UNITED STATES BANKRUPTCY COURT
EASTERN DISTRICT OF KENTUCKY
LEW PERRIN MCGEE CASE NO. 97-50234
ROBERT J. BROWN, TRUSTEE PLAINTIFF
VS. ADVERSARY NO. 99-5037
UNKNOWN DEFENDANT, AND
LEW PERRIN MCGEE DEFENDANTS
This matter presents a question of whether, on the facts presented, a chapter 7 trustee, utilizing the arsenal of avoidance powers of the trustee under the Bankruptcy Code, may recover monies paid by the debtor to an investor during the course of the debtors Ponzi scheme operation.
The complaint in this adversary proceeding is similar to the complaints of the chapter 7 trustee in more than 40 other adversary proceedings against investors caught up in the debtors Ponzi scheme.
The plaintiff, Robert J. Brown, is the chapter 7 trustee of the defendant debtor, Lew Perrin McGee.
The defendant debtor, through false representations, persuaded the defendant Lorenzo Brandenburg to cash out more than $200,000 of his safely invested retirement monies and to turn over the proceeds to the debtor for reinvestment at a higher interest rate. Mr. Brandenburg and many other elderly retired persons targeted by the debtor belatedly discovered the debtor was operating a Ponzi scheme.
The defendant debtor, Lew Perrin McGee, was the proprietor of an insurance agency which he operated under the name of Perrin McGee & Company.
The insurance agency became a front for the debtors Ponzi scheme. From 1991 until early 1995 the debtor was a registered broker-dealer agent employed by Equico Securities, Inc. He was also a registered insurance agent for Equicos parent company, The Equitable Life Assurance Society of the United States, as well as a registered agent for other insurance companies.
The debtors employment as agent for Equico and Equitable was terminated on April 4, 1995. Subsequently, the debtors license as a registered securities broker was terminated by the Commonwealth of Kentucky Department of Financial Institutions. Ultimately, the Department of Insurance terminated the debtors license as an insurance broker. However, the debtor was able to continue his Ponzi scheme activities until the end of 1996.
From at least as early as February of 1993 through December of 1996 the debtor operated a Ponzi scheme, as evidenced by Exhibit A to the complaint. There are indications in the record the debtor commenced his Ponzi scheme activities at an earlier date. Some of the notes attached to the proofs of claim jointly stipulated as admissible as Exhibit N are dated in 1992. The supporting documents attached to the proof of claim of Joseph W. Wright (Claim No. 86), included with composite Exhibit N, indicate the debtor may have commenced his Ponzi scheme operation as early as 1990.
The defendant Lorenzo Brandenburg is typical of the numerous retiree victims of the debtors Ponzi scheme operation. Many of the victims became acquainted with the debtor through the Hunter Presbyterian Church, Lexington, Kentucky, where the debtor sang in the choir. His wife, Joyce H. McGee, was the church organist.
Mr. Brandenburgs son, Larry, introduced his parents to the debtor in 1991. The son was music director at Hunter Presbyterian Church at that time. Although not members of the church, the Brandenburgs attended musical programs at the church arranged by their son. Later, the son worked for the debtor at the debtors insurance and securities brokerage agency for a period of time.
Mr. Brandenburg was born in Fayette County, Kentucky on April 18, 1927. His father died when he was three years old, leaving his mother with eight children, five girls and three boys, all of which she could not support. Mr. Brandenburg and three of his siblings were sent to an orphanage in Tiffin, Ohio. He received schooling and vocational training at the orphanage. He was released from the orphanage in 1943 at age 16 and returned home to help support his mother.
He obtained work for Archer and Smith Tool Company and then Hayden Hardware Company as a sales clerk. He married his wife Lucille when he was only 17 years of age. He served approximately 18 months in the Merchant Marines during and after World War II before returning home and obtaining employment at the W.T. Young peanut butter plant in 1946. He was drafted in 1953 and served a two-year stint in the Army during the Korean War, after which he resumed work at the plant. This was approximately the time Mr. Young was in the process of selling the plant to Proctor and Gamble.
Mr. Brandenburg started working at the plant in 1946 when it was owned by W.T. Young and worked there for nine years before Mr. Young sold the plant to Proctor and Gamble in 1955. He continued to work at the plant for 32 years after it was acquired by P&G. Mr. Brandenburg retired from the Proctor and Gamble peanut butter manufacturing plant at Lexington, Kentucky in 1987 at age 60.
Initially, Mr. Brandenburg worked in the plant as a packer, a traffic manager and buyer. Later he worked in the personnel department, hiring and training employees. He was also Public Affairs Manager, representing the plant in the community. During the period of his employment with P&G, Mr. Brandenburg participated in the companys profit sharing plan, whereby the company put shares of P&G stock in his retirement account each year.
On his retirement from P&G in 1987, Mr. Brandenburg sold most of the P&G stock accumulated in his retirement account and placed the proceeds in an IRA which he established through a local bank. His IRA monies were invested in CDs and mutual funds.
