JAMES P. SMITH, Bankruptcy Judge.
Before the Court is Plaintiff's complaint to deny discharge of debt under 11 U.S.C. § 523(a). The issue presented is whether Plaintiff has established, by a preponderance of the evidence, that Debtor James M. Donnan, III ("Donnan") knowingly participated in a Ponzi scheme
Donnan is a resident of Athens, Georgia, a former television and radio football analyst and was head coach for the University of Georgia football team from 1996 through 2000. GLC was initially in the business of buying and selling consumer products. Donnan became associated with GLC in 2007. Dr. Fennell was a golf friend of Donnan's and a successful maxillofacial surgeon in Athens. After learning of GLC through Donnan, Dr. Fennell made two investments in GLC in May and August 2010, totaling $450,000. Dr. Fennell died on May 30, 2011, after a long battle with cancer. Plaintiff, his widow, is the executor of his estate.
GLC, while initially conducting a legitimate inventory liquidation business, ultimately devolved into a Ponzi scheme. Between 2007 and 2010, approximately 103 individuals and entities (including Dr. Fennell) invested over $81 million in GLC for the supposed purchase of inventory by GLC. However, during that period of time, GLC purchased approximately $11 million in inventory and had gross sales of approximately $6 million. Nevertheless, during that time, GLC paid its investors over $70 million. Thus, it is clear that the principal source of funds for payment to the investors was the money other investors were putting into GLC, the classic Ponzi scheme model.
Ultimately, the Ponzi scheme collapsed, with Dr. Fennell and many other investors remaining largely unpaid. On February 28, 2011, GLC filed a voluntary Chapter 11 petition in the United States Bankruptcy Court for the Southern District of Ohio. On October 29, 2011, an order confirming a plan of liquidation was entered in the GLC bankruptcy case. James Burritt, who had served as GLC's Chief Restructuring Officer, was appointed Plan Administrator.
Donnan and his wife, Mary W. Donnan
On October 27, 2011, Plaintiff timely filed her complaint objecting to the dischargeability of the claim of $427,500
After the trial, at the Court's request, the parties submitted proposed findings of fact and conclusions of law, followed by replies by each party. Having considered the evidence, the filings by the parties and the relevant legal authorities, the Court now publishes its findings of fact and conclusions of law pursuant to Fed. R. Civ. P. 52(a)(1), made applicable to this adversary proceeding by Bankruptcy Rule 7052.
GLC was started in 2004 by Greg and Linda Crabtree. Until Burritt was retained as Chief Restructuring Officer in December 2010, the Crabtrees were GLC's only officers and directors, and were primarily responsible for its operations. The Crabtrees resigned their positions with GLC on February 21, 2011.
GLC raised capital for its operations from private, third-party investors. Investors were presented with two types of investment opportunities. In some cases, investors were told that they were funding the purchase of specific inventory that had already been presold at a high profit margin. In other cases, they were told they were funding the purchase of close-out seasonal goods (such as Christmas decorations or patio furniture) that would be stored and sold the next season. Most, though apparently not all, investors signed a two paragraph contract
At various times, GLC operated from six locations in West Virginia, Ohio, Tennessee, Indiana and North Carolina. Over the years, GLC opened and closed numerous speciality stores from which merchandise was sold. Some of the third-party investors were involved in opening these speciality stores. In 2010, GLC owned trucks, fork lifts and equipment, had forty employees with a monthly payroll of over $61,000 and had four warehouses full of inventory.
Donnan met Greg Crabtree in spring 2007 through a mutual friend, Dan Shoemaker. His first transaction involving Crabtree was to loan Shoemaker $25,000 for Shoemaker to invest in a deal with Crabtree for the purchase and sale of TVs, refrigerators and other appliance overruns. The transaction was apparently successful because Donnan was repaid.
Thereafter, Crabtree asked Donnan to make a loan to him to buy merchandise that could be resold at a profit. Donnan made the loan which was repaid with interest. Donnan then introduced Crabtree to Maurice Koury, the owner of Carolina Hosiery Mills in Burlington, North Carolina. Koury was a friend of Donnan from the early 1970s when Donnan was an assistant football coach at the University of North Carolina. Koury was a wealthy and highly successful businessman in the areas of clothing manufacturing, real estate and sporting goods. GLC began doing business with Koury by purchasing for resale excess hosiery and socks from Carolina Hosiery.
Koury and Donnan also began making loans to GLC to purchase merchandise for resale. Although some of these investments were not successful, most of them were, resulting in a high rate of return.
Until early 2008, Koury and Donnan were the only individuals loaning money to GLC. Koury's Chief Financial Officer, Milt Perry, was doing due diligence on these transactions, such as reviewing invoices, purchase orders and sales. Although Donnan knew nothing about the business of inventory liquidation, he participated in the transactions in reliance on Perry's due diligence and Koury's business experience and participation. Donnan, Koury and Crabtree also invested in a retail store in Burlington, North Carolina, opened by GLC for the sale of overruns of appliances and Koury's hosiery products.
