In the summer of 2007, we reported on Gredd v. Bear, Stearns Securities Corp. (In re Manhattan Investment Fund, Ltd.),1 decided by the United States Bankruptcy Court for the Southern District of New York. In Gredd, on a motion for summary judgment, the Bankruptcy Court found that monies deposited in a Bear Stearns brokerage account by Manhattan Investment Fund (the “Fund”) and used as margin payments to cover short selling positions were transfers made with actual intent to hinder, delay or defraud creditors that could be recovered by the chapter 11 trustee as fraudulent transfers. In our article on this decision, we called the trustee’s argument a “creative fraud” case, and wondered whether the Bankruptcy Court had used hindsight to question the actions of Bear Stearns. Our concerns now appear well founded, particularly with respect to the actions of Bear Stearns. Whether Bear Stearns acted in good faith has yet to be determined; however, a recent decision by the District Court for the Southern District of New York, at the very least, opens the door to a further fact finding mission.

In Gredd, the Bankruptcy Court based its decision that the transfers could be recovered, in part, on a finding that the Fund was a Ponzi scheme. The Bankruptcy Court concluded that, if a company or a fund transfers money as part of a Ponzi scheme, as a matter of law, it is presumed to be made with actual intent to hinder, delay or defraud creditors. On appeal, in Bear, Stearns Securities Corp. v. Gredd (In re Manhattan Investment Fund Ltd.)2, Bear Stearns challenged this finding, arguing (i) that the payments subject to avoidance were not removed from the reach of creditors when they were placed in the Bear Stearns margin account, (ii) that, as a legal matter, there is no Ponzi scheme presumption and (iii) that, in any event, the returns offered by the Fund were not significant enough to constitute such a scheme.

The District Court found that “once a transfer occurred [from the Fund’s account to the Bear Stearns’ margin account], those contributions were no longer accessible to the Fund”3 or its creditors. The District Court also rejected Bear Stearns’ argument that In re Sharp International Corp., 403 F.3d 43 (2d Cir. 2005) eliminated the Ponzi scheme presumption and held that it continues to apply. The District Court found that the Sharp case, at most, emphasized that the scheme at issue must relate to the allegedly fraudulent transfers. The Court also dismissed Bear Stearns’ argument that, because the Fund did not offer artificially high returns to investors, it was not a Ponzi scheme. The Court reasoned that it was enough that new investments were solicited in order to pay redemption requests of old investors, and that Berger, the key player, was reporting that the Fund was doing exceedingly well. Because the transfers were also in furtherance of the Ponzi scheme (they were used to open new trading positions and to support existing open positions), they were deemed to be made with actual intent to hinder, delay or defraud creditors.

The District Court next reviewed the Bankruptcy Court’s determination that Bear Stearns was an initial transferee under section 550(a) of the Bankruptcy Code. A fraudulent transfer can be recovered from a transferee if the transferee is an initial transferee as opposed to a financial intermediary or mere conduit. The Court found that Bear Stearns was not a conduit because the funds were not received by it in order for Bear Stearns to pass them on to another party. The District Court further found that Bear Stearns had sufficient dominion and control over the monies at issue. Despite the fact that Bear Stearns did not have unfettered control over the transferred funds, so long as there were open short positions, Bear Stearns was able to use the funds to cover these positions. The Court explained that creditors receiving loan repayment have frequently been found to be initial transferees. Because Bear Stearns had enough control over the funds such that it could use the money for its own purposes (to protect itself against possible liability from the Fund’s risky trading), it was an initial transferee.

The District Court then reviewed the Bankruptcy Court’s decision that Bear Stearns had not accepted the transfers in good faith. Pursuant to section 548(c) of the Bankruptcy Code, even if a transfer otherwise meets the requirements of a fraudulent transfer, if it is received in good faith, the transfer cannot be recovered. The Bankruptcy Court had broken the determination of this issue down into two parts: (i) whether Bear Stearns was on inquiry notice of the fraud, and (ii) whether it was diligent in its investigation of the fraud. The District Court found that Bear Stearns was put on inquiry notice the day after one of its employees heard information at a cocktail party that indicated the Fund was reporting positive performance numbers. At that point in time, Bear Stearns did not know how many prime brokers the Fund used, but it did know that Bear Stearns was one of its prime brokers and that the Fund had been losing money in its account.

The District Court, however, also concluded that Bear Stearns took numerous appropriate actions once it was informed that something was amiss. It made numerous inquiries, and even followed up by contacting the Fund’s auditor, Deloitte & Touche, to urge caution in its upcoming audit. Bear Stearns further drafted questions for an investor to pose to Berger in order to clarify the Fund’s position. When the responses to those questions were vague, Bear Stearns contacted other prime brokers, obtained the Fund’s financial statements and informed the SEC of the issues it had with the Fund. The District Court stated that it was not clear whether this level of inquiry showed diligence sufficient to constitute good faith, but it could well meet that standard. The District Court thus concluded that summary judgment on this issue of whether the transfer from the Fund was in good faith was “improvidently granted.”4 The Court explained, “[a]s noted, Bear Stearns took a variety of steps to uncover the truth about the Fund. We cannot say that no reasonable jury could find that Bear Stearns’ actions were diligent.”5 In the end, the District Court reversed this portion of the Bankruptcy Court’s decision and ordered that a trial be held to determine the good faith issue.