The potential recovery of more than $1 billion from lenders who profited from relationships with convicted Wayzata businessman Tom Petters, orchestrator of the largest financial fraud in state history, could be in jeopardy as a result of a recent court opinion.
In an unrelated but similar case, the Minnesota Supreme Court ruled last month that Minnesota law doesn’t include a key provision that makes it easier to recover, or clawback, so-called false profits from a Ponzi scheme of the type Petters ran.
Attorneys on both sides of the bar — those who prosecute clawback cases and those who defend clawback targets — are studying the case to assess its impact on recovery efforts in the $3.65 billion Petters scheme.
“The impact of the decision on the Petters’ cases, procedurally and on the merits, is currently up in the air,” said Tom Atmore, a litigation and appellate attorney with the Minneapolis firm Leonard O’Brien Spencer Gale & Sayre. “Among other things, the Minnesota Supreme Court said that each transaction has to be looked at on a case-by-case basis, and the parties and the court will have to sort through what that means for the Petters clawback cases.”
The ruling means clawback lawsuits will have to prove that lenders knew or should have known that they were involved in a Ponzi scheme. Under the decision, mere association with a business venture that turns out to be fraudulent is not necessarily sufficient to force the return of profits.
Under terms of a “Ponzi scheme presumption,” financial transfers between lenders and the scheme operator are considered fraudulent on their face, and lenders cannot recover more than they invested with a debtor. That means that interest payments on the loan can be recovered.
The case causing the stir involved a court-appointed receiver who sought proceeds from loans made by Alliance Bank, a Minnesota bank that became intertwined indirectly with a Ponzi scheme involving First United Funding and Corey N. Johnston, a Lakeville resident currently serving a six-year sentence on federal charges of bank fraud and filing a false tax return.
The Supreme Court ruled that the receiver in the First United case, Patrick Finn and Lighthouse Management Group, lacked legal standing to recover $1.2 million in interest, or profits, that Alliance Bank received through its lending activities simply because United Funding was involved in a larger Ponzi scheme.
“Once the Ponzi scheme presumption is set aside, the undisputed factual record requires summary judgment in favor of Alliance Bank rather than against it,” the Supreme Court said.
In the Petters situation, Petters and his main business entity, Petters Company Inc. (PCI), took out loans to purportedly purchase consumer electronic goods at the wholesale level for resale to big-box retailers.
But the transactions were a sham, for the most part, and lenders were repaid principal and interest with funds provided by newer investors. The elaborate Ponzi scheme lasted for more than a decade until an insider revealed its existence to federal authorities in September 2008.
The bankruptcy trustee for the Petters corporate entity, Doug Kelley, contends the Supreme Court ruling will have little if any impact on his clawback efforts because he can still prove his case by establishing “badges of fraud,” or evidence that shows something was amiss that lenders should have seen.
“Whether I prove the Ponzi presumption or use badges of fraud, I can easily prove fraudulent intent,” Kelley said in an interview. “We have no dearth of direct evidence of fraud in this case.”
To that point, in a ruling last week by the Eighth U.S. Circuit Court of Appeals on a related case involving a lender to Petters-owned Polaroid, the court upheld an earlier decision to deny efforts by lender Ritchie Capital Management to recover funds invested with Polaroid on the grounds that fraudulent activity was readily apparent under the “badges of fraud” application.
There currently are 105 clawback lawsuits active in the Petters bankruptcy, seeking more than $1 billion. The clawbacks range from small individual lenders to international banks.
Of the active clawbacks, Kelley has summary judgment motions pending in 64 lawsuits seeking $85 million. Those suits also seek interest of $34 million for a total of $119 million.
In previous Petters rulings, U.S. Bankruptcy Judge Gregory Kishel has allowed Kelley to proceed with the Ponzi presumption as a legal theory.
“Under Judge Kishel’s previous rulings [on the defendants’ motions to dismiss], Doug Kelley had a relatively clear path to recover what he calls false profits. With the Minnesota decision, that path is no longer clear,” said Stephen Mertz, a bankruptcy and commercial law attorney in the Minneapolis office of Faegre Baker Daniels.