Beginning in spring 2008, Donnan first began discussing the GLC investments with other people. Crabtree would send Donnan a fax or call him to tell him about potential deals, what the profit on the deals would be and ask Donnan to attempt to raise the money to finance the deals. Donnan would then approach friends and acquaintances, tell them about the potential deals and ask if they wanted to invest.
As stated earlier, from 2007 through 2010, over 103 individuals and entities made investments in GLC. Donnan was one of, if not the primary person raising funds for GLC.
In late January 2010, Donnan met with a number of the larger investors to discuss GLC's operations and opportunities. As stated in a confirming memorandum prepared by one of the investors, the meeting:
This "advisory committee" recommended an audit of GLC's records, a review of its tax filings and a system of checks and balances to separate GLC's funds from Crabtree's retail operations. They recommended the creation of a "Georgia GLC, LLC", with Donnan as CEO. They made several other recommendations as to how the business could be continued in the event something happened to Crabtree and how the business might be expanded to additional geographical areas. Donnan testified that he was not interested in becoming CEO because he did not understand the business of buying and selling inventory and had other interests, including his grandchildren, which occupied his time. However, he did agree to their request that he open a bank account at First Sentry Bank in West Virginia to keep the investment money separate from Crabtree's retail operations and be a signator on that account. This account was opened by GLC in January 2010. There was no other testimony as to additional actions taken by the "advisory committee" or its recommendations.
Until July 2010, it appeared that all of the investor transactions were successful and investors received repayment as promised. However, in early July 2010, Crabtree sent Donnan a fax advising him that one of the deals would have to be restructured because it was not closing as expected. This deal, involving Christmas inventory and only one investor, was to have been repaid in full by August 1, 2010. Crabtree advised Donnan in the fax that it would have to be restructured for payments to be made periodically through September 2010. Subsequently, in September, Donnan asked Crabtree about the status of this deal and Crabtree stated that he still had not been paid for the merchandise, but felt confident the deal would eventually close. At this same time, another investor who had visited the warehouses of GLC reported to Donnan his concern that there was insufficient inventory to accomplish the various agreements which GLC had outstanding.
At this point, Donnan contacted three other investors with business backgrounds in accounting, manufacturing and inventory liquidation and asked them to go with him to GLC's office and warehouse in Huntington, West Virginia to investigate GLC's inventory and operations. This group made three trips to Huntington during October 2010.
After the second trip, the group talked to Crabtree about the need to obtain professional help to restructure GLC. Several investors and Crabtree interviewed different restructuring groups by telephone conference call and retained the firm of Conway McKenzie to do an analysis of GLC. The group also retained counsel to make recommendations on restructuring GLC.
At the conclusion of the last trip, the group met with Crabtree to discuss with him their concerns over GLC's operations and possible solutions. At this meeting, Crabtree disclosed that he had begun to use investor money to pay back other investors. Donnan testified that this was when he learned of the fraud for the first time. At that point, between fifteen and twenty investors (including Donnan) from the Athens, Georgia area formed an ad hoc creditors committee, hired counsel and began investigating GLC's operations. This led to the hiring of James Burritt of Mainstream Management who, on December 7, 2010, became Chief Restructuring Officer of GLC.
Burritt and his management team discovered that GLC had almost no financial records regarding its operations or the investors. The management team had to rebuild the records of the company from bank records obtained from the various banks where GLC had accounts. With significant assistance from Donnan, the management team was able to develop a list of investors and obtain copies of some of their investment contracts.
Burritt testified that he was unable to find any record where specific inventory had been purchased with specific investor funds as those investors had been promised. His team found the warehouses containing the inventory to be in complete disarray, filled with every type of consumer product imaginable. However, there was no inventory control system in place to keep track of the inventory, its cost or value. Much of the inventory, such as outdated food and over-the-counter medicines, was not saleable. His team determined that the cost value of the inventory was approximately $7.7 million.
After recreating the records of the company, Burritt's team was able to track, for the period of 2008 through 2010, the amount of money invested in GLC, the amount of inventory purchased, the sale of inventory and the returns paid to investors. They determined that GLC became insolvent in 2008. An analysis of the records established that GLC was more in the business of bringing in investment capital than producing income from sales. The analysis established that most of the money from investors was used to pay other investors, rather than to purchase inventory or create sales.
Dr. Fennell, Donnan and several other men were golf friends at a country club in Athens, Georgia. Through this association, all of them were aware that Donnan was successfully investing in GLC, as this was a frequent topic of conversation during their golf matches. Frequently during their golf games, Donnan would take calls from Crabtree to discuss potential deals. Over the years, many in the golf group became GLC investors.