In March of 1992 the debtor approached Mr. Brandenburg about rolling over his IRA into a variable annuity IRA with Equitable. At that time Mr. Brandenburgs IRA was invested in CDs, a Keyport Fixed Annuity and Fidelity and Puritan Mutual Funds. In order to roll over the funds into a new IRA with Equitable, Mr. Brandenburg had to pay a 7% surrender charge on his $100,000 investment in the Keyport Fixed Annuity. The debtor assured Mr. Brandenburg he would recoup this $7,000 loss in a very short time in an Equi-Vest Variable Annuity IRA. Mr. Brandenburg took the loss and moved his IRA investment into an Equi-Vest Variable Annuity IRA with Equitable through Perrin McGee & Company.
After this transaction, between 1992 and 1994, Mr. Brandenburg had very little contact with the debtor. Mr. Brandenburg received periodic statements regarding the status of his investment with Equi-Vest.
In September of 1994 Mr. Brandenburg again was approached by the debtor about a new investment opportunity that would pay a good interest rate over a three-year period, at the end of which Equitable would pay a 25% matching fund. The debtor represented that the investment would be in a special account with Equitable, this special account being Perrin McGees retirement account. Since the money would be in McGees retirement account it would have to be invested in McGees name, but McGee would give his personal note to Mr. Brandenburg for the money going into the retirement account. McGee explained Equitable was offering this opportunity to its top agents and he was one of their top agents.
These representations of the debtor were false. The debtors retirement plan with Equitable was non-contributory and there was no special fund available only to top agents of Equitable. The debtor was deceiving his employer by urging customers to withdraw monies invested with Equi-Vest and deceiving his customers about an investment opportunity that did not exist in order to get his hands on customers savings.
The statements Mr. Brandenburg received from Equi-Vest indicated that as of September 13, 1994, his IRA annuity with Equitable had a value of $213,647.39.
On September 15, 1994 the debtor prepared a worksheet for Mr. Brandenburg indicating that investment of the $213,647.39, plus 25% matching funds of $53,411.85, or a total of $267,059.24 at 8.5% interest would produce an income for Mr. Brandenburg of $22,700.04 per year for three years.
The debtor agreed to reimburse Mr. Brandenburg for the penalty of $11,836.96 Mr. Brandenburg would incur in cashing out his IRA with Equitable.
The debtor also agreed to pay the taxes Mr. Brandenburg would incur for the first year up to $53,411.85 as a result of cashing out the Equitable IRA. The debtor was to be reimbursed for payment of the withdrawal penalty and taxes from the $53,411.85 in matching funds Mr. Brandenburg was to receive from Equitable at the end of the three-year investment period.
The debtor represented that Mr. Brandenburg could withdraw from principal up to 10% of the invested amount each year to make up any deficit in income Mr. Brandenburg needed to meet living expenses, and there would be no taxes due on such withdrawals because the tax thereon was to be paid on cashing out the IRA.
Mr. Brandenburg agreed to this new investment opportunity. On November 1, 1994 the debtor executed his personal note in the amount of $213,647.39 to Mr. Brandenburg payable in three years with interest at 10.75%. On the same date Mr. Brandenburg presented to the debtor a check in the amount of $100,000 and two months later, on January 19, 1995, a check for $94,825.98. These amounts, totaling $194,825.98 represented the amount received by Mr. Brandenburg on closing out his IRA with Equi-Vest, after deduction of the penalty assessed for withdrawal, and perhaps after other expenses relating to the withdrawal or some amount retained by Mr. Brandenburg for living expenses. According to the testimony of Mr. Brandenburg the payments were made in two installments, the first in 1994 and the second in 1995 to minimize the taxes and penalty on the withdrawals from his Equi-Vest IRA with Equitable. See trial transcript, pg. 64. In any event the amount Mr. Brandenburg turned over to the debtor for investment was $18,821.41 less than the amount of the note received by Mr. Brandenburg from the debtor to evidence Mr. Brandenburgs loan of the money to the debtor to be placed in the debtors retirement account with Equitable.
Mr. Brandenburg never suspected the debtor was misleading him in recommending this new investment opportunity. The debtor had previously recommended to him the roll over of his IRA into an IRA with Equi-Vest pursuant to which Mr. Brandenburgs retirement account had grown as anticipated. The debtor was a registered agent for Equitable Life Assurance Society and Equico Securities through which Mr. Brandenburg had invested in his Equi-Vest IRA. The debtor was licensed by the state of Kentucky to sell insurance and securities. The debtor was a pillar of Hunter Presbyterian Church where Mr. Brandenburgs son had been music director; the son had been employed at the debtors insurance agency and securities brokerage business for a period of time. Mr. Brandenburg was led to believe he would not only grow his own retirement account but would also be helping the debtor improve his retirement benefits with Equitable in taking advantage of this new investment opportunity proposed by the debtor.
