The following is a case update written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), analyzing a recent decision of interest:
In a published opinion arising from a Ponzi scheme bankruptcy case, the Seventh Circuit Court of Appeals (the Court) ruled that a transaction whereby a second factor paid off the first factor and received the accounts which were the first factor’s collateral property was not avoidable as a preferential or fraudulent transfer because it was not a transfer of “an interest of the debtor in property.” Mann v. LSQ Funding Grp., L.C., 71 F.4th 640 (7th Cir. 2023).
To view the opinion, click here.
Debtor Engstrom, Inc. was a Ponzi scheme, set up by its CEO Cheri Campion. It fabricated accounts receivable (accounts) which it then sold to support factoring agreements, using the funds received to pay off older debt and enhance Campion’s lifestyle. It eventually crumbled when caught in the fraud. LSQ Funding Group, L.C. was one of the factors; it bought phony accounts and paid Engstrom per its agreements. When it caught onto the fraud, it terminated the agreement, at which time Engstrom owed it $10.3 million. To pay the LSQ debt, Engstrom (allegedly in concert with LSQ) solicited Millenium Funding as a new factor to essentially stand in the shoes of LSQ. Millenium paid LSQ $10.3 million and simultaneously received LSQ’s interest in the accounts. Millenium discovered the accounts were worthless about the time Engstrom filed bankruptcy, within three months of the transaction.
The Chapter 7 trustee (Trustee) filed an avoidance action against LSQ, seeking to recover the $10.3 million as a preferential and/or fraudulent transfer under 11 U.S.C. §§ 547 and 548. The bankruptcy court granted summary judgment for LSQ, dismissing the action, by applying the earmarking doctrine. This doctrine exempts from § 547(b)’s avoidance power financial transactions where one creditor gives a debtor “earmarked” funds to pay off a specific debt and assumes the original creditor’s position, as happened here between Millenium and LSQ. The district court affirmed. Trustee appealed to the Court, which also affirmed but on different grounds.
The Court did not focus on the earmarking doctrine. It instead concentrated on the words of the avoidance statutes – in particular the requirement in both §§ 547 and 548 that the transfer be of “an interest of the debtor in property.” In the context of preferential transfers, “an interest of the debtor in property” is understood “as that property that would have been part of the estate had it not been transferred” before the bankruptcy proceeding, as determined by Circuit precedent. Two approaches were used to determine whether a transfer affected such interest: (1) whether the debtor could exercise control over the property transferred (the control test) and (2) whether the transfer diminished the estate property (the diminution test). The Court concluded the second test was applicable to decide this matter, i.e., whether the transfer of the $10.3 million from Millenium to LSQ diminished the estate. The Court’s quick answer was “no.” The funds had gone directly from Millenium to LSQ, never passing through the debtor’s accounts, and Millenium was instantly substituted as Engstrom’s creditor for LSQ, receiving the same accounts. Trustee even admitted at argument that the transfer did not diminish property available to creditors. No preferential transfer occurred.
Trustee argued, however, that in the fraudulent transfer context, diminishing the estate was not a necessary factor, rather that Ponzi scheme fraud alone made the transfer avoidable. The Court rejected this argument, looking again at the wording of the statute which required the transfer to be of an “interest of the debtor in property.” It saw no reason to construe those words any differently in a fraudulent transfer setting than in a preferential transfer context. So it used the same diminution test: did the transfer result in a loss of property of the estate? Again, the answer was “no,” since the debtor did not own the accounts, which themselves were worthless, as Trustee acknowledged. The Court reinforced the correctness of its conclusion for three reasons: (1) because the same words in different parts of the same act generally have identical meanings; (2) because Supreme Court precedent supported the identical reading; and (3) because other circuits had ruled that Ponzi scheme “outright fraud alone cannot bring a transaction within the avoiding powers of the Bankruptcy Code.” (citation omitted)
The Trustee here argued that because this transaction arose in the context of a Ponzi scheme, which is admittedly a fraudulent transaction, that fact alone provided an exception to the necessity that a fraudulent transfer must remove from the estate some valuable asset which could be used to pay creditors. That argument makes no sense. The whole policy behind recovering fraudulent transfers is to add back into the bankruptcy estate something of value that was transferred away. When what was transferred away did not belong to the debtor, or in this instance was worthless from the beginning, there was nothing lost. Therefore, there is no value to recover. The Seventh Circuit got it right. The lesson for practitioners has to be that whether the diminution test or the control test applies, before you go after a fraudulent transfer, make certain whatever was transferred had value that could have been monetized by the debtor.
This review was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.). Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.