraudulent Intent

This presumption can have severe consequences for lenders. They are not spared if they act without knowledge of the fraud. The Bankruptcy Section 548(a)(1)(A) contains the transfer recovery statute.

The regulation allows bankruptcy trustees to claw back payments made to lenders, including those applied to principal and interest. The statute also requires proof of the lender’s actual intent.

According to the statute, one must prove that the intent is to hinder, defraud, or delay creditors. However, courts’ sentencing has challenged this need. 

Substitute for Debtor’s Admittance

Courts have allowed the law to be applied without the debtor’s admittance of intention to commit fraud. Instead, the court recognizes “Badges of fraud” as sufficient. Badges of fraud are circumstantial evidence that shows fraudulent intent. 

The irrebuttable Ponzi scheme presumption substitutes for the debtor’s admittance. It is more powerful than “Badges” of fraud. The Ponzi scheme presumption wipes out the need to seek the debtor’s admittance to fraudulent intent. 

What It Means for Good Faith Lenders

In Ponzi schemes, the debtor pays victims and good-faith lenders. The victims’ money could be part of the money used to perpetuate the fraud. On the other hand, it is unclear if the good-faith lender’s money was used to perpetuate the fraud.

The Ponzi scheme presumption does not recognize any differences between these two payments. That was the case in Jerrold S. Pressman, Debtor, and Poshow Kirkland as Trustee of the Bright Conscience Trust vs. Rund (In re EPD Inv. Company, L.L.C.), NO. 22-55944 (9THCir. 2024). 

In this case, the litigant claimed the defendant secured a $2 million loan before its collapse. The court did not require proof of claim and ruled that EPD operated a Ponzi scheme. 

The court also ruled that EPD defrauded the litigant to defraud, hinder, and delay creditors. The implication of the court’s ruling allowed for the recovery of all payments the litigant received, except for the principal.

The court of appeal rejected the appeal and upheld that lenders are part of the possible class of Ponzi scheme victims regardless of the terms of the loan.

The Application of the Ponzi Scheme Presumption

There are three significant aspects of the Ponzi scheme presumption. They include the following:

1. It does not apply to any third-party lender that gives out loans, having obtained collateral, to borrowers intending to use them for a Ponzi scheme
2. Lenders cannot use any regulations or authority to fight a clawback claim
3. When a lender has an inkling of a borrower’s engagement in a Ponzi scheme, the lender must consider reducing the principal 

Concluding Remarks

The decision highlights the importance of rigorous due diligence for lenders. By conducting thorough investigations into borrowers’ business operations and financial history, lenders can reduce the risk of being caught up in a Ponzi scheme.

Moreover, lenders should closely monitor borrowers’ activities and take immediate action if they suspect fraudulent behavior. It may involve accelerating the loan, seeking alternative remedies, or consulting legal counsel. 

The EPD Investment decision is a stark reminder of the potential risks associated with lending to Ponzi scheme operators. By understanding the legal landscape and taking proactive measures, lenders can protect their interests and minimize their loss exposure.