The parties have stipulated that between January 1, 1992 and December 31, 1996 numerous named individuals entrusted to the debtor monies in the total amount of $4,097,781.07, on the representations of the debtor that such monies would be invested by him in their behalf in a legitimate income earning vehicle or the debtors personal retirement account with Equitable for the benefit of such individuals. Instead, the debtor deposited the monies in his personal bank account at Bank One, Account No. 361-1843, in which the monies were commingled with funds received by the debtor from other sources. The parties have further stipulated that during the period from January 1, 1992 to January 27, 1997 the debtor disbursed from this personal bank account to investors payments totaling $1,776,723.74. These disbursements were represented to be in payment of interest on notes executed by the debtor in exchange for the monies entrusted to him for investment, for reimbursement of expenses of an investor, as for example Mr. Brandenburgs withdrawal penalty and taxes, as evidence of loans from the debtor to an investor, or as evidence of withdrawals in reduction of the principal amount of an individuals investment made through the debtor.
There is a $2.3 million difference between the approximately $4.1 million customers entrusted to the debtor for investment and the nearly $1.8 million the debtor remitted to customers such as Mr. Brandenburg for various reasons, including payments represented to be interest on the notes the debtor had executed to customers in exchange for the monies delivered to him for investment. The record indicates the debtor deposited in his personal bank account the funds of customers entrusted to him for investment and used the funds for personal expenses and possibly to establish or acquire other insurance agencies. The schedules to the debtors petition and his income tax returns indicate he formed Subchapter S corporations to acquire and operate other insurance agencies in several states.
When the debtors Ponzi scheme operation collapsed so did his insurance agencies. The liquidation of the assets of the debtor has produced relatively minimal monies for distribution to creditors. By this and other adversary proceedings the trustee seeks to recover from victims of the debtors Ponzi scheme monies paid to them by the debtor. The trustee believes it is his duty to recover significant payments made by the debtor to several of the participants in the debtors Ponzi scheme operation and to redistribute said monies on a pro rata basis to all of the victims of the debtors Ponzi scheme.
The parties have stipulated that Mr. Brandenburg received payments from the debtor totaling $110,720.39 as follows:
October 14, 1994 $5,000.00 Loan for living
check was due
December 30, 1994 32,817.00 Loan to pay
first year taxes
January 3, 1995 5,741.77 Interest
April 4, 1995 5,741.77 Interest
April 9, 1995 9,120.00 Interest
June 16, 1995 8,825.00 Interest
July 17, 1995 5,741.77 Interest
October 31, 1995 1,500.00 Interest
November 21, 1995 4,341.00 Interest
January 23, 1996 8,825.00 Interest
February 2, 1996 5,741.77 Interest
April 8, 1996 5,741.77 Interest
August 5, 1996 5,841.77 Interest
November 6, 1996 5,741.77 Interest
This is the amount the trustee seeks to recover from Mr. Brandenburg in this adversary proceeding. The amount remitted to Mr. Brandenburg by the debtor is $84,105.59 less than the $194,825.98 Mr. Brandenburg entrusted to the debtor for investment.
The debtor filed a petition for relief under chapter 7 of the Bankruptcy Code in this court on February 5, 1997.
Subsequent to bankruptcy the debtor was indicted by a state court grand jury on 41 counts of theft by deception, 54 counts of securities fraud, and 54 counts of sales of an unregistered security. On March 13, 1998 the debtor entered a guilty plea to numerous courts of theft by deception and a guilty plea to seven counts of sale of unregistered securities, for which the debtor is serving time in a Kentucky state prison.
The indictment for sale of unregistered securities is based on an agreed order entered into by the debtor and the Commonwealth of Kentucky Department of Financial Securities on June 13, 1997 which recites and finds that the notes issued by the debtor to customers, such as the note issued to Mr. Brandenburg on November 1, 1994, constitute securities within the express meaning of KRS 292.310(13) and were fraudulent pursuant to KRS 292.330(1).
The present action was commenced by the filing of the complaint by the trustee, together with similar complaints commencing adversary proceedings against more than 40 other victims of the debtors Ponzi scheme. All of the complaints were filed on February 4, 1999. On that date the trustee filed 43 separate applications in the debtors bankruptcy case for authorization to pay the filing fee in each of the adversary proceedings as an administrative expense. On February 4, 1999 orders were entered on each of the applications granting the trustees request to pay the filing fees in the adversary proceedings as an administrative expense. The parties have stipulated that thereafter the trustee paid the filing fee in this adversary proceeding on February 16, 1999, that the summons was issued on the complaint on February 23, 1999, and that the summons and a copy of the complaint were served on Mr. Brandenburg on March 3, 1999. These facts are recited because the defendant has moved to dismiss the state law fraudulent and preferential conveyance counts of the complaint as barred by the two-year statute of limitations set out in title 11 U.S.C. § 546(a).
CONCLUSIONS OF LAW:
The court is of the opinion this action and the several other actions commenced by the trustee on the same date, insofar as the actions invoke Kentucky fraudulent and preferential conveyance statutes, as made available to the trustee by title 11 U.S.C. § 544(b), were timely commenced. The debtor filed his petition for relief under chapter 7 of the Bankruptcy Code in this court on February 5, 1997. The applicable state statutes of limitation with respect to Kentucky fraudulent and preferential conveyance actions had not expired when bankruptcy intervened. The complaint commencing this action and the complaints of the trustee initiating the several other similar avoidance actions were all filed on February 4, 1999, within the two-year grace period fixed by title 11 U.S.C. § 546(a).
