Opinion
Case No. 96-71387-BHL-7A, Adv. Nos. 98-7048, 98-7062, 98-7056
December 9, 1999
ORDER
This matter was initiated by the filing of the aforesaid adversary proceedings and was consolidated for purposes of trial. The trial was conducted on October 19, 1999, at which time the parties were present and were represented by counsel.
The Court, having heard testimony and argument of counsel, and having reviewed the pleadings and applicable law, hereby finds that transfers made from Charter Finance Corporation to the Defendant Investors in the ninety days preceding the filing of the bankruptcy petition herein, constitute preferential transfers which are subject to the Trustee's avoidance powers under § 548 of the Bankruptcy Code. Because the transfers were not in the ordinary course of the Debtor's business, the Court grants judgment in favor of the Trustee in the amount of $15,000 against William E. Laswell, $8,700 against Gerald R. Fowler, and $6,562.47 against Sidney G. Bristow.
IT IS SO ORDERED AND ADJUDGED this __ day of December, 1999, at New Albany, Indiana.
MEMORANDUM
The Trustee filed an Amended Complaint on April 2, 1998, alleging that the officers and directors of the Debtor were involved in a Ponzi scheme, whereby it engaged in a fraudulent arrangement in which the Debtor made payments to investors from money obtained from later investors rather than from profits of the underlying business venture. The matter came before the Court for trial on the Amended Complaint on October 19, 1999. Specifically, the Trustee seeks judgment against the Defendants, Sidney G. Bristow, Gerald R. Fowler, and William E. Laswell.
Charter Finance Corporation is an Indiana corporation which conducted business as a consumer finance corporation in Evansville, Indiana, for over fifty years. The Debtor was in the business of making loans to consumers at interest rates which could be as high as 36%. The Trustee has asserted that the Debtor was insolvent from at least December 31, 1990. Each of the Defendants are alleged to be insiders and investors in the Debtor business.
The Trustee contends that Joseph E. Smith prepared false financial statements for 1991, 1992, 1993 and 1994. He asserts that the Debtor was insolvent from at least December 31, 1990, with unreasonably small capital and that it possessed debts beyond its ability to pay. The Trustee argues that, during that time, the Debtor was unable to make sufficient profits to pay the interest and principal obligations to investors as those obligations matured and that the Debtor was engaged in a Ponzi scheme, wherein the Debtor paid those obligations to investors from funds collected from the transfer of other notes to investors.
The parties have stipulated to the following facts:
1. This Court has jurisdiction over this matter pursuant to 28 U.S.C. § 1334, and § 157(a) and (b) and the General Orders of the United States District Court for the Southern District of Indiana referring all cases and proceedings arising under Title 11 to the United States Bankruptcy Court.
2. Venue is proper in this district pursuant to 28 U.S.C. § 1408 and 1409.
3. Dennis J. Dewey is the duly qualified and acting Trustee in Bankruptcy of Charter Finance Corporation ["Debtor"].
4. Debtor is an Indiana corporation, and presently a debtor in a Chapter 7 bankruptcy case pending before the United States Bankruptcy Court for the Southern District of Indiana, Evansville Division, Case No. 96-71387-BHL-7A.
5. According to the financial analysis prepared by the Trustee's accountants, the Debtor had the following assets, liabilities and equity or deficit based upon fair valuation on the following dates:
Date Assets Liabilities Equity (Deficit)
12-31-90 $1,101,564.00 $5,048,561.00 ($3,946,997.00)
12-31-91 $992,075.00 $6,089,034.00 ($5,096,959.00)
12-31-92 $829,758.00 $7,270,909.00 ($6,441,151.00)
12-31-93 $197,427.00 $9,303,766.00 ($9,106,339.00)
12-31-94 $1,233,492.00 $11,478,250.00 ($10,244,758.00)
12-31-95 $1,063,868.00 $13,593,225.00 ($12,529,357.00)
12-31-96 $246,418.00 $15,623,649.00 ($15,377,231.00)
6. An involuntary Bankruptcy Petition was filed against the Debtor on October 24, 1996 ["Petition Date"].
7. Since at least the 31st day of December, 1990, the Debtor did not receive sufficient income from principal and interest payments from its loan customers to pay principal and interest obligations to the investors on the Investor Notes.
8. False financial statements were prepared by Joseph B. Smith at a time when he knew or should have known that the Debtor was insolvent.
9. The financial statements are false insofar as the Trustee or his agent has reviewed the investor account balances for 1991, 1992, 1993, 1994, 1995, and 1996.
10. In each one of those years, the investor account balances were greater and in excess of the amount reported on the false financial statements prepared by Joseph B. Smith.
11. Joseph Smith was president of Charter Finance Corporation since 1973.
12. Joseph Smith's duties included making loans to and collecting loans from people who came in to Charter to borrow money and to lend money.
13. Joseph Smith, as president of the corporation, never informed directors about the financial condition of the corporation.
