The First Circuit Court of Appeals issued an opinion on October 29, 2019, in In re TelexFree, LLC, No. 18-2001, 2019 WL 5558088, at *1 (1st Cir. Oct. 29, 2019) that has significant consequences for ponzi scheme litigation in bankruptcy court.

The TelexFree Ponzi Scheme and Related Bankruptcy Litigation

The appeal before the court was from bankruptcy court orders adopted by the district court arising out of the bankruptcies of TelexFree, LLC; TelexFree, Inc.; and TelexFree Financial, Inc. (collectively, “TelexFree”), one of the largest Ponzi/pyramid schemes in U.S. history.

Designed to look like a legitimate business, TelexFree was a combination of a Ponzi scheme and a pyramid scheme. Reduced to its essentials, new participants paid previous investors. Those paid more than they invested were called net winners, and those who took out less were referred to as net losers, the same nomenclature used in the Madoff cases.

To generate recoveries for distribution to all net losers, the TelexFree trustee brought fraudulent transfer and preference suits against net winners under Sections 547 and 548. The fraudulent transfer suits were based on the idea that money paid to net winners was actually stolen from net losers.

The dispute in the case was over who would be allowed to seek to recover payments made by new participants in the scheme to the existing participants who recruited them (the “Contested Funds”). The Trustee was attempting to recoup these Contested Funds through avoidance actions, while victims represented by the Plaintiffs' Interim Executive Committee (“PIEC”) were asserting unjust enrichment claims to recover the same sums.

The First Circuit Opinion

In its opinion, the First Circuit upheld the district court and reached the same result as the Second Circuit’s Madoff opinions. See Picard v. Fairfield Greenwich Ltd., 762 F.3d 199 (2d Cir. 2014); Marshall v. Picard (In re Bernard L. Madoff Inv. Sec. LLC), 740 F.3d 81 (2d Cir. 2014).

Adopting the bankruptcy court's analysis, the district court stayed the unjust enrichment claims under 11 U.S.C. § 362(a)(3) based on the following findings:

  1. that the trustee has standing to bring the avoidance actions because the Contested Funds were “interests of the debtor in property” under 11 U.S.C. §§ 547 and 548;
  2. that these avoidance actions were themselves “property of the estate” under 11 U.S.C. § 541; and
  3. that the unjust enrichment claims were acts to “obtain” or “control” property of the estate (i.e., the avoidance actions) -- and thus barred by 11 U.S.C. § 362(a)( -- because they are “derivative” of the avoidance actions under the analyses set forth in the Second Circuit's Madoff cases. See Picard v. Fairfield Greenwich Ltd. (“Madoff III”), 762 F.3d 199 (2d Cir. 2014); Marshall v. Picard (In re Bernard L. Madoff Inv. Sec. LLC) (“Madoff II”), 740 F.3d 81 (2d Cir. 2014).

The net effect of these rulings was to permit the trustee to pursue the Contested Funds and to stop PIEC's efforts to pursue those funds.

On appeal, the First Circuit addressed “only arguments that the appellant makes as to why the bankruptcy court erred in ruling that their unjust enrichment claims are stayed pursuant to § 362(a)(3). Those arguments... are: (1) that the avoidance action claims are not “property of the estate” within the meaning of that stay provision because the bankruptcy court's ‘standing’ finding is flawed; and (2) that, in any event, the unjust enrichment claims do not seek to ‘obtain’ or ‘control’ the ‘property of the estate’ within the meaning of that stay provision because those claims are not ‘derivative’ of the avoidance action claims under the derivative analyses the Second Circuit employed in the Madoff cases.” TelexFree, LLC, No. 18-2001, 2019 WL 5558088, at *1.

As to the first argument regarding the alleged lack of standing by the Trustee to sue net winners (on the theory that the avoidance actions were not estate property), the court soundly rejected the theory, stating:

We affirm the district court's finding that TelexFree had a property interest in the Contested Funds for the purposes of Darr's Avoidance Actions under both §§ 547 and 548, and therefore that Darr has standing to bring his claims. The bankruptcy court carefully evaluated the substance of the TelexFree scheme when it approved the trustee's net equity formula. The formula recognizes that membership fees paid directly to TelexFree -- in which TelexFree indisputably would have had a property interest -- are functionally the same as membership fees that were paid to recruiting participants as part of a triangular transaction. Where membership fees were paid directly to TelexFree, recruiting participants were compensated with credits which, according to the terms of the contract, they could redeem for cash at a later point using money generated largely from membership fees. In the triangular model, new participants gave their membership fees in cash directly to already-recruited participants.

In both situations, participants engaged in a system designed and implemented by TelexFree. New participants knew, or should have known, that the recruiting participant was acting at TelexFree's behest and that the recruiting participant had no authority to let a new participant into the TelexFree scheme unilaterally. On joining the scheme, the new participant received an invoice and user account from TelexFree. Membership in the scheme was governed by a contract that TelexFree wrote. The new participants would have never paid the recruiting participants but for TelexFree's promise that they could join the scheme.

Id. at *6.

The court also rejected two arguments set forth by PIEC for why the Trustee lacked standing. First, the court rejected the contention that the Trustee could not sue, because the contracts with the company were fraudulent and void ab initio. According to the court, the transactions were voidable “at most,” not void. Id.

Second, PIEC took the position that the doctrine of in pari delicto barred the Trustee’s suits. Again, the First Circuit held otherwise, saying in pari delicto “does not defeat [the Trustee’s] standing to bring avoidance actions.” Id.

Finally, the court held that the claims brought by PIEC were derivative of the Trustee’s claims and thus were barred by the automatic stay:

This brings us to the issue of whether PIEC's unjust enrichment claims are derivative of Darr's Avoidance Actions and thus an impermissible attempt to obtain possession of or exercise control over Darr's Avoidance Actions in violation of 11 U.S.C. § 362(a)(3). The bankruptcy court ruled the unjust enrichment claims brought by PIEC are derivative of the trustee's Avoidance Actions because they seek to accomplish the same thing as the trustee's actions and to go about it in the same way. That is, PIEC has admitted that the proposed classes' efforts to prove unjust enrichment will not focus on any supposed wrongdoing by individual Net Winners. Rather, PIEC seeks to prove its unjust enrichment case through the overall fraudulent scheme created by TelexFree. That is what the trustee seeks to do.

Id. at *9.

The opinion from the First Circuit is important inasmuch as it will have a significant effect on how ponzi scheme litigation plays out in bankruptcy court. And because the opinion aligned with the Second Circuit’s holding in the Madoff cases, it is reasonable to suspect that courts outside of the First and Second Circuits may look to follow their lead.