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September 17, 2014 Articles

"Neo Badges": The Evolution of the Badges of Fraud

History shows that the badges evolve to keep up with the creative spirit of those who commit fraud.

By Ronald Peterson and Landon Raiford

The “badges of fraud” in a fraudulent transfer analysis are one of the most familiar concepts to bankruptcy practitioners. As the popular refrain goes, “[b]ecause proof of actual intent to hinder, delay or defraud creditors may rarely be established by direct evidence, courts infer fraudulent intent from the circumstances surrounding the transfer.” In re Sherman, 67 F.3d 1348, 1353 (8th Cir. 1995). Consequently, courts look for the presence of what colloquially are known as “‘badges of fraud’: proof by a creditor of certain objective facts . . . [that] raise a rebuttable presumption of actual fraudulent intent.” BFP v. Resolution Trust Corp., 511 U.S. 531, 541 (1994). This article addresses the evolution of the badges of fraud from the Statute of Elizabeth to what the authors refer to as the latest “neo badges of fraud.”

The Original Elizabethan Badges of Fraud
“The modern law of fraudulent transfers had its origin in the Statute of 13 Elizabeth, which invalidated ‘covinous and fraudulent’ transfers designed ‘to delay, hinder or defraud creditors and others.’” BFP, 511 U.S. at 540; Statute of Elizabeth, 13 Eliz., ch. 5, § 2 (1571). The Statute of Elizabeth primarily was designed to recover transfers made in connection with criminal acts. Specifically, the Statute of Elizabeth was conceived to close a loophole in the 1559 Act of Uniformity, which required all persons to attend Anglican church once a week or else pay the Crown a fine. Jonathan C. Lipson & Jennifer L. Vandermeuse, “Stern, Seriously: The Article I Judicial Power, Fraudulent Transfers, and  Leveraged Buyouts,” Wis. L. Rev. 1161, 1211 (2013). Parliament, however, discovered that individuals were violating the Act of Uniformity but escaping punishment by transferring their property, in trust, to friends and family and beyond the Crown’s reach. Id. The Statute of Elizabeth rectified this situation by labeling such transfers fraudulent.

Even under the Statute of Elizabeth, the courts wrestled with the fact that it is the rare fraudster who boldly proclaims his or her fraudulent intent. The earliest known articulation of the badges of fraud is found in the most famous Statute of Elizabeth case, Twyne’s Case, 76 Eng. Rep. 809 (Star Chamber 1601), which involved the fraudulent transfer of sheep. The court found a fraudulent transfer and based its ruling on six facts that suggested the transfer was made with the actual intent:

  • “[T]he gift is general, without exception of his apparel, or any thing of necessity. . . .”

  • “The donor continued in possession, and used them as his own; and by reason thereof he traded and trafficked with others, and defrauded and deceived them.”

  • “It was made in secret. . . .”

  • “It was made pending the writ.”

  • There “was a trust between the parties, for the donor possessed all, and used them as his proper goods, and fraud is always apparelled and clad with a trust, and a trust is the cover of fraud.”

  • “The deed contains, that the gift was made honestly, truly, and bona fide. . . .”

Id. at 812–14.

Queen Elizabeth Changes with The Times
The badges of fraud articulated in Twyne’s Case were products of their time and consisted of those machinations that “were early marked in the English mercantile community.” Heath v. Helmick, 173 F.2d 157, 160 (9th Cir. 1949). Times, however, have changed and so have the badges of fraud. While there is no comprehensive list of the badges of fraud, the Uniform Fraudulent Transfer Act provides a robust, illustrative list of modern badges of fraud that courts consistently rely on. These badges include whether the transfer was made to an insider, whether the transfer was concealed, whether the transfer was of substantially all of the debtor’s asset, and whether the debtor was insolvent or became insolvent as a result of the transfer. As with the badges laid down in Twyne’s Case, the modern badges serve merely as guideposts, and the “use of the badges of fraud . . . is also dictated by common sense. . . . [And] a court is not limited to only those factors or ‘badges’ enumerated, but is free to consider any other factors bearing upon the issue of fraudulent intent.” In re Sholdan, 217 F.3d 1006, 1009–10 (8th Cir. 2000).

