Publicly, Diamond Finance Co. (“Diamond”) provided car loans to individuals with less-than-stellar credit. While Diamond did have “some actual business,” its purpose “quickly became a front to lure unsuspecting investors.”

Like most Ponzi schemes, Diamond eventually collapsed; an involuntary chapter 7 bankruptcy was filed against it. The chapter 7 trustee (the “Trustee”) brought an adversary proceeding against Torac Realty, LLC (“Torac”), an investor in, and lender to, Diamond. After a bench trial, U.S. Bankruptcy Judge Robert E. Grossman ruled that Diamond was a Ponzi scheme, and that the Trustee succeeded on each of its claims. Thus, the transferred funds were recoverable by the bankruptcy estate. In re: Diamond Finance Co., Inc., 20-br-71877, 2024 WL 738564, at *1 (Bankr. E.D.N.Y. Feb. 22, 2024).

Readers may have noticed our many posts about transfers in the days preceding bankruptcy and the ability to recover such assets. The Diamond case provides another interesting example.

The court began with the New York Debtor and Creditor Law (“DCL”). The Trustee’s first three claims concerned constructive fraudulent conveyance under the DCL. To prove such claims, two elements must be met: (1) the transfer was made without fair consideration and (2) one of the following three conditions exist for the transferor: (i) insolvency; (ii) undercapitalization; or (iii) a belief that it will incur debts beyond its ability to pay.

Given the Trustee’s establishment of Diamond as a Ponzi scheme, insolvency was established via the “Ponzi presumption.” Id. at *16. Thus, the question before the court was whether the transfers were made without fair consideration.

The court split its analysis in two. It made short shrift of payments to Torac that went beyond the principal amount paid to Diamond, finding that they were “not made for fair equivalent value.”

Principal repayments, however, required a closer analysis. The Trustee argued that the principal payments to Diamond were not made in good faith, rather, they were made with full knowledge of the Ponzi scheme. The court ultimately agreed, finding that Torac’s relationships with Diamond, including common ownership of a Diamond affiliate, gave it imputed knowledge of the Ponzi scheme. “Therefore, every dollar advanced by Torac did not serve to improve [Diamond’s] financial health but went in large part to pay off new investors, thereby deepening [Diamond’s] insolvency.” Thus, the court found that there was no fair consideration given for the transfers back to Torac as repayment, as “Torac did not take such transfers with the requisite good faith.”

Judge Grossman then held that the same analysis established liability for constructive fraudulent transfer under Bankruptcy Code section 548(a)(1)(B), and similarly rejected a good-faith defense by Torac. The court also rejected Torac’s argument that the transfers made by Diamond’s affiliates, rather than Diamond itself, presented an obstacle. Instead, the Trustee traced the funds sufficiently to meet “his burden of showing that the funds [] paid to the Defendant originated with [Diamond] and are property of the estate.”

The underlying facts and the court's analysis provide clear application of the statutory tests the Trustee needed to satisfy in order to avoid the transfers and permit recovery of the assets secreted in the days before bankruptcy.