14. Since 1973, Joseph Smith, as president of the corporation, was responsible for the entire operations, including meeting with auditors from the Indiana Department of Financial Institutions.
15. The book value of outstanding accounts receivables as of December 31, 1995 totaled $825,699.11.
16. Charter Finance Corporation never kept their books on an accrual method of accounting.
17. Since at least November, 1990, Joseph Smith solicited funs from potential and actual investors.
18. Joseph Smith kept a current account on a weekly basis of how much money he needed to cover cash calls by investors.
19. Joseph Smith knew what he had in the bank or at Hilliard Lyons and how much he had to cover any cash calls by investors and that was how he ran the business.
20. In 1980, the Debtor's bookkeeper left the employment of the Debtor and from that time forward, Joseph Smith did not have accurate or current financial information of the Debtor.
21. Defendants received the transfers or payments from Debtor as set forth on Group Exhibits 2A, 2B and 2C from July 26, 1996 to October 24, 1996, and these transfers were transfers of property of the Debtor.
The parties further stipulation to the following additional facts:
22. Debtor is an Indiana corporation incorporated in 1931, and which continuously, from that date until 1996, conducted a consumer finance business in Evansville, Indiana. Debtor made interest bearing loans [the "Loans"] to customers at interest rates varying from 15% to 36%. Debtor advertised its business in the phone book and through direct mail advertising.
23. Debtor was licensed by the Indiana Department of Financial Institutions [the "Department"] as a supervised lender pursuant to I.C. § 24-4.5-3-502 et seq. and filed the annual reports with the Department. The Debtor was subject to periodic examination of its customer loan records by the Department pursuant to I.C. § 24-4.5-3-506. The Debtor was occasionally cited by the Department for charging interest rates in excess of the statutory limits and ordered to make appropriate refunds.
24. Joseph E. Smith was the president of Debtor since 1973. He was responsible for making and collecting the Loans. He drew a monthly cash salary of $700 and was entitled to car expenses and a yearly bonus. In addition, Smith and his wife, Rita, along with their son and debtor employee, Gerald Smith, invested significant amounts of their own funds in the Debtor, pursuant to the same terms and conditions as the defendants in this action. Smith made cash investments of $70,146.31, with total investments, including accumulated interest of $145,316.08 as a Note Investor. He received payments upon the Notes in the same manner as other Note Investors.
25. Debtor raised capital by issuing notes [individually, a "Note" and collectively the "Notes"] to William E. Laswell, Gerald R. Fowler, and Sidney G. Bristow ["Defendants"] and other investors [collectively, the "Note Investors"].
26. Funds received from investors were used, together with income to the Debtor, in the form of payments of principal and interest from its loan customers, to pay ordinary operating expenses, such as rent and salaries, to provide funds for new loan notes to be made to the Debtor's customers and to pay interest and principal due investors.
27. Investors were given a choice by the Debtor of receiving regular interest payments upon their notes or allowing the interest to accumulate and be reinvested. These Defendants all elected to receive interest payments.
28. The Notes issued to Defendants were for a term of six months at interest rates between 17 1/2% and 18% per annum. At the maturity of the Note, Defendants were entitled to receive the principal amount plus interest. Each month Defendants received interest payments in the amount due and on the date due from Debtor via check. From time to time, although not during the ninety day period immediately preceding the Petition, Defendants may have invested additional money as principal and/or withdrew part of the principal. Debtor routinely complied with the Defendants' requests with respect to the payment or reinvestment of interest and/or principal upon maturity of the Note and conducted its business with Defendants in the same manner throughout its association with Defendants.
29. Interest payment to each Defendant were reported annually by the Debtor on Form 1099.
30. When Debtor mailed checks to Note Investors based on the Notes, Debtor frequently included a form letter that reminded Note Investors of the opportunity to invest additional funds with the Debtor or to tell their friends about investing in Debtor.
31. The parties agree that as of the Petition Date the Defendants had unpaid promissory notes from the Debtor in the following principal amounts: $500,000 (Laswell), Bristow, in excess of $180,000, and Fowler $165,000.
32. The transfers from the Debtor to the Defendants, as itemized in Defendants' Exhibit 11, are avoidable transfers pursuant to 11 U.S.C. § 547(b) unless the transfers also qualify for one of the exceptions to avoidance provided by 11 U.S.C. § 547(c). Those transfers amount to $15,000 to William E. Laswell, $8,700 to Gerald R. Fowler, and $6,562.47 to Sidney G. Bristow.
33. The transfers from the Debtor to each of the Defendants which are at issue in this proceeding were made in accordance with the terms of the agreement in which the debt from the Debtor to each of the Defendants was incurred, in that each payment was made on the date due and in the amount due. These interest payments were made on the date and in the amount due, during the 90 day period immediately preceding the petition date, in the same manner as the Debtor made interest payments prior to this 90 day period to these Defendants and to other investors who requested that interest by paid rather than allowed to accumulate.
