Not Every Fraud is a Ponzi Scheme???

Heavy thoughts

The case of H. Jason Gold v. First Tennessee Bank, N.A. (In re Taneja),  Adversary Case No. 10-1225 (Bankr. E.D. Va. July 30 2012), concerns an elaborate fraud perpetrated by a mortgage broker, Financial Mortgage, Inc. (“FMI”), against various warehouse lenders, and a bankruptcy trustee’s later attempt to recover payments made by the mortgage broker to its innocent lenders as fraudulent conveyances.


Founded in the 1990’s, FMI was a mortgage broker that originated home mortgages for many years legitimately.  However, things changed when competition to originate mortgages became rampid.

In general, FMI obtained a purchaser for the mortgage loans it originated before the payment on the loan was first due. Each mortgage undertaken by FMI was funded on a temporary basis by an advance on a line of credit provided by a warehouse lender, which temporarily funded loans until a secondary mortgage purchaser bought the loan and paid off the advance.  Many times, mortgage loans were pooled together and sold to special purpose vehicles (SPVs), which are commonly referred to as the secondary market.  The SPVs then sold equity interests in themselves to investors to fund the loans.

Mortgage Loan Fraud Assessment based upon Susp...

Starting in 1999, FMI began making loans that it was unable to sell to the secondary market, resulting in an increasing balance on the warehouse lender’s line of credit. The primary warehouse lender ceased making new advances, which lead to FMI finding a new primary warehouse lender, which advanced up to $20 million.  With the new warehouse lender, however, FMI was required to repay the advances within 90 days, whether or not the mortgage was sold to the secondary market.

Beginning in 2000 and 2001, FMI began submitting fake loans to its warehouse lenders.  FMI created bogus loans for the purpose of obtaining advances from the lenders, which advances could then be used to pay down the line of credit used for previous mortgage loans.

After numerous fake loans, the pattern ended because of extraordinary market conditions resulting from the bursting of the real estate bubble, after which secondary mortgage purchasers tightened lending standards and stopped purchasing mortgage loans, particularly subprime mortgages.  According to industry professionals, the secondary market for mortgages nearly collapsed.

By the time it had gotten into serious problems, FMI had already instituted a significant fraud on its warehouse lenders and secondary mortgage purchasers by creating numerous fraudulent loans. The Court found that FMI had a regular practice of forging necessary documents to obtain the advance from the warehouse lender.  A secondary mortgage purchaser subsequently bought the fraudulent loan and repaid the warehouse lender’s advance.  FMI would then make the regular monthly payments for each fake loan with new loans from warehouse lenders, thereby creating an impression that the loans were legitimate.

In 2001, the primary warehouse lender, First Tennessee Bank, N.A., had discovered the scheme and terminated the relationship with FMI.  FMI had paid approximately $3.7 million of loan advances prior to this discovery. When the fraud became apparent, all of FMI’s warehouse lenders had numerous fraudulent loans outstanding.  According to court filings, First Tennessee had lost $5,637,293 in advances and all other lenders and secondary mortgage purchasers had lost more than $33 million.

The owner of FMI ultimately pled guilty to money laundering and is presently in prison.

Ponzi 101

Black’s law Dictionary defines a Ponzi scheme as:

a fraudulent investment scheme in which money contributed by later investors generates artificially high dividend for the original investors, whose example attracts larger investments. Money from the new investors is used directly to repay or pay interest to old investors, usually without any operation of revenue-producing activity other than the continual raising of new funds.  This scheme takes its name from Charles Ponzi, who in the late 1920’s was convicted for fraudulent schemes he conducted in Boston.

In this case, the bankruptcy trustee argued that FMI’s fraudulent scheme was a Ponzi scheme and any party caught within the scheme was liable.  This is an important categorization, as once a fraudulent scheme is deemed to be a Ponzi scheme, a presumption arises that all of the related transactions were made with the intent to hinder, delay and defraud creditors, a critical element of fraudulent conveyance.  This presumption relieves the trustee of the burden of proving that each transaction within a scheme was made with the intend to hinder, delay or defraud creditors.  See Merrill v. Abbott (In re Independent Clearing House Company), 77 B.R. 843, 860 (D. Utah 1987).  The trustee needed to establish a Ponzi scheme, so that it could more easily prove that $3,958,022 in payments made by FMI to First Tennessee Bank were fraudulent conveyances, even though the payments repaid legitimate advances made by First Tennessee.

