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In re Telexfree, LLC

United States Court of Appeals, First Circuit

October 29, 2019

IN RE: TELEXFREE, LLC; TELEXFREE, INC.; TELEXFREE FINANCIAL, INC., Debtors.
v.
RITA DOS SANTOS, individually and as putative class representative; MARIA MURDOCH, individually and as putative class representative; ANGELA BATISTA-JIMENEZ, individually and as putative class representative; ELISANGELA OLIVEIRA, individually and as putative class representative; DIOGO DE ARAUGO, individually and as putative class representative, Defendants, STEPHEN DARR, as Trustee of the Estates of TelexFree, LLC, TelexFree, Inc., and TelexFree Financial, Inc., Plaintiff, Appellee, PLAINTIFFS' INTERIM EXECUTIVE COMMITTEE, Interested Party, Appellant.

          APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF MASSACHUSETTS Hon. Timothy S. Hillman, U.S. District Judge

          Robert J. Bonsignore, with whom Lisa Sleboda, Bonsignore Trial Lawyers, PLLC, William R. Baldiga, James W. Stoll, and Brown Rudnick LLP were on brief, for Appellant.

          Harold B. Murphy, with whom Charles R. Bennett, Jr., Andrew G. Lizotte, Shawn Lu, and Murphy & King, P.C. were on brief, for Appellee.

          Before Lynch, Selya, and Barron, Circuit Judges.

          LYNCH, CIRCUIT JUDGE.

         This appeal is from bankruptcy court orders adopted by the district court arising out of the bankruptcies of TelexFree, LLC; TelexFree, Inc.; and TelexFree Financial, Inc. (collectively, "TelexFree"), one of the largest Ponzi/pyramid schemes in U.S. history. The dispute in this case is over who will be allowed to seek to recover payments made by new participants in the scheme to the existing participants who recruited them (the "Contested Funds"). Trustee Stephen Darr is attempting to recoup these Contested Funds through avoidance actions, while victims represented by the Plaintiffs' Interim Executive Committee ("PIEC") are asserting unjust enrichment claims to recover the same sums.

         Adopting the bankruptcy court's analysis, the district court stayed the unjust enrichment claims under 11 U.S.C. § 362(a)(3) based on the following findings:

         (1)that the trustee has standing to bring the avoidance actions because the Contested Funds were "interests of the debtor in property" under 11 U.S.C. §§ 547 and 548;

         (2)that these avoidance actions were themselves "property of the estate" under 11 U.S.C. § 541; and

         (3)that the unjust enrichment claims were acts to "obtain" or "control" property of the estate (i.e., the avoidance actions) --and thus barred by 11 U.S.C. § 362(a)(3) -- because they are "derivative" of the avoidance actions under the analyses set forth in the Second Circuit's Madoff cases. See Picard v. Fairfield Greenwich Ltd. ("Madoff III"), 762 F.3d 199 (2d Cir. 2014); Marshall v. Picard (In re Bernard L. Madoff Inv. Sec. LLC) ("Madoff II"), 740 F.3d 81 (2d Cir. 2014). The net effect of these rulings was to permit the trustee to pursue the Contested Funds and to stop PIEC's efforts to pursue those funds.

         We assess and reject the only arguments that the appellant makes as to why the bankruptcy court erred in ruling that their unjust enrichment claims are stayed pursuant to § 362(a)(3). Those arguments, which we reject, are: (1) that the avoidance action claims are not "property of the estate" within the meaning of that stay provision because the bankruptcy court's "standing" finding is flawed; and (2) that, in any event, the unjust enrichment claims do not seek to "obtain" or "control" the "property of the estate" within the meaning of that stay provision because those claims are not "derivative" of the avoidance action claims under the derivative analyses the Second Circuit employed in the Madoff cases.

         We affirm, write narrowly, and do not reach other arguments or potential arguments. We describe below the facts and, more explicitly, the nature of the dispute between Darr and PIEC.

         I.

