Western District of Missouri Bankruptcy Judge Dennis R. Dow holds that, in this bankruptcy preference action against trade creditors (the “Defendants”), the source of funds is irrelevant to the determination of the application of the §547(c)(2) ordinary course defense.  The Chapter 7 trustee (the “Trustee”) argued that the source of the funds debtors Joseph and Rebecca Graff (the “Debtors”) used to pay the Defendants was inconsistent with the ordinary course defense.  The Trustee attempted to bootstrap case authority denying the ordinary course of business defense as to payments to investors in a “Ponzi scheme”.  The Court rejected the argument.  This decision addresses an issue of increasing importance as Chapter 7 trustees seek to apply the Ponzi scheme label to legitimate business dealings in order to establish the prima facie elements of preference claims and defeat preference defenses.

Background:  Debtors Legitimate Contractors

The Debtors were general construction contractors.  The Defendants in the preference actions were the Debtors’ subcontractors who had provided goods and services to property owners for whom the Debtors worked.  The Debtors had agreed with the construction project property owners to use the funds to pay the subcontractors referenced in the construction draw request.  The funds were not used by the Debtors for this purpose.  The Defendants were actually paid from funds from projects on which other subcontractors worked.

The Trustee had conceded that timing of the alleged preferential transfers was consistent with the timing of prepetition payments from the Debtors to the Defendants.  The Trustee’s sole argument was that the the Debtors’ business practices were “quasi-fraudulent”.  It appears undisputed that “the Debtors obtained the funds from the property owners under false pretenses (i.e., representing to the owners that the subcontractors would be paid in accordance with the draw request).”

A Distressed Business vs. a Ponzi Scheme

The Court first rejected the Trustee’s efforts to equate the misrepresentations the Debtors’ used in obtaining the funds to a Ponzi scheme.

[T]he Court rejects the Trustee’s attempt to draw an analogy between the Debtors’ business practices vis a vis these Defendants and a Ponzi scheme. A Ponzi scheme has been described as “a financial fraud in which a purported investment venture uses the capital it receives from a new round of investors to pay off its obligations to a previous round of investors, all the while conducting little or no actual business activity.” In re Bennett Funding Group, Inc., 253 B.R. 316, 318 n.3 (Bankr. N.D.N.Y. 2000)(citations omitted). See also In re Armstrong, 291 F.3d 517, 520 (8th Cir. 2001)(“Ponzi schemes are fraudulent business ventures in which investors’ ‘returns’ are generated by capital from new investors rather than the success of the underlying business venture.”); In re M & L Business Machine Company, Inc., 84 F.3d 1330, 1332 (10th Cir. 1996)(describing a Ponzi scheme as an investment scheme in which investors’ returns are not financed through the success of the underlying business venture, but rather from principal sums of newly attracted investments). The Court recognizes that several courts have concluded that the ordinary course defense is inapplicable, as a matter of law, to transfers made by a debtor engaged in a Ponzi scheme. See, e.g., In re Bullion Reserve of North America, 836 F.2d 1214, 1219 (9th Cir. 1988)(“transfers made in a ‘Ponzi’ scheme are not made in the ordinary course of business”); In re Taubman, 160 B.R. 964, 991 (Bankr. S.D. Ohio 1993)(same); Wider v. Wootton, 907 F.2d 570, 572 (5th Cir. 1990)(same). In a typical Ponzi scheme, the “operator” attracts investors by promising them a substantial return on their investment. Here, the Debtors made no representations to the Defendants other than that they would pay them for their services. In turn, the Defendants’ only expectation was to get compensated. In a typical Ponzi scheme, the operator must rely on the capital infusion of new investors to pay the earlier investors since there is no underlying business to generate income. Here, the source of the Debtors’ payments to the Defendants was income generated from their legitimate construction business. In a typical Ponzi scheme, the operator, motivated by his own financial gain, makes misrepresentations to new investors in order to perpetuate the fraud and continue delivering inflated returns. Here, the Debtors were simply trying to manage their cash flow, pay their subcontractors and suppliers, and maintain their construction business. There is no evidence that the Debtors were engaging in a fraudulent scheme in order to improve their own financial condition. By definition, these Debtors were not operating a Ponzi scheme.

A “Ponzi Scheme By Performance”?

The Court then addressed the Trustee’s contention that the Defendants’ business practices had effectively created a pseudo Ponzi scheme.  The Court carefully disects and distinguishes other bankruptcy court decisions that apparently extended the reasoning of Ponzi scheme cases to legitimate business enterprises.

Although the Trustee does not allege that the Debtors operated a Ponzi scheme in the strict sense, she does allege that these cases involve a “resulting Ponzi scheme” or “Ponzi scheme by performance,” citing In re Nation-Wide Exchange Services, Inc., 291 B.R. 131 (Bankr. D. Minn. 2003). The debtor in that case was a “Qualified Intermediary” for “like-kind exchanges.” The company was retained by owners of business and investment property to receive the proceeds from the sale of such assets and hold them until they were reinvested in similar property. Complications occurred when the principal of the debtor deposited proceeds from various sales into a general account he maintained at a national brokerage firm. He subsequently made numerous short-term “day trades” from this commingled account and lost a substantial amount of the funds the debtor was to administer in like-kind exchanges. As a result, the debtor used the proceeds from sales of clients secured later to meet the disbursement obligations to earlier clients; the conversion of funds led to federal criminal charges against the principal and ultimately, imprisonment. The situation at hand does not fit that scenario. Unlike the debtor in Nation-Wide, the Debtors were engaged in a legitimate business. They were not mismanaging funds entrusted to them by the property owners, nor were they converting the funds for their own financial gain. Rather the payments the Debtors made to their subcontractors and suppliers were funded by their construction projects, and they were merely paying them as cash became available, not unlike many struggling business enterprises.