The defendant bases his motion to dismiss the counts of the complaint which invoke Kentucky fraudulent and preferential conveyance statutes on the difference in the wording of Rule 3 of the Federal Rules of Civil Procedure and Rule 3 of the Kentucky Rules of Civil Procedure. Rule 3 of the Federal Rules of Civil Procedure provides a civil action is commenced by filing a complaint with the court. Rule 3 of the Kentucky Rules of Civil Procedure provides a civil action is commenced by the filing of a complaint with the court and the issuance of a summons thereon in good faith. The defendant, relying on the Kentucky rule, argues the complaint, insofar as it invokes Kentucky fraudulent and preferential conveyance statutes, was not timely filed because the filing fee was not paid by the trustee until February 16, 1999, the summons was not issued on the complaint until February 23, 1999, and the summons was not served on the defendant until March 3, 1999.
The problem with the defendants argument is, although certain counts of the complaint invoke Kentucky fraudulent and preferential conveyance statutes, these causes of action would not exist in favor of a trustee in bankruptcy and could not be prosecuted by the trustee but for title 11 U.S.C. § 544(b) which empowers the trustee to prosecute such an action standing in the shoes of a creditor holding an unsecured claim. Thus, avoidance counts of the trustees complaint which call into play state law are in reality federal causes of action in which the extent of the powers of the trustee is governed by state law fixing the rights of an unsecured creditor of the debtor in pursuing the action. These federal causes of action, when filed in the Bankruptcy Court, are governed by the Federal Rules of Civil Procedure. Accordingly, the complaint herein was timely filed in conformity with Rule 7003 of the Federal Rules of Bankruptcy Procedure.
The complaint also invokes the fraudulent conveyance provisions of the Bankruptcy Code, title 11 U.S.C. § 548.
Mr. Brandenburg received payments from the debtor totaling $110,720.39 between October 14, 1994 and November 6, 1996. As previously indicated, the debtors petition for relief under chapter 7 of the Bankruptcy Code was filed February 5, 1997. The number and amount of payments which the trustee seeks to recover under state and federal statutes is constricted by the statute of limitations (the reachback period) applicable to each statute.
The limitation period under the Kentucky statutes for avoidance of transfers alleged to be either actually or constructively fraudulent is five years, KRS 413.120(12), which reach back period encompasses all of the payments received from the debtor by Mr. Brandenburg.
In Count I of the complaint, based on KRS 378.010, the trustee alleges all of the payments which Mr. Brandenburg received within five years of bankruptcy were made by the debtor McGee from property of McGee with intent to hinder, delay, and defraud creditors of McGee.
In relevant introductory paragraphs of the complaint the trustee alleges that between 1993 and 1996 McGee induced customers to transfer to him funds totaling in excess of $3.5 million by falsely representing he was effecting in their behalf transactions in certain securities or investments with the funds when in fact the funds were commingled by the debtor, were not invested, and that the source of funds disbursed to customers such as Mr. Brandenburg was money transferred to McGee by other customers because McGee was operating a Ponzi scheme. The trustee further alleges that at the time Mr. Brandenburg transferred funds to McGee for investment, Mr. Brandenburg at all times had notice of facts sufficient to put him on inquiry that would have led to discovery of McGees fraudulent intent.
In Count II of the complaint, based on KRS 378.020, which provides for avoidance of transfers of property of a debtor that are constructively fraudulent, the trustee alleges all of the payments received by Mr. Brandenburg were made by the debtor from property of the debtor without valuable consideration. The complaint does not allege in this count that the debtor was insolvent at the time of the payments, unless insolvency is to be inferred from the fact the debtor was operating a Ponzi scheme.
In Counts III and IV of the complaint the trustee alleges the payments made by the debtor from property of the debtor to Mr. Brandenburg within one year of bankruptcy are avoidable by the trustee under title 11 U.S.C. § 548(a)(1)(A) as having been made with intent to hinder, delay, or defraud creditors, or in the alternative, under title 11 U.S.C. § 548(a)(1)(B) as having been made by the debtor while insolvent and for less than reasonably equivalent value. Because of the one-year statute of limitations, 11 U.S.C. § 548(b), the payments which the trustee seeks to avoid and recover under Counts III and IV total $17,325.31.
In Count V of the complaint, based on KRS 378.060, the Kentucky preference statute, with respect to which there is a six-month statute of limitations, the trustee seeks to avoid and recover payments received by Mr. Brandenburg from the debtor from property of the debtor within six months of bankruptcy. The trustee alleges these payments, which total $11,583.54, were made by the debtor from property of the debtor while insolvent or in contemplation of insolvency with the design to prefer one or more creditors to the exclusion, in whole or in part, of others.
None of the payments in question were made by the debtor to Mr. Brandenburg within 90 days of bankruptcy. Consequently, the preference avoidance section of the Bankruptcy Code, title 11 U.S.C. § 547, is not invoked.
Defendant Brandenburg contends the funds which the debtor obtained from customers by fraud are not property of the estate. However, the court considers that contention to have been rejected by the Supreme Court in the original Ponzi case. The court held that because Ponzi had defeasible title to the money he had received from dupes such money was property of the estate of the bankrupt for the purpose of determining whether payments made to some of claimants were preferential. See Cunningham v. Brown cited in footnote 1, 44 S.Ct. 424, at pgs. 426-427. Title 11 U.S.C. § 749 is consistent with the holding in Cunningham.
