Limiting Ponzi Scheme Recoveries in Bankruptcy: United States Supreme Court Declines to Review Fraudulent Transfer Ruling in Favor of Bank

The United States Supreme Court recently declined to review a decision from the United States Court of Appeals for the Fourth Circuit favorable to a bank regarding alleged fraudulent transfers to the bank. In doing so, the Supreme Court left intact the Fourth Circuit's holding that a Chapter 7 bankruptcy trustee cannot avoid pre-bankruptcy deposits into the bankrupt debtor's unrestricted checking account at the bank.

The Scheme

The case involved a debtor who maintained a checking account at First Citizens Bank. Like most accountholders, the debtor routinely deposited checks and received wire transfers into his account.  Unlike most other accountholders, the debtor used his checking account while running a Ponzi scheme.  The scheme eventually unraveled in late 2009 when the debtor was unable to secure additional funds to pay prior investors in his Ponzi scheme.

The Bankruptcy Case

In early 2010, several of the debtor's investors filed an involuntary Chapter 7 bankruptcy petition against him in the United States Bankruptcy Court for the Middle District of North Carolina, and a trustee was appointed in the case. While millions of dollars had been deposited into the debtor's First Citizens checking account over the years, only a few dollars remained in the account when the bankruptcy case was filed.  Those funds became part of the debtor's bankruptcy estate.

The Investor Suits

Relying on a presumption in bankruptcy law that all transfers made in furtherance of a Ponzi scheme are presumed to be fraudulent, the Trustee first targeted numerous Ponzi scheme investors who had received distributions from the debtor within two years prior to the bankruptcy filing. In all, the Trustee sued more than 40 investors seeking to recover more than $9.5 million in alleged fraudulent transfers they had received from the debtor.  Most of these investor suits were settled with the investors paying most of their ill-gotten proceeds back to the Trustee.

The First Citizens Suit

In April 2012 the Trustee sued First Citizens, alleging that a dozen deposits into the debtor's checking account were avoidable as fraudulent transfers. The Trustee also asserted claims for civil conspiracy and for unfair and deceptive trade practices. Most of the targeted deposits were checks or wire transfers from investors in the Ponzi scheme to the debtor.

Three of the targeted deposits were not from investors, but were made in conjunction with loans from First Citizens to the debtor, including a construction loan and a loan for working capital, but the loans were only secured by real estate, and not the checking account deposits.

The Trustee contended that these deposits were transfers by the debtor to First Citizens of funds that belonged to the debtor. In addition, the Trustee contended that each of the targeted deposits was an avoidable transfer insofar as the transfers were made in furtherance of the debtor's Ponzi scheme and were therefore presumed to be fraudulent.

The Trustee sought to recover from First Citizens for all of the deposits into the debtor's bank account.

Interestingly, the funds deposited into the debtor's First Citizens checking account (other than the proceeds of the First Citizens loans) were, for the most part, quickly paid out to earlier investors, so the Trustee was effectively suing both First Citizens and the investors for the same money.

The Bankruptcy Court Rulings

The Trustee's claims against First Citizens for civil conspiracy and unfair and deceptive trade practices were dismissed early in the case. The bankruptcy court later granted summary judgment in favor of First Citizens regarding the alleged fraudulent transfers, observing that the purpose of fraudulent transfer law is to allow creditors to avoid transfers that unfairly or improperly deplete a debtor's assets.  Because the deposits in question went into an ordinary checking account and the funds in the account remained subject to the debtor's control and availability at all times, the deposits were not avoidable fraudulent transfers. 

The Trustee appealed the bankruptcy court's decision to the United States District Court for the Middle District of North Carolina.

The District Court Decision

On appeal, the district court noted that the issue of fraudulent transfer liability based on deposits into a debtor's checking account rarely arises and was far afield from the normal fraudulent transfer case where usually there is no question that the targeted transfer depleted the bankruptcy estate. 

