Lenders provide financing to support legitimate business ventures. However, this becomes problematic when the borrower diverts the funds into fraudulent operations like a Ponzi scheme. In such cases, lenders may face far more risk than expected, especially under current bankruptcy laws.
“One of the most critical and potentially devastating legal concepts for lenders is the Ponzi scheme presumption. This presumption allows courts to infer that a debtor operating a Ponzi scheme made payments with the intent to defraud creditors,” says Scott Silver of Securities Fraud Attorneys.
The law does not require the lender to provide direct evidence of fraudulent intent. In practice, this means that even good-faith lenders, who did not know about the fraud, may be subject to clawbacks of payments they received.
In this article, we will examine how the Ponzi scheme presumption works, its legal foundation, and how it can expose lenders to significant losses:
The Nexus Between Ponzi Schemes and Lender Exposure
A Ponzi scheme is a fraudulent investment operation in which the returns to earlier investors are paid using new investors’ capital rather than profits from legitimate business activity.
Operators of Ponzi schemes often borrow money from traditional lenders to sustain the illusion of profitability. They typically use this money to lease office space, purchase equipment, or finance fake operations.
The borrower may appear credible from the outside, and the lender may issue a loan with proper documentation and collateral. But when the scheme collapses and a bankruptcy trustee is appointed, the lender could be pulled into legal proceedings to recover funds distributed by the debtor.
The Laws Governing Ponzi Schemes
You can better understand this concept by considering the relevant laws governing Ponzi Schemes:
Law One: Fraudulent Transfer Law
Section 548(a)(1)(A) of the Bankruptcy Code allows trustees to claw back transfers made by a debtor with “actual intent to hinder, delay, or defraud” creditors. Proving actual intent can be challenging. However, courts have developed shortcuts that reduce the burden of needing evidence.
This is the presumption of Ponzi. Under this presumption, when a trustee successfully establishes that a debtor operated a Ponzi scheme, all transfers made during the scheme are presumed to have been made with fraudulent intent.
It includes transfers to innocent parties, including lenders, vendors, or service providers. In essence, once you identify the scheme, there is no need for further proof to attribute intent to the debtor automatically.
Law Two: Lenders Treated as Scheme Participants
Court precedent once made it possible to treat lenders as participants in a Ponzi scheme. A recent case underscoring the danger for lenders is Poshow Kirkland, Trustee of the Bright Conscience Trust v. Rund (In re EPD Investment Company, LLC), No. 22-55944 (9th Cir. 2024).
In this case, a lender issued a $2 million loan to EPD Investment Company, a business later revealed to be operating a Ponzi scheme.
The lender received payments on the loan. When EPD collapsed, the bankruptcy trustee sued to recover the payments, citing the Ponzi scheme presumption. The court ruled in favor of the trustee, finding that the trustee can recover all payments, except those applied to the return of principal, as fraudulent transfers.
The court rejected the lender’s appeal, emphasizing that good faith alone is not a defense under the Ponzi scheme presumption. Despite acting with no knowledge of the fraud, the lender was treated as part of the general class of victims.
How the Law Applies to the Ponzi Scheme Presumption
It is important to note that, according to the law, the Ponzi scheme presumption does not apply to third-party lenders that give out loans to borrowers who intend to use the money for Ponzi schemes as long as they have obtained collateral.
Furthermore, the lender cannot fight a clawback claim using any regulations in such a case. Therefore, it is essential that when a lender catches a sniff of the borrower’s engagement in a Ponzi, they consider reducing the principal.
Final Thoughts
Given these legal risks, lenders must proactively avoid financing fraudulent ventures. They should conduct thorough background checks on borrowers, including reviews of business operations, financial statements, and third-party audits.
Scrutinize sources of borrower income and ensure that revenue streams are verifiable and consistent with legitimate business models. They should also regularly monitor loan performance and borrower activities. Unusual payment patterns, secrecy, or consistently high returns should raise red flags.
The EPD Investment case is a blueprint for what can go wrong when legal presumptions override individualized assessments. Before issuing loans to unfamiliar borrowers, lenders must adopt heightened due diligence protocols and legal safeguards to protect their capital and reputation.