Before discussing the above-mentioned Kentucky fraudulent and preferential conveyance statutes, the court notes there is another state statute of limitation which, although not alluded to in the briefs of the parties, the court believes is applicable to the facts of this case. The debtor was a registered securities broker-dealer. On motion of the plaintiff trustee the court ruled the debtors case should be administered as a stockbroker liquidation proceeding pursuant to Subchapter III of chapter 7 of the Bankruptcy Code. §§ 741-752. This ruling is supported by the fact the Commonwealth of Kentucky Department of Financial Institutions has determined the personal promissory notes the debtor issued to customers in exchange for monies turned over to him for investment were securities within the express meaning of KRS 292.310(13). The notes were not registered as securities. Thus, the issuance of the notes with respect to each of the holders was fraudulent pursuant to KRS 292.330(1). See Agreed Order entered into between the debtor and the Department June 13, 1997.
KRS 292.320 provides:
(1) It is unlawful for any person, in connection with the offer, sale or purchase of any security, directly or indirectly:
(a) To employ any device, scheme, or artifice to defraud;
(b) To make any untrue statement of a material fact
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.
(2) It is unlawful for any person who receives any consideration from another person primarily for advising the other person as to the value of securities or their purchase or sale, whether through the issuance of analysis reports or otherwise:
(a) To employ any device, scheme, or artifice to defraud the other person; or
(b) To engage in any act, scheme, or artifice to defraud the other person.
It appears to the court that the language of this statute clearly encompasses the Ponzi scheme operation of the debtor in this case.
KRS 292.480(1) fixes the civil liability of a person such as the debtor who offers or sells a security in violation of chapter 292 or any rules or regulations promulgated thereunder or who offers or sells a security by means of any untrue statement of a material fact. The seller of a security sold by untruthful representations is liable to the buyer to the extent of the consideration paid for the security, plus interest, costs, and attorney fees, less the amount of any income received on the security.
KRS 392.480(3) provides that [n]o person may sue under this section (which adopts by reference all of chapter 292) more than three years after the contract of sale.
It is established law in this state that the three-year statute of limitation in KRS 292.480(3) rather than the general five-year statute set out in KRS 413.120(12) prevails in actions for fraud in the sale or purchase of securities. City of Owensboro v. First U.S. Corp., 534 S.W.2d 789 (Ky. 1975); First State Bank of Pineville v. Slusher, 101 S.W.2d 661 (Ky. 1937); Carothers v. Rice, 633 F.2d 7 (6th Cir. 1980).
The Kentucky Blue Sky Law statute of limitation, KRS 292.480(3), does not have a discovery exception tolling the statute until the fraud is discovered. Cali-Ken Petro Co. v. Miller, 815 F.Supp. 216 (W.D. Ky. 1993).
In Carothers v. Rice, 633 F.2d 7, the Court of Appeals for this circuit held that although the language of KRS 292.480(1) by its terms specifies the remedy available only to a defrauded purchaser of a security the courts of Kentucky nevertheless have implied a remedy under the statute for a defrauded seller of a security as well.
The pertinent question presented by the facts of the matter before this court is whether a defrauded purchaser of a security has an implied right of action under KRS 292.480(1) to recover payments made by the debtor/seller to another defrauded purchaser on the grounds the payments to the latter were made with intent to hinder, delay or defraud creditors, or were made without consideration, or were preferential.
This court believes that implying such a right of action would be contrary to the measure of damages which the defrauded purchaser of a security is entitled to receive under the statute which is the consideration paid for the security, plus interest, costs and reasonable attorney fees, less the amount of any income received on the security. (Underscoring supplied) If a defrauded purchaser of a security were required to forfeit to a common fund (the bankruptcy estate) all income received on the security in order to share in the distribution of that fund pro rata with other defrauded purchasers of the security, some of whom are not being sued for contribution to the fund because the amount of income they received on the security is too small to warrant action against them, the measure of damages provisions of the statute would be frustrated in an inequitable manner. Moreover, implying a right of action against a defrauded purchaser of a security for the benefit of other defrauded purchasers of the security would result in heaping insult on injury, a consequence to be avoided in the administration of law.
There is the question of whether the remedy provided by KRS 292.480(1) is the exclusive remedy in a securities fraud case or whether KRS 292.480(1) should be administered in tandem with KRS 378.010, 378.020, and 378.060, with the result that the trustee may pursue recovery under the latter statutes restricted only by the three-year statute of limitation in KRS 292.480(3) with respect to recovery under KRS 378.010 or 378.020.
The court is of the opinion that the civil action provided by KRS 292.480(1) was intended to be the exclusive remedy in securities fraud cases and that KRS 378.010, 378.020 and 378.060 are thereby made inapplicable. This in substance was the holding of the Kentucky Court of Appeals in the City of Owensboro case, as recognized by the Sixth Circuit Court of Appeals in the Carothers case.