The district court noted that fraudulent transfer liability is limited to transfers of property that would have been property of the bankruptcy estate had it not been transferred prior to the commencement of the bankruptcy case. If a transfer did not and could not diminish the bankruptcy estate, then the debtor's interest in the transferred property did not change and the transfer is not subject to avoidance. 

Because the deposits into the debtor's own checking account did not negatively impact the bankruptcy estate and had no potential to diminish the estate, the district court affirmed the bankruptcy court's ruling. The Trustee then appealed to the Fourth Circuit.

The Fourth Circuit Decision

In January, 2017 the Fourth Circuit affirmed the district court's decision but on somewhat different grounds. It found that the targeted transactions did not fall within the definition of "transfers" under the Bankruptcy Code because they did not involve the requisite disposal of, or parting with, property by the debtor. When the debtor made the deposits and accepted the wire transfers into his First Citizens checking account, he continued to possess, control, and retain custody of those funds.  The funds in the account were freely withdrawable by the debtor at his will, and were at all times part of the bankruptcy estate.  Simply because First Citizens maintained the checking account, this did not suffice to make the deposits and wire transfers into the account "transfers" from the debtor to First Citizens. 

The Fourth Circuit's ruling included two specific and significant caveats. First, to escape definition as "transfer," a bank deposit must in reality be an actual deposit, made in good faith as such, and not made as a cloak for a payment or other forbidden transaction.  Second, the bank account at issue must be wholly unrestricted such that the bank does not exercise any control over the funds and the depositor may withdraw the funds at will. 

The Ninth Circuit Decision

In March, 2017, less than two months after the Fourth Circuit's decision, the United States Court of Appeals for the Ninth Circuit issued a ruling in a separate case in which it held that a $526,402.05 deposit by the debtor into its bank account was avoidable as a preferential transfer and therefore recoverable from the bank. 

In the Ninth Circuit case, however, the bank in question had a security interest in the funds in the account by virtue of an outstanding loan from the bank to the debtor that was secured by the debtor's deposit accounts. Hence, all funds deposited into the account became subject to the bank's security interest.  The targeted deposit therefore increased the size of the bank's secured claim, allowing the bank to obtain more while other creditors obtained less.  The Ninth Circuit specifically noted in its decision that the deposit subjected the funds to the bank's security interest, gave the bank title to the funds, and depleted the assets available for distribution to the debtor's creditors.

The Supreme Court Declines to Review

The Trustee in the case originating in North Carolina filed a petition for a writ of certiorari seeking review of the Fourth Circuit decision by the United States Supreme Court, arguing that the Fourth Circuit decision and the Ninth Circuit decision created a clear and intractable "circuit split" that required resolution by the Supreme Court. On the other hand, First Citizens argued that the cases cited by the Trustee concerned different claims and materially different facts from the Fourth Circuit case. 

First Citizens also argued against review because both the Fourth Circuit and the Ninth Circuit reserved judgment on whether each would reach the same result if presented with the other's facts. The Fourth Circuit expressed no opinion on whether it would have reached the same result if the deposits into the debtor's account caused the funds to be restricted in any way. Likewise, the Ninth Circuit acknowledged cases holding that a bank deposit is not a fraudulent transfer if it does not deplete the assets of the bankruptcy estate.  First Citizens argued that no genuine split among the circuit courts existed, and therefore granting certiorari to review the Fourth Circuit's decision was unnecessary.

On October 10, 2017, the Supreme Court denied the Trustee's certiorari petition, thus ending the protracted litigation between the Trustee and First Citizens by leaving the Fourth Circuit opinion intact. As a result, at least in the Fourth Circuit, the law is clear that a bankruptcy trustee cannot recover from banks for ordinary deposits into an unrestricted checking account when the deposits do not diminish, or even potentially diminish, the bankruptcy estate. 

Banks therefore have a strong defense to any avoidance action that is based solely on the deposit of funds into an unrestricted account.

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