The Court acknowledges that some courts have extended the reasoning behind the Ponzi scheme cases to legitimate business enterprises that conduct their operations in an unorthodox or illegal manner. The case of First Federal v. Barrow, 878 F.2d 912 (6th Cir. 1989), is indicative of this line of authority. The debtors in Barrow were engaged in the business of mortgage investments. Pursuant to a loan servicing agreement, the debtors purportedly collected the mortgage payments, deposited them into segregated escrow accounts, and made disbursements to the appropriate principal (e.g., the taxing authority, insurance carrier). Instead, all monies received by the debtors were deposited and commingled with existing cash balances, and used to satisfy obligations incurred during previous days, weeks or months. Significantly, the record disclosed that the debtors made disbursements to certain favored creditors on behalf of selective investors. Following the bankruptcy filing, the trustee commenced an action to recover preferential payments; the bankruptcy court held that the transfers were in fact preferential and subject to recovery by the trustee. The Sixth Circuit affirmed the bankruptcy court’s conclusion:

This court cannot seriously consider appellants’ assertions … characterizing the transfers here in issue as transfers made in the ordinary course of business or financial affairs of the debtors, given the totally unorthodox and illegal manner in which debtors conducted their collective business operations during the ninety-day predeclaration period. The obviously calculated fraudulent business manipulations designed to expedite the diversion and misappropriation of the mortgagors’ and appellants’ monies by commingling the purported escrow funds through the Salem Central Account, which consistently had a negative balance, do not comport with ordinary course of business practices commonly pursued by properly conducted mortgage companies or and/or service institutions.

Id. at 918 (citations omitted). See also In re Montgomery, 123 B.R. 801 (Bankr. M.D. Tenn. 1991) (check-kiting in connection with real estate closing business was a form of Ponzi scheme and not entitled to §547(c)(2) protection). Again, this case is distinguishable. The common denominator of the cases holding that the §547(c) defenses are not available is the pervasive nature of the fraud in which the debtors are engaged. Here, the Debtors ran a legitimate construction business, albeit one that was constantly in financial distress. As a consequence, the Debtors were routinely behind in their payments to the Defendants. They followed a course of conduct in their business relationships with the Defendants in terms of payment practices. They were not committing illegal acts nor were they engaging in activities that would result in their own personal gain. They were simply trying to stay afloat. While the Court acknowledges that there may have existed slight discrepancies in terms of the amounts in the draw requests submitted by the Debtors and misrepresentations as to the specific subcontractors who were to receive the funds, those business practices hardly rise to the level of fraud apparent in Ponzi-like schemes.

The Source of Preferential Payment Simply is Irrelevant

Finally, the Court honed in on the critical question – In the context of a Ponzi scheme or business conducted in an illegal manner, can the ordinary course defense be available to protect creditors providing legitimate goods and services.  In responding to this issue, the Court focuses on the business relationship between the debtor and the trade creditor as distinguished from the relationship that created the elements of the illegal enterprise.

Other courts have disagreed with this broad-brush approach of making the ordinary course defense unavailable, as a matter of law, when the debtor is conducting business in an unorthodox or illegal manner. In Hedged-Investments, supra, for example, the Tenth Circuit reviewed the line of cases and the underlying policy of §547(c)(2), and concluded that they “do not support the sweeping rule that §547(c)(2) has absolutely no application in the context of a Ponzi scheme.” Hedged-Investments, at 476. Instead, the court found that the precedent supports a narrower proposition:

[T]he 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….none of the provisions of §547(c)(2) preclude its application to transfers made to noninvestor-creditors in the ordinary course of business and according to ordinary business terms. Moreover, the purposes of §547(c)(2) clearly are served by permitting its application to noninvestor-creditors whose transfers are received in the ordinary course of business….If, for instance, a Ponzi scheme uses telephone services, is billed for that service, and pays the phone company, disallowing the avoidance of that payment following a bankruptcy petition is consistent with the purposes of §547.

Id. (emphasis in original). See also M & L, at 1340 (rejecting the “sweeping rule” in favor of one allowing the ordinary course defense to be applied to payments made to non-investment creditors). In this case, the alleged preferential transfers were made to non-investors, but not in the context of a Ponzi scheme. Thus, while these cases do not involve facts which comport exactly with the facts at hand, the Court is persuaded by the reasoning behind them. If the transferee’s only expectation was to get compensated for services provided, and the debtor made the transfer in the ordinary course of their business dealings, then permitting the application of the §547(c)(2) defense in that context is wholly consistent with its purpose.

The Trustee’s position that the source of funds is relevant to a preference analysis is not supported by the statute itself or relevant case law. The consideration of how the transferor acquired the funds paid to the transferee is not encompassed by either the express language of §547, which focuses on the relationship between the debtor and the transferee, or the four-part test traditionally used by the courts to evaluate the ordinary course of business defense, no part of which implicates the source of funds used by the debtor to pay creditors. Additionally, allowing the defense in this context does not promote inequality among creditors and a “race to the courthouse” by any one creditor as the Trustee suggests. There is no evidence that the Debtors favored one subcontractor over another.

Finally, the Trustee’s position is untenable. It would not only require creditors to track the source of their payments, but also to monitor representations debtors made to third parties regarding their use of funds. That burden would most certainly deter rather than facilitate the customary transactions that §547 was designed to protect, a burden this Court is unwilling to impose. Therefore, the ordinary course of business defense should be available under these facts and evaluated according to traditionally applicable factors.