However, for purposes of finality the court will discuss the applicability of the above Kentucky fraudulent and preferential conveyance statutes.
By Count I of the complaint the trustee seeks to recover the payments in question under KRS 378.010 which is as follows:
378.010 Fraudulent conveyances and encumbrances Void as to whomException.Every gift, conveyance, assignment or transfer of, or charge upon, any estate, real or personal, or right or thing in action, or any rent or profit thereof, made with the intent to delay, hinder or defraud creditors, purchasers or other persons, and every bond or other evidence of debt given, action commenced or judgment suffered, with like intent, shall be void as against such creditors, purchasers and other persons. This section shall not affect the title of a purchaser for a valuable consideration, unless it appears that he had notice of the fraudulent intent of his immediate grantor or of the fraud rendering void the title of such grantor. (1906)
One purpose of the payments made by the debtor to Mr. Brandenburg and other customers was to deceive them into believing their funds were validly invested in interest-bearing securities, a ruse necessary to the perpetuation of the debtors Ponzi scheme.
However, in order to avoid and recover these payments as fraudulent conveyances under KRS 378.010 the trustee must establish that Mr. Brandenburg does not qualify as a purchaser for valuable consideration and that he had notice of the fraudulent intent of the debtor or of the debtors fraudulent scheme.
It is undisputed that Mr. Brandenburg loaned the debtor the sum of $194,825.94 for what Mr. Brandenburg understood was to be an investment with Equitable in the debtors retirement account for the benefit of both parties. This transaction is evidenced by the debtors note of November 1, 1994 in the amount of $213,647.39 issued to Mr. Brandenburg payable in three years with interest at 10.75%. The amount turned over to the debtor for investment is evidenced by two checks, one dated November 1, 1994 for $100,000.00 bearing the notation personal note, and one dated January 19, 1995 for $94,928.94 bearing the notation personal loan. The record establishes the debtor owed Mr. Brandenburg an antecedent debt in at least the amount of $194,928.94 over the period of time payments totaling $110,720.39 were made by the debtor to Mr. Brandenburg. The initial payment of $5,000 made on October 14, 1994 is somewhat difficult to track because on that date Mr. Brandenburg withdrew $105,000 from his Equi-Vest account with Equitable and on November 1, 1994 wrote the check for $100,000 to the debtor marked personal note. In his answer Mr. Brandenburg pleads he repaid the $5,000 loan evidenced by the debtors check in that amount dated October 11, 1994 bearing the notation loan, which Mr. Brandenburg testified was a loan for living expenses. It appears entirely possible the extra $5,000 Mr. Brandenburg withdrew from his Equi-Vest account on October 14, 1994 could have been used to repay the $5,000 loan from the debtor. The parties have not addressed this detail in their joint proposed findings of fact. In any event this appears to be a separate transaction with respect to which the debtor has pleaded the defense of setoff.
In view of the fact Mr. Brandenburg received back from the debtor less than he entrusted to the debtor for investment and was still owed between $84,105.59 and $89,105.59 by the debtor when bankruptcy intervened, the court is satisfied the debtor qualifies as a purchaser for valuable consideration with respect to the payments he received from the debtor.
The trustee argues Mr. Brandenburg has failed to meet the burden of proving he did not have notice of the debtors fraudulent Ponzi scheme. It is interesting to note that under KRS 292.480(1) the burden of proving no misleading or untruthful representations were made is on the debtor/seller, whereas under KRS 378.010 the buyer of a security bears the burden of proving he was not alerted to the sellers fraudulent intent.
The trustee asks the court to infer notice of facts sufficient to put Mr. Brandenburg on inquiry, which would have led to discovery of the fraudulent intent of the debtor. Based on inferences, the trustee argues Mr. Brandenburg is lacking in good faith under an objective standard of evaluation of his conduct.
The trustee asserts the investment opportunity was suspect because all of Mr. Brandenburgs savings were to be invested in the debtors name in the debtors retirement account with Equitable; a prudent investor would have inquired of Equitable and would have learned no such investment opportunity existed; that the promised return on the investment of 8.5% plus 25% matching funds at the end of three years was so extraordinarily high as to trigger inquiry; that the foregoing, plus the debtors offer to pay the large amount of taxes Mr. Brandenburg incurred on liquidation of his IRA was so unconventional that an ordinarily prudent man with knowledge of its terms would have questioned the legitimacy of the deal.
Counterbalancing the factual bases for such inferences is the fact the Brandenburgs met the debtor, Perrin McGee, through the Hunter Presbyterian Church where their son was music director, where McGee sang in the choir and Mrs. McGee was the organist. Also, the Brandenburgs son Larry had worked for a time at McGees insurance agency and brokerage firm. Mr. Brandenburg had transferred his IRA retirement account from a local bank to an Equi-Vest IRA account with Equitable with McGees assistance and had been satisfied with the increased earnings resulting from that transaction. The Brandenburgs personal relationship with McGee, although not close or social in nature, was such that Mr. Brandenburg apparently believed he was converting his investment from one type of investment with Equitable to a more favorable investment with the same company.