In April 2010, Donnan and one of his golf friends were attending the Master's golf tournament in Augusta, Georgia. While there, they ran across Dr. Fennell, who was attending with other friends. Dr. Fennell approached Donnan and told him that he wanted to make an investment in GLC. The next week, the two got together at the golf course in Athens, and Donnan explained to Dr. Fennell how the deal would work. Dr. Fennell had already obtained an investment contract from GLC and signed it there in Donnan's presence. Dr. Fennell then wire transferred $150,000 to GLC's bank account at First State Bank in West Virginia
Subsequently, Dr. Fennell discussed with another golf friend investor a transaction involving patio furniture which GLC would buy as an end of season close-out deal to be sold the following season. This friend had successfully participated in a similar GLC patio deal the year before. Dr. Fennell subsequently advised Donnan that he wanted to make a $300,000 investment in the patio deal. Dr. Fennell obtained a contract from GLC and Donnan provided him with wiring instructions to GLC's bank account at First Sentry Bank.
Plaintiff seeks to bar discharge of the claim by Dr. Fennell's estate on the grounds that the claim was incurred as a result of false pretenses, false representation or actual fraud (11 U.S.C. § 523(a)(2)(A)), embezzlement (§ 523(a)(4)) and willful and malicious injury (§ 523(a)(6)).
In order to establish an exception to discharge under 11 U.S.C. § 523(a), a creditor must have a claim against the debtor. On August 22, 2011, Plaintiff timely filed her proof of claim asserting a claim against Donnan (Claim No. 13-1). However, it is undisputed that the two agreements pursuant to which Dr. Fennell invested in GLC are between GLC and Dr. Fennell. It is also undisputed that the funds went to GLC and not to Donnan.
In his second affirmative defense to the complaint filed in this adversary proceeding, Donnan asserts that he owes no debt to Plaintiff because Dr. Fennell invested in GLC. In his sixth affirmative defense, Donnan asserts:
Then, in his seventh affirmative defense, Donnan asserts, in part, "Defendant objects to the allowance of the proof of claim filed by Plaintiff as she has no claim against Defendant."
Plaintiff alleges in her complaint that Dr. Fennell made these investments in GLC as a result of fraud committed by Donnan. Numerous courts have found that a creditor who provides services to or loans money to a corporation or limited liability company has, for purposes of section 523(a), a claim against an individual debtor who acted as agent of the artificial entity and who personally committed the tortious acts complained of.
As will be explained below, Plaintiff has failed to carry her burden with respect to other elements of sections 523(a)(2), (4) and (6). Accordingly, for purposes of this opinion, the Court will assume, without deciding, that Plaintiff has a claim against Donnan for purposes of section 523(a).
11 U.S.C. § 523(a)(2)(A) bars the discharge of debts resulting from "false pretenses, a false representation, or actual fraud..."
Plaintiff contends that Donnan acted with intent to deceive when he made representations to Dr. Fennell about investing in GLC for the purpose of purchasing inventory when Donnan knew that GLC was operating a Ponzi scheme. However, there was no direct evidence introduced at trial to show that Donnan had prior knowledge of the Ponzi scheme. Donnan testified that he did not learn that Crabtree was funding investor repayments from later investments until October 2010, when Crabtree made the confession to Donnan and other investors. There was no direct evidence to contradict Donnan's testimony.
Relying on a series of cases arising out of Ponzi schemes involving fraudulent conveyance avoidance actions under 11 U.S.C. § 548(a)(1)(A),
It is true that courts have uniformly held that proof of the existence of a Ponzi scheme establishes fraudulent intent for purposes of avoiding fraudulent transfers under 11 U.S.C. § 548(a)(1)(A). For instance, in the case of
As the Eleventh Circuit has held:
To "punish" a debtor who has not knowingly participated in a fraud would be contrary to the purposes of the bankruptcy laws. Accordingly, the Court rejects Plaintiff's argument that proof of the Ponzi scheme alone, without proof of Donnan's knowing participation therein, is sufficient to supply the element of intent required under section 523(a)(2)(A).
Plaintiff contends that Donnan's knowledge of the Ponzi scheme is established by the fact that he kept notes regarding the investments and expected returns by the investors and gave GLC employees instructions as to when payments should be made to the investors. However, Donnan testified, without contradiction, that he kept those notes regarding the investments because he did not know if anyone else was keeping track of the investments and when the payments were due. Nothing in those notes suggests that Donnan was aware that the underlying transactions for the purchase and sale of merchandise were fictitious and not being implemented as represented by Crabtree.
