Collection Issues in Ponzi Cases

It is quite common for a Court, in response to an SEC action for injunctive relief, to appoint a receiver. The injunction normally prohibits any third party from suing the persons or entities involved in the receivership itself. Often, there are both named defendants and “relief defendants.: A “relief defendant” is one who, while not accused of directly participating in the Ponzi scheme, is a person or an entity in possession of assets derived from the Ponzi scheme.

The practitioner must be careful not to file a shotgun suit, because naming any of the defendants or relief defendants in an SEC injunction or receivership case will net a contempt action from the Court.

If the seller of the Ponzi scheme investment is a registered representative, he or she is subject to liability in a FINRA arbitration, most likely for “selling away.” ₁ If the seller/promoter/broker is unregistered, the investor will have to sue in Court. If the investor is successful, a judgment will be entered, and then the collection process must begin. Some practitioners will hire “collection attorneys” who specialize in the collection of judgments to find assets. It is recommended that a securities attorney unfamiliar with the collections process hire a collection attorney to collect a judgment.

The Commercial Law League is a good source to find a collection attorney (aka “creditors rights attorney”), or a bankruptcy attorney, if needed.₂ Moreover, a good source for collection attorneys is the local bankruptcy bar association, as there are normally many creditors’ rights attorneys who will collect judgments in and out of bankruptcy court.

Still others will hire private investigators who will charge a fee to find bank accounts or other assets to garnish or attach. There are private investigators, in this author’s experience, who will only charge a fee if they locate a bank account for the judgment creditor. There are other investigators who specialize in asset searches, again, charging a fee on contingency only if they are successful. Since the area of collections is so broad, it is recommended that the judgment creditor hire an attorney who is skilled in collections, who in turn may use the services of a private investigator to identify assets to satisfy the judgment.

If the debtor files for bankruptcy, the victim of the Ponzi scheme, holding the judgment, can sue the debtor for a finding that the judgment is “nondischargeable,” meaning that the judgment remains collectable against the debtor. This is significant, because judgments are often collectable for many years, and, once the debtor “discharges” all of his other debts, the nondischargable judgment may be easier to collect. A recorded judgment may be deemed a “secured” debt against the debtor’s remaining assets, putting the investor/creditor higher up on the food chain, eligible for a distribution of moneys or assets from the bankruptcy estate.

The purpose of the nondischargability action is to prevent the judgment from being wiped out in bankruptcy, as part of the debtor’s discharge. A discharge means the debtor gets a “fresh start” free from the claims of the all the creditors. However, the Bankruptcy Code was not designed to shield debtors from committing fraud, and then washing one’s hands in bankruptcy. Under Section 523(a)(2)(A) of the Bankruptcy Code there is an exception to discharge from debts obtained by fraud. It states, in pertinent part, as follows: (a) A discharge under section 727 … does not discharge an individual debtor from any debt(2) for money, property, services, … to the extent obtained by-

(A) false pretenses, a false representation, or actual fraud ….₃

Exceptions to discharge are narrowly construed to further the Bankruptcy Code’s “fresh start” policy; thus, the claimant has the burden to demonstrate that his claim comes within an exception to discharge by a preponderance of the evidence.₄. Still, the very purpose of some sections of the Bankruptcy Code “is to make certain that those who seek shelter of the bankruptcy code do not play fast and loose with their assets or with the reality of their affairs.”₅ In this respect, § 523(a)(2)(A), is intended to make certain that those who obtain property by fraudulent means are not afforded bankruptcy protection.₆

To establish that a debt should not be subject to discharge, a claimant must prove:

(1) that the debtor made a fraudulent misrepresentation;
(2) that the debtor’s conduct was with the intention and purpose of deceiving or defrauding the creditor;
(3) that the creditor relied on the debtor’s representations or other fraud; and
(4) that the creditor sustained loss and damage as a proximate result of the representations of fraud.₇

Element one is satisfied if the debtor’s representation was known to be false or recklessly made without knowing whether it was true or false.₈ Pertinent considerations for determining recklessness are the debtor’s pattern of conduct and his prior business expertise.₉ The conclusion that a debtor knew that his representations were false is closely linked to, but separate from, the issue of an intent to deceive to influence another’s conduct.