The court is not persuaded on objective analysis of the totality of the facts that it should infer that Mr. Brandenburg should have known McGee was acting in a manner disloyal to his employer and scamming established customers of his securities brokerage and insurance agency. The court is convinced Mr. Brandenburg acted in total reliance on the false representations of McGee and acted in good faith in his dealings with Mr. McGee.
Accordingly, the court is of the opinion the trustee is not entitled to recover the payments in question from Mr. Brandenburg under KRS 378.010. The payments were received by Mr. Brandenburg for value and in good faith.
By Count II of the complaint the trustee seeks to recover the payments made by the debtor to Mr. Brandenburg as constructively fraudulent under KRS 378.020 which reads as follows:
378.020. Conveyance or encumbrance without considerationEffect.Every gift, conveyance, assignment, transfer or charge made by a debtor, of or upon any of his estate without valuable consideration therefore, shall be void as to all his then existing creditors, but shall not, on that account alone, be void as to creditors whose claims are thereafter contracted, nor as to purchasers from the debtor with notice of the voluntary alienation or charge. (1907.)
The court has previously concluded Mr. Brandenburg gave valuable consideration in exchange for the payments he received from the debtor. Consequently, the payments are not avoidable and recoverable by the trustee under KRS 378.020 as constructively fraudulent.
By Count V of the complaint the trustee seeks to recover as preferential under KRS 378.060 payments totaling $11,583.54 which the debtor made to Mr. Brandenburg within six months of bankruptcy.
The statute is as follows:
378.060. Preferential conveyance, encumbrance or other act in contemplation of insolvencyEffectException.Any sale, mortgage or assignment made by a debtor and any judgment suffered by a defendant, or any act or device done or resorted to by a debtor, in contemplation of insolvency and with the design to prefer one or more creditors to the exclusion, in whole or in part, of others, shall operate as an assignment and transfer of all the property of the debtor, and shall inure to the benefit of all his creditors, except as provided in subsection (2) of KRS 378.090, in proportion to the amount of their respective demands including those which are future and contingent. Nothing in KRS 378.060 to 378.090 shall vitiate or affect any mortgage made in good faith to secure any debt or liability created simultaneously with the mortgage, if the mortgage is lodged for record within thirty (30) days after its execution. (1910.)
Relying on this statute is somewhat inconsistent with the scheme of distribution in this stockbroker liquidation proceeding wherein recoveries are to be deemed customer property and the proceeds distributed only to customers who are creditors of the debtor rather than for the benefit of all [the debtors] creditors as contemplated by the Kentucky preference statute.
If the statute were applicable, the question becomes whether the debtor made the payments in contemplation of insolvency and with the design to prefer one or more creditors to the exclusion, in whole or in part, of others.
The statute is in the disjunctive.
Assuming the debtor contemplated insolvency the effect of the payments made by the debtor to Mr. Brandenburg and other customers was to prefer such creditors. However, it is not at all clear that the debtors design was to make preferential payments to such creditors. In some instances payments may have been made to creditors to induce them to turn over additional monies to the debtor for investment, as indeed many customers did, as for example the Rosers whose dealings with the debtor are discussed in the courts opinion in a companion adversary proceeding. The effect of these additional investments was to stave off the debtors insolvency.
Design means sinister or hostile scheme. The effect of the payments made by the debtor in furtherance of his sinister Ponzi scheme was to prefer one or more creditors, to the exclusion of others, in whole or in part. However, that is not necessarily what the operator of a Ponzi scheme has in mind. Certainly his purpose in making the payments was to defraud creditors and delay their inquiries concerning monies turned over to him for investment and to induce customers and their friends to turn over additional monies to him for investment. It is not at all clear that the debtors actual intention in making payments to certain customers was to prefer them to the exclusion, in whole or in part, to others. One can infer that his purpose was to perpetuate the ruse that customers were earning steady and significant returns on their investments in order to preserve and extend the life of his Ponzi scheme operation. This inference is more plausible than the inference from the mere fact the payments were made that the intent of the debtor was to prefer the customers who received such payments.
KRS 378.060 which is grounded on the debtors intent in making payments rather than the effect of the payments is not particularly apropos of a Ponzi scheme operation. For this reason, the court is of the opinion Count V of the complaint should be dismissed.
TITLE 11 U.S.C. § 548(a)(1)(A) AND (a)(1)(B)
By Counts III and IV of the complaint, which are grounded on title 11 U.S.C. § 548(a)(1)(A) and (a)(1)(B), the trustee seeks to recover payments totaling $17,325.31 made by the debtor to Mr. Brandenburg within one year of bankruptcy.
Title 11 U.S.C. § 548(a)(1)(A) and (B) provide:
§ 548. Fraudulent transfers and obligations.
(a)(1) The trustee may avoid any transfer of an interest of the debtor in property, or any obligation incurred by the debtor, that was made or incurred on or within one year before the date of the filing of the petition, if the debtor voluntarily or involuntarily
(A) made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted; or
(B)(i) received less than a reasonably equivalent value in exchange for such transfer or obligation; and
(ii)(I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation;
(II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital; or
(III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtors ability to pay as such debts matured.