Plaintiff argues that Donnan's knowledge of the Ponzi scheme is evidenced by certain "agreements" between Donnan and Crabtree (prepared in Donnan's handwriting) which were introduced at trial. Some of these documents refer to Donnan and Crabtree as being "partners" or having a "joint venture". The documents describe agreements for Donnan and Crabtree to buy and sell products with money invested by them and other investors (named in some of the documents). Some of the documents state the amounts and timing of repayments of principal and interest to the investors. Others state that the returns are to be determined later. These documents, dated in 2008 and 2009, were signed by Donnan, Crabtree and their wives.
Donnan testified that he prepared these agreements because he wanted to make sure that their wives would have a record of the investments that had been made in the event something happened to him or Crabtree. He stopped preparing these documents when his assistant, Jennifer Gilcrese, began keeping up with the investments on her computer. His testimony showed that, as a layperson, he ascribed no legal meaning to the use of the words "partner" and "joint venture". In any event, all of the documents make reference to specific product deals and there is simply nothing in these documents that would suggest that Donnan knew that the underlying deals were fictitious.
Plaintiff argues that Donnan was a signator on the GLC bank account at First Sentury Bank. Plaintiff argues that Donnan's making payments to investors from this account, into which investor money was being deposited, establishes that Donnan knew that investor money was being used to pay investors. Plaintiff's argument would have merit had she provided a tracing of the funds in and out of this account to show that investors funds were diverted to other investors. However, what little evidence was introduced about this account does not support this argument.
Plaintiff introduced what appears to be portions of the April and May 2010 statements
Plaintiff also argues that Donnan should have known about the Ponzi scheme and acted with reckless disregard for the truth. However, the evidence does not support this argument.
Donnan testified at trial that he was not familiar with the purchase and sales aspect of the business. Rather, when he first started investing in GLC, he simply followed the lead of Koury and Koury's financial officer, who was conducting due diligence. In addition, several investors testified that they had conducted their own investigation of GLC and thereafter met with Crabtree and Donnan to discuss expanding the GLC business. One of these investors, who had considerable experience in the inventory liquidation business, testified that the high rates of return being realized on the GLC investments were not out of line with returns that he had obtained in his own business. Further, in early 2010, Donnan had accompanied Crabtree and another investor to Las Vegas to a convention involving the liquidation business at which over 7,000 people were in attendance. They met with a representative of a large national retailer who discussed with them deals that he had done with Crabtree and discussed possible future deals. They also observed Crabtree negotiating several deals for the purchase and sale of inventory. All of this information led not only Donnan, but several sophisticated and successful businessmen to believe that GLC was a legitimate business. Accordingly, the evidence does not establish that Donnan should have known of the Ponzi scheme or acted with reckless disregard for the truth.
The Court also notes that, on December 6, 2010, the ad hoc committee of investors formed after Crabtree's confession met with Conway McKenzie and the law firm of Morris, Manning & Martin to discuss options for salvaging the GLC situation. The minutes of this meeting were introduced by Plaintiff at trial without objection.
Finally, the testimony of Nelson Bowers was introduced at trial through his deposition. Bowers is a businessman from Lookout Mountain, Tennessee, and a long-time friend of Donnan. After learning of GLC from Donnan, Bowers invested and lost approximately $1.5 million. He testified that, the night before the ad hoc committee meeting, Crabtree told him that Donnan had no knowledge that Crabtree was "taking other people's money and paying off other investors".
In conclusion, the direct and circumstantial evidence introduced at trial does not establish by a preponderance of the evidence that Donnan was aware of or knowingly participated in the GLC Ponzi scheme. Since Plaintiff has failed to establish that Donnan acted with intent to deceive, there is no need to discuss the other elements of section 523(a)(2)(A).
In Count II of her complaint, Plaintiff seeks to except from discharge the claim against Donnan under 11 U.S.C. § 523(a)(4). That provision provides, in relevant part, that a debt incurred through "embezzlement" is nondischargeable.
The evidence is undisputed that, pursuant to agreements with GLC, both of Dr. Fennell's investments were deposited into GLC accounts at banks in West Virginia and were thus never in Donnan's possession. Accordingly, Plaintiff has failed to establish a basis for nondischargeability under section 523(a)(4).
In Count III of her complaint, Plaintiff seeks a determination of nondischargeability under 11 U.S.C. § 523(a)(6). That provision provides for the nondischargeability of a debt "for willful and malicious injury by the debtor to another entity or to the property of another entity".
In the case of
When the debtor has knowingly participated in a Ponzi scheme, courts have found willful and malicious injury for purposes of section 523(a)(6).
The Court, having determined that Plaintiff has failed to carry her burden, will enter an order dismissing Plaintiff's complaint with prejudice. As a result of this decision, Donnan's motion under Fed. R. Civ. P. 52(c) is moot and the Court will enter an order consistent therewith.