Court’s Holding

The Court first noted that there was no one definition of a Ponzi scheme.  In addition to the definition provided by Black’s Law Dictionary, several courts have illustrated what a Ponzi scheme looks like.  Most of the courts agree with the description provided by Black’s Law Dictionary, but they elaborate that in a Ponzi scheme there is little or no legitimate business operations and eventually the Ponzi scheme collapses because more and more investors are needed to pay the original investors and the investor pool is a limited resource that eventually runs dry.  According to the Taneja Court, in a Ponzi scheme “[t]here is a mathematical impossibility of continuing the fraud indefinitely, which is contrary to the impression given to the investors that the business venture will continue profitability for the indefinite future.”

The Court then noted the justifications for imposing the Ponzi scheme presumption is equity.  According to the Court, in a Ponzi scheme, the early investors are repaid their investment with an unreasonable profit.  But, by the time the scheme fails, the early investors have their money and their profit and have left the scene.  The most recent investors relied on the same representations and the satisfaction of the early investors, but are left holding the proverbial bag.  All of the investors are similarly motivated and all of them are subject to the same fraud and fraudulent misrepresentations.  The only distinguishing factor is that some were first and others were last; early investors being preferred by the fortuity of timing.  The early investors unwittingly further the fraud by appearing to be satisfied investors.  In these circumstances, it is equitable that all similarly situated victims be treated the same, requiring the early investors to disgorge their investments and profits to a common pot that is shared pro rata among all victims.

The Court ultimately held that the bankruptcy trustee had not met his burden of proving that a Ponzi scheme existed, even though there was ample proof of significant fraud perpetrated by FMI on the warehouse lenders, including First Tennessee, and secondary market purchasers.  According to the Court, all Ponzi schemes are fraudulent, but not all frauds are Ponzi schemes.

In its reasoning, the Court found that there were no high rates of returns provided to First Tennessee.  Rather, all transactions between FMI and First Tennessee were at market interest rates, which were arrived through arms-length negotiations and on ordinary commercial terms.

The Court also noted that FMI did have a legitimate business venture, having been a legitimate mortgage broker more than a decade before it collapsed.  The Court stated:  “It is true that there were many loans that were fraudulent, but the existence of some or many fraudulent loans out of a much larger universe of legitimate loans does not make the business venture an illegitimate or illegal business venture.”

The Court also found significant that neither the warehouse lenders nor the secondary mortgage purchasers were investors in FMI, whereas in normal Ponzi schemes the investors are the ones that look toward the success of the company; not creditors.  The evidence also did not reveal that there was an ever-increasing number of investors, as is usually required to sustain a Ponzi scheme for a while.


In the end, while the Court did not hold that the business of FMI constituted a Ponzi scheme, this holding did not technically preclude the trustee from proving that each payment made by FMI to First Tennessee was made with the intent to hinder, delay and defraud creditors.  The Court’s holding only precluded the trustee from relying on an evidentiary presumption that all transactions involved in a Ponzi scheme are fraudulent.

Nevertheless, the Court did go on to further find that First Tennessee’s actions during the relevant time period would allow it to assert a “good faith defense” under section 550(b) of the Bankruptcy Code, which provides that a transferee of a fraudulent conveyance has an affirmative defense to a recovery by a trustee if the transferee took the conveyance at issue “for value, . . . in good faith, and without knowledge of the voidability of the transfer avoided.”  In this respect, the Court found that First Tennessee had acted as a typical warehouse lender in making advances to FMI and in collecting payments and at no time while it was advancing loans was it aware that FMI was producing fake loans.  The trustee therefore appears to have pursued the wrong party.