Indeed, most cases revolve around the second element: whether the debtor acted with the requisite intent to defraud. When a debtor invests funds on behalf of another party, “a debtor will be found to have acted with the requisite intent to defraud under § 523(a)(2)(A) when, at the time the transaction occurred, it is established that the debtor, for his or her personal gain, knowingly mislead the investor as to a material fact concerning the investment.”₁₀

A showing of reckless indifference to the truth is sufficient to demonstrate the requisite intent to deceive. ₁₁ Because a debtor will rarely, if ever, admit to acting with an intent to deceive, intent may be inferred from the totality of the circumstances.₁₂ Element three will be satisfied by a showing of “justifiable reliance” on the representations. This standard of reliance requires more than actual reliance but less than reasonable reliance.₁₃

An instructive case is In re Justice.₁₄ In In re Justice, the bankruptcy court found that the actions of the debtor, who was the creditor’s financial advisor, in inducing the creditor to invest in what turned out to be a fraudulent securities investment constituted gross recklessness rising to the level of an intent to deceive.₁₅

In Justice, the debtor represented the investment as “safe” to the creditor; the debtor, who had experience with securities, relied solely on the claims of the investment brochure that it was exempt from registration and otherwise legitimate; the debtor did not call the SEC, the Ohio Attorney General, any financial rating service, or otherwise test the validity of the information; and the debtor did not question how the investment could guarantee such a high rate of return.₁₆ The Court found the debt nondischargeable.

Similarly, in In re White, the Court found that the debt was nondischargeable, in part because the note-brokers did no real investigation of the product that they sold: “the overwhelming failure of White and Pangle to do any real investigation into the Notes characterizes their recklessness. Their actions evidence that they wanted to receive commissions without asking the hard questions.”₁₇.

In In re White, the Court also found that under the circumstances, nothing was apparent to indicate to the investors that they should be wary of the investment, especially given that the solicitations arose out of a church relationship.₁₈ The Court also rejected the debtor’s other argument that the investor was an experienced businessman, who should have done research into the investments himself.₁₉

1. Since this topic is covered by another author in this program, it is not being covered in detail in this article. http://www.clla.org.
2. 11 U.S.C. §523(a)(2)(A) (2004).
3. Grogan v. Garner, 498 U.S. 279, 286, 111 S.Ct. 654, 112 L.Ed.2d 755 (1991)
4. Palmacci v. Umpierrez, 121 F.3d 781, 786 (1st Cir.1997).
5. In re Biondo, 180 F.3d 126, 134 (4th Cir.1999); In re Hale, 274 B.R. 220, 222-23 (Bankr.E.D.Va.2001).
6. In re Woolley, 145 B.R. 830, 834 (Bankr.E.D.Va.1991) (citing In re Taylor, 514 F.2d 1370, 1373 (9th Cir.1975)).
7. at 834-35.
8. In re Grim, 293 B.R. 156, 163 (Bankr.N.D.Ohio 2003).
9. Umpierrez, 121 F.3d at 787; In re Bonnanzio, 91 F.3d 296, 301 (2d Cir.1996); In re Woolley, 145 B.R. at 835.
10. Umpierrez, 121 F.3d at 789; In re Woolley, 145 B.R. at 836.
11. In re Justice, No. 01-02156, 2002 Bankr.LEXIS 1540, n. 3 (Bankr.N.D.Ohio Dec. 27, 2002). “It is a more subjective standard … that takes into account the interactions between and experiences of the two parties involved.” Id. (quoting Jeffrey R. Priebe, Fields v. Mans and In re Keim: Excepting Debts From Bankruptcy Discharge and The Difference Between Experienced Horsemen and Reasonable Men, 54 Ark. L.Rev. 99, 109-110 (2001)).
12. No. 01-2156, 2002 Bankr.LEXIS 1540 (Bankr.S.D.Ohio).
13. 2002 Bankr.LEXIS 1540, at n.20.
14. 2002 Bankr.LEXIS 1540, at n.16-22.
15. In re White, 128 Fed.Appx. 994, 998, 2005 WL 984195, *3 (4th Cir.2005).
16. Fraudulent solicitations through a church are commonly called “affinity fraud.”