The ever-evolving nature of the badges of fraud is most apparent in the jurisprudence of the past 25 years, during which the explosion of complicated financial transactions ushered in a new wave of fraudulent transfer litigation. In response to these new fraudulent machinations, courts have recognized new, neo-badges of fraud that are themselves sufficient to find an actual intent to delay, hinder, and/or defraud creditors. These modern badges of fraud include the following:

  • whether the transfer occurred in connection with a criminal or illegal activity (In re Sentinel Mgmt. Grp., Inc., 728 F.3d 660, 668 (7th Cir. 2013); In re Bernard L. Madoff Inv. Secs. LLC, 458 B.R. 87, 104–5 (Bankr. S.D.N.Y. 2011); In re DBSI, Inc., 477 B.R. 504, 509–10 (Bankr. D. Del. 2012));

  • whether the debtor violated a regulatory scheme designed to protect a class of creditors (In re Sentinel, 728 F.3d at 668);

  • whether the debtor issued inaccurate information or failed to disclose material information (Id. at 667; In re Tronox Inc., 503 B.R. 239, 298–99 (Bankr. S.D.N.Y. 2013); ASARCO LLC v. Americas Mining Corp., 396 B.R. 278, 372–73 (S.D. Tex. 2008));

  • whether the debtor engaged in a data wipe (In re Tronox, 503 B.R. at 281–82); and

  • whether the transfer was made without a legitimate business justification (In re Tronox, 503 B.R. at 288–89; In re XYZ Options, Inc., 154 F.3d 1262, 1271 n.16 (11th Cir. 1998); In re The Heritage Organization, L.L.C., 413 B.R. 438, 487–88 (Bankr. N.D. Tex. 2009)).

These neo-badges of fraud simply continue the tradition established in the early seventeenth century of looking to all relevant factors in determining whether fraudulent intent is present. Of course, the particular factors most often considered by the courts have and will continue to evolve as the courts are presented with different forms of fraudulent enterprises and as new fraudulent patterns emerge.

“One Big Badge of Fraud”
Another modern construct is the idea that there are some schemes that are so fundamentally tainted with fraud and malfeasance that any transfer made in connection with that scheme is, as a matter of law, fraudulent. The prime example of such a scheme is the infamous Ponzi scheme, which has come back in vogue in recent years. In this context, the courts have had no trouble holding that “[w]ith respect to Ponzi schemes, transfers made in furtherance of the scheme are presumed to have been made with the intent to defraud for purposes of recovering the payments under §§ 548(a) and 544(b).” Perkins v. Haines, 661 F.3d 623, 626 (11th Cir. 2011); see also Donell v. Kowell, 533 F.3d 762 (9th Cir. 2008); Warfield v. Byron, 436 F.3d 551 (5th Cir. 2006); In re DBSI, Inc., 476 B.R. 413, 422 (Bankr. D. Del. 2012) (where a Ponzi scheme has been established, the court will presume that “all payments made by a debtor in furtherance of a Ponzi scheme are made with actual fraudulent intent”); In re Pearlman, 472 B.R. 115, 123–24 (Bankr. M.D. Fla. 2012); In re Bernard L. Madoff Inv. Secs., 458 B.R. at 105; In re Bayou Grp., LLC, 439 B.R. 284, 305–6 (S.D.N.Y. 2010); In re Manhattan Inv. Fund Ltd., 397 B.R. 1 (S.D.N.Y. 2007).

The guiding principle behind the Ponzi presumption is that a Ponzi scheme is essentially “one big badge of fraud.” In re Polaroid Corp., 472 B.R. 22, 35 (Bankr. D. Minn. 2012) (emphasis in original). In other words, courts have recognized that the Ponzi presumption is simply a conglomerate of badges of fraud that courts have historically found sufficient to shift the presumption of actual fraudulent intent. In re Sholdan, 217 F.3d 1006, 1009–10 (8th Cir. 2000). By definition, Ponzi schemes involve transfers with no legitimate business justification. In re Marroquin, 441 B.R. 586, 599 (Bankr. N.D. Ohio 2010) (“[T]he Ponzi business commonly has little or no legitimate business purpose.”). Ponzi schemes involve criminal acts. See Cunningham v. Brown, 265 U.S. 1, 7 (1924) (describing “the remarkable criminal financial career of Charles Ponzi”); United States v. Deavours, 219 F.3d 400, 403 (5th Cir. 2000) (operators of Ponzi scheme make transfers to investors “to extend their criminal activities and the profitability thereof”). Ponzi schemes are perpetrated based on inaccurate information or failures to disclose material information. In re Bernard L. Madoff Inv. Secs. LLC, 424 B.R. 122, 130 (Bankr. S.D.N.Y. 2010). Ponzi schemes are insolvent from inception, and their insolvency deepens with each transaction. Cunningham, 265 U.S. at 8 (holding that the original Ponzi scheme “was always insolvent, and became daily more so, the more his business succeeded”); Warfield v. Byron, 436 F.3d 551, 558 (5th Cir. 2006) (holding that Ponzi schemes “as a matter of law [are] insolvent [] from inception”).

The history of the badges of fraud shows that the badges constantly evolve to keep up with the creative spirit of those who commit fraud. Today, we are witnessing not only the consolidation of new badges but also the emergence of a super badge of fraud (the Ponzi scheme presumption) whose existence alone shows that a transfer was made with the actual intent to delay, hinder, and defraud.

Keywords: bankruptcy and insolvency litigation, fraudulent transfer, badges of fraud, Ponzi presumption, Twyne’s Case

Ronald Peterson and Landon Raiford – September 17, 2014