Discussion
Since 1924, when the trustees in bankruptcy of Charles Ponzi attempted to recover preferential payments from defrauded creditors, courts have struggled to transform the investors in such schemes into mere creditors. See, Cunningham v. Brown, 265 U.S. 1, 12, 44 S.Ct. 424, 426 (1924). Despite the fact that these individuals may have been fraudulently induced to lend money to the debtor, they must be treated as ordinary creditors to avoid the "race to the courthouse." Id. A Ponzi scheme is simply defined as a fraudulent investment arrangement whereby an entity makes payments to investors from monies obtained from later investors rather than from any "profits" of the underlying business venture. It seems clear, under the aforesaid definition, that the Debtor's business dealings constituted a classic Ponzi scheme. Although the Debtor did operate a legitimate business for years, at some point no later than 1990, and from that point forward, the Debtor solicited investors for the purpose of using the newly acquired funds to meet ongoing cash calls. Whether the corporation was originally operated as a Ponzi scheme or subsequently developed into one, is not a substantive distinction. When the pyramid collapses, the damage is the same. While the Defendants rely upon cases which note that Ponzi schemes are fraudulent at their inception, the facts of this case are not inopposite. It is the fraud which marks the inception of the scheme, regardless of whether that scheme develops during the course of the Debtor's seemingly legitimate business dealings. When subsequent investors begin funding earlier investors' returns, rather than profits from the legitimate business, the fraud has begun.
There was testimony that the Debtor's president, Joseph Smith, did not maintain any books and any financial statements which he did produce were worthless. It was termed a "sloppy operation from A to Z." Whether the onset of the scheme was due to mismanagement or evil intent, the Court need not decide. In Southmark Corp. v. Cagan, 999 F.2d 216 (7th Cir. 1993), the Seventh Circuit similarly concluded that an arrangement whereby earlier investors were paid with money garnered by more recent ones was a Ponzi scheme regardless of whether by "criminal malice or poor business acumen." Id. at 219.
The issue before the Court is whether the Trustee can avoid certain transfers made within the ninety days preceding the Petition Date as preferential. The Defendants argue that any such transfers occurred in the ordinary course of business between the Debtor and the Defendant Investors, and are not avoidable under 11 U.S.C. § 547(c)(2)(B). The majority of the courts which have considered the issue have concluded that the ordinary course defense is unavailing in the context of a Ponzi scheme. See, In re Bullion Reserve, 836 F.2d at 1219 (citing Graulty v. Brooks, 819 F.2d 214, 216-17 (9th Cir. 1987)); accord Wider v. Wootton, 907 F.2d 570, 572 (5th Cir. 1990); In re Montgomery, 123 B.R. 810, 814-15 (Bankr.M.D.Tenn. 1991); In re American Continental Corp., 142 B.R. 894, 900 (D.Ariz. 1992); In re Baker Getty Fin. Serv., Inc., 88 B.R. 792, 799 (Bankr.N.D.Ohio 1988); In re Southern Indus. Banking Corp., 87 B.R. 524, 525 (Bankr.E.D.Tenn. 1988). The Tenth Circuit, however, considered the foregoing and rejected the bright line test adopted by those courts. In re Hedged-Investments Associates, 48 F.3d 470 (1995). In that case, the court observed that
. . . the precedent relied on by the Ninth Circuit in Graulty and its progeny do not support the sweeping rule that § 547(c)(2) has absolutely no application in the context of a Ponzi scheme. Rather, that precedent supports only the narrower proposition that transfers to investors are not entitled to the ordinary course of business exception. This narrower rule is not based, however, on the grounds that Congress did not intend to cover illegitimate businesses under § 547(c), but on the grounds that transfers to investors in a Ponzi scheme are not transfers made "according to ordinary business terms." 11 U.S.C. § 547(c)(2)(C). The ordinary business terms of investment companies does not include payment of fraudulent "profits" to early investors that those investors did not earn, but are made possible only by the investments of later investors-the sine qua non of a Ponzi scheme. Thus, the literal terms of § 547(c)(2)(C) preclude application of the ordinary course of business defense to transfers made to investors in the course of a Ponzi scheme.
Id. at 475. The court noted that its holding bolstered the purposes of § 547(c)(2), i.e. to leave undisturbed normal financial relations.
Under either the narrower standard espoused by the Tenth Circuit, or the bright line test of the Ninth, transfers made to investors in a Ponzi scheme are not made according to ordinary business terms and thus, § 547(c) provides no defense to the Trustee's preference claim.
Based upon all of the foregoing, therefore, the Court enters judgment in favor of the Trustee on his claim under § 548(a)(2)(A) in the amount of $15,000 against William E. Laswell, $8,700 against Gerald R. Fowler, and $6,562.47 against Sidney G. Bristow.
IT IS SO ORDERED AND ADJUDGED this __ day of December, 1999, at New Albany, Indiana.