The Case Of The Clawback Crusader

While our country awaits the decision of the US Supreme Court in the so-called Obamacare case, there is another fascinating legal battle going on right here in Minnesota.

Imagine that you are the pastor of a medium size congregation on the outskirts of the Twin Cities metro area. Every year the population of your town is increasing, and with that trend comes a growth spurt for your congregation and the need to expand your facilities. You and your parishioners pray that you will find the means to make that expansion happen, and soon thereafter a donor comes forward with a six or seven figure check. Plans are drawn, a new addition (perhaps a community center where seniors can gather, or a pre-school and day care facility) is constructed, and your building is no longer overcrowded. You feel blessed, and lucky. But, several years later you learn that the donor was a major Ponzi scheme operator, and that the funds he gave you were tainted. Now the government wants you to return that money. Since the money is already spent, in the form of bricks and mortar, that just might be kind of hard to do.

In a different scenario, imagine that years ago you invested most of your life's savings with that same Ponzi schemer, thinking that not only would your money be safe but that you would earn a decent return on your investment. Now your money, along with funds entrusted with that schemer in good faith by hundreds of other innocent people like yourself, has vanished. The money that all of you thought was being invested was actually spent either to support the extremely lavish personal life style of the Ponzi artist, or to pay off people who unwittingly invested before you did.

The two situations described above are not uncommon in the aftermath of the Tom Petters scandal which rocked Minnesota when it first came to light four years ago. By way of background, a Ponzi scheme entails an investment of funds by an initial group of innocent people who are led to believe that the person with whom they are investing will, in turn, reinvest their funds on the individuals' behalf. But instead of making those investments that the Ponzi artist has described to the individuals, he uses the money for other purposes, such as funding his own personal expenses or putting the money in a different investment vehicle than the one promised. Meanwhile, the artist concocts phony statements which look like the real McCoy to the unsavvy investors, with those statements showing a much more handsome rate of return than those people could get anywhere else. Hardly any of the original investors ask to cash out, because they have been led to believe, via verbal assurances and the phony statements, that they are making money hand over fist. In the unlikely event that an original investor does want out, the funds for liquidation come from a second wave of innocent investors. In other words, the first investors are being paid with the seed money invested by the second investors, and so on down the line.

In the Petters' racket, he created phony statements showing investment in goods which, he said, were being sold as inventory to big box retailers such as Best Buy. By the time his accomplice, Deanna Coleman, ratted on him to the US Attorney's office, Petters' Ponzi scheme had resulted in $3.65 billion (that's with a "b") worth of investments made by unsuspecting individuals going down in flames. There was no contract with any retailer. Petters was found guilty and was sentenced to fifty years (compared to Coleman's slap on the wrist of a one year sentence). Petters' companies were forced into bankruptcy, which is under the jurisdiction of the federal court. The court has appointed Doug Kelley, whom I have dubbed "the Clawback Crusader," as the trustee in bankruptcy.

As in any bankruptcy, the job of the trustee is to try to make the pot of dough for the unsecured creditors of the bankrupt debtor as large as possible. One of the tools available to the trustee is the clawback procedure. In a clawback, the trustee forces the recipients of so-called "ill gotten gains" from the debtor to return the money to the court, via the trustee. The theory behind the clawbacks is this: the money obtained in good faith by the unsuspecting party (such as the congregation in my first scenario above) from the bad guy was not his to give in the first place. As cold as that seems, Kelley's argument is that permitting the non-profit recipients to keep the money donated to them by Petters would be unfair to the folks who got screwed by Petters, such as the investors in my second scenario above. Kelley estimates that the amount of money he's targeting for clawbacks is $425 million! At the end of the day (if you can stand that cliche), either the congregation will have to somehow find a way to give the Petters donation back, or the original investors will be left out in the cold, with none of their investments salvaged.

This week, the Minnesota state legislature passed a bill giving the non-profits a huge break. Under the newly passed law, non-profits would only be subject to the trustee's clawback with respect to those funds received from the debtor (in this case, Petters) within two years of the clawback demand. Any funds received further in the past could be kept. (The old law was a six year statute of limitations.) Governor Dayton signed the bill into law, over the dramatic objections of Kelley. Kelley has yet to announce if he will appeal.

The new law obviously works to the severe detriment of the investors. The money which trustee Kelley will be able to recoup for them under the clawback will be significantly less, because Petters made almost all of his donations to the non-profits more than two (but less than six) years ago. Most of those donations were subject to the clawback under the old law, but not under the new one. Conversely, many of the non-profits, such as Minnesota Teen Challenge, Big Brothers And Big Sisters Of The Twin Cities, and the College Of St. Benedict, praised Dayton and the legislature. For now, they can breathe a sigh of relief.

The fact that I was a not a bankruptcy lawyer does not stop me from making a prediction here. If Kelley appeals, I believe he has a better than even chance of getting the new law overturned on the grounds of it being unconstitutional. In my view, the investors have a better claim to those funds than do the non-profits, notwithstanding the fact that the non-profits have long-since spent the money. Additionally, I question whether Minnesota lawmakers can pass such a law retroactively. The rules of the game (reducing the statute of limitations from six years to two) should not be changed after the horse is already out the barn door. Finally, the Bankruptcy Code is a federal law, and if a conflict is deemed to exist between federal and state law, the bigger boys are going to prevail.

Whether or not my prediction proves accurate, this is a very sorry state of affairs. It is impossible for both the non-profits and the investors to win. They are both victims, but one of them will be the much bigger loser.