Title 11 U.S.C. § 548(c) provides:
(c) Except to the extent that a transfer or obligation voidable under this section is voidable under section 544, 545, or 547 of this title, a transferee or obligee of such a transfer or obligation that takes for value and in good faith has a lien on or may retain any interest transferred or may enforce any obligation incurred, as the case may be, to the extent that such transferee or obligee gave value to the debtor in exchange for such transfer or obligation.
Title 11 U.S.C. § 548(d)(2)(A) provides:
(2) In this section --
(A) value means property, or satisfaction or securing of a present or antecedent debt of the debtor, but does not include an unperformed promise to furnish support to the debtor or to a relative of the debtor.
According to legislative history, if the transferees only liability to the trustee is under section 548, and if the transferee takes for value and in good faith, subsection (c) of section 548 grants the transferee a lien on the property transferred or other similar protection. House Report 95-595, 95th Cong., 1st Sess., pg. 375, reprinted in Bankruptcy Service, L.Ed., Vol. 9 and in Collier on Bankruptcy, 15th Ed., Appendix 2.
The court has determined the payments made by the debtor to Mr. Brandenburg are not avoidable under section 544(b) because the payments are not avoidable under KRS 292.480(1) or KRS 378.010, 378.020, or 378.060 by a creditor holding an allowable unsecured claim against the debtor. Section 545 which empowers the trustee to avoid statutory liens is not applicable. Section 547 is not application because more than 90 days elapsed between the date of the last payment and the date the debtor filed his petition for relief under chapter 7 of the Bankruptcy Code.
Consequently, based on the courts finding that the payments in question were received by the debtor for value and in good faith (tested under the objective standard of analysis used by the court), the court is of the opinion the trustee is by the language of section 548(c) barred from relief under section 548 of the Bankruptcy Code.
Accordingly, the court finds Counts III and IV of the complaint should be dismissed.
The defendant has asked for permission to amend his answer to plead the defense of recoupment. The court is of the opinion this request should be granted. Although the defendant made two payments to the debtor evidenced by the checks dated November 1, 1995 and January 19, 1996, these payments were pursuant to a single transaction evidenced by the debtors note of November 1, 1995, a single security. Therefore, because the bankruptcy estates claim against the defendant and the defendants claim against the debtor arise out of a single transaction, the court believes the defense of recoupment should be applicable to the facts presented by this controversy.
Dated this _____ day of November 2000
By the court
JOE LEE, U.S. BANKRUPTCY JUDGE
Robert J. Brown, Esq.
Mary L. Fullington, Esq.
Kevin G. Henry, Esq.
W. Thomas Bunch, Esq.
UNITED STATES BANKRUPTCY COURT
EASTERN DISTRICT OF KENTUCKY
LEW PERRIN MCGEE CASE NO. 97-50234
ROBERT J. BROWN, TRUSTEE PLAINTIFF
VS. ADVERSARY NO. 99-5037
UNKNOWN DEFENDANT, AND
LEW PERRIN MCGEE DEFENDANTS
In conformity with the memorandum opinion of the court this day entered, the court finds the complaint of the trustee in this adversary proceeding should be and hereby is DISMISSED.
In the event any of the counts of the complaint herein should be reinstated, defendant Brandenburg may amend his answer to plead the defense of recoupment.
Dated this _____ day of November 2000
By the court
JOE LEE, U.S. BANKRUPTCY JUDGE
Robert J. Brown, Esq.
Mary L. Fullington, Esq.
Kevin G. Henry, Esq.
W. Thomas Bunch, Esq.
 See Cunningham (Trustee of Charles Ponzi) v. Brown, 265 U.S. 1, 44 S.Ct. 424, 68 L.Ed. 873 (1924), from which the characterization Ponzi scheme is derived.
 The dates the aforementioned state agencies took action against the debtor are not clear. The record indicates the Department of Financial Institutions began its investigation of the debtors activities on February 5, 1997, the date the debtor filed for relief under the Bankruptcy Code.
 This exceeded the interest rate originally represented as 8.5%.
 The record indicates Mr. Brandenburg withdrew $105,000 from his Equi-Vest account on October 14, 1994 and may have used $5,000 of this amount to repay the debtor for a loan of $5,000 for living expenses pending the initial withdrawal from the Equi-Vest account. The loan is evidenced by the debtors check for $5,000 dated October 11, 1994.
 According to the schedules to his petition and his income tax returns the debtor acquired and operated insurance agencies as follows: Perrin McGee & Co.; Blue Creek Insurance Agency, Inc.; Cypress Creek Insurance Agency, Inc.; Fairacres Insurance Agency, Inc.; Interstate Insurance Agency, Inc.; Lakeview Insurance Agency, Inc.; Oakview Insurance Agency, Inc.; Red Mountain Insurance Agency, Inc; and Manzano Insurance Agency, Inc.
 Defendant Brandenburg alleges he repaid this loan before the debtors bankruptcy.
 Rule 7003 of the Federal Rules of Bankruptcy Procedure makes Rule 3 of the Federal Rules of Civil Procedure applicable.
 Compare title 11 U.S.C. § 547(b) wherein preferential payments are determined by the effect of the payments rather than by the intent of the debtor in making the payments.