         A. The TelexFree Scheme

         TelexFree was a hybrid Ponzi and pyramid scheme that operated in the United States from 2012 until 2014, when its founders were criminally charged, its operations closed, and it declared bankruptcy. It is considered one of the largest such schemes in U.S. history, with approximately $1.7 billion lost and one million participants, many of them immigrants, defrauded.

         The material facts are not disputed by the parties. TelexFree held itself out as a multi-level marketing company that sold international phone subscription packages. Participants paid membership fees to join the TelexFree scheme and have the right to sell phone subscription packages to others.[1] Each participant, including new participants, was assigned an online user account by the company. Many participants had multiple accounts, as they were encouraged to do by the economic incentives of the scheme. The participants, for bankruptcy purposes, later were divided into "Net Winners" and "Net Losers," important concepts which we explain below.

         The actual phone subscriptions sold were tangential to TelexFree's true purpose, like all pyramid schemes. TelexFree's operations, rather, were geared towards recruiting new participants into the scheme. New participants, on signing up, owed a membership fee to TelexFree. Instead of paying TelexFree, new participants could pay the existing members directly, and the existing members could redeem some accumulated "credits" to settle the new members' obligations to TelexFree. New participants then themselves often recruited additional participants into the scheme. Participants who joined early in the scheme could make significant money from all the "downstream" participants, while many newer participants lost money, sometimes their entire life savings.

         TelexFree combined these classic pyramid scheme features with the features of a classic Ponzi scheme. The company advertised that participants could receive guaranteed returns on the money they put into TelexFree, without ever having to sell a VoIP subscription package or even to sign up a new participant. To keep up the facade of a legitimate business, the company required participants to post commercially-useless internet advertisements.

         For example, participants who joined the scheme through the "AdCentral Plan" paid TelexFree $339 -- a $50 membership fee and a $289 contract fee. In return, they were allowed to sell ten VoIP subscription packages (although they were not required to) and were required to post one internet advertisement a day. If the participants met their advertising quota, they would earn the right to sell another VoIP subscription package each week. Or, instead of selling it, they could turn the extra VoIP subscription package back into TelexFree in exchange for twenty dollars' worth of credits. In that way, participants could reliably transform a $339 investment into $1, 040, or a 207% annual rate of return. Other membership plans had even higher rates of return. This was not true compensation for labor but was instead an astronomical guaranteed return on investment, paid for by newer recruits' membership fees.

         Ostensibly, there were three main ways to make money through the TelexFree scheme: selling phone subscription packages, posting internet advertisements, and signing up new participants. Often, TelexFree participants were not paid in cash directly but through digital "credits" that they, under the terms of their subscription contracts, could redeem for cash at a later point.[2]

         The Contested Funds at issue relate to the signing up of new participants. When an existing participant recruited someone new into the scheme, TelexFree would send an invoice to the new participant for the membership fee. One way the new participant could satisfy the invoice was by paying the company the membership fee directly, although only about twelve percent of membership fees were paid that way.

         The much more common method used was that the new participant paid her membership fee directly to the participant who recruited her. TelexFree then would remove from the recruiting participant's account credits of equal value to the membership fee that this recruiting participant retained. TelexFree then considered the new participant's invoice satisfied and, once annually, issued an Internal Revenue Service Form 1099 to the recruiting participant for the value of the credits he redeemed. Existing TelexFree participants could monetize their accumulated credits this fast and reliable way.

         The parties disagree about how to properly characterize these transactions. The bankruptcy and district courts adopted the trustee's characterization. The trustee characterizes this series of transactions as a single "triangular transaction." He argues that the payments made by the new participants to the recruiting participants were integral to the economics of the TelexFree scheme and are best understood as an indirect way for the new participants to pay TelexFree membership fees and TelexFree simultaneously to pay the recruiting participants for their accumulated credits. The concept of one "triangular transaction" was adopted by the bankruptcy court when it approved the net equity formula, discussed below. It is that formula which the trustee will use to distribute estate assets to the TelexFree victims.

         In contrast, PIEC characterizes the triangular transaction as three separate transactions. In its view, since the credits assigned to participants were fictitious and the entire scheme criminal, the bankruptcy court was required to look to only the so-called "participant-to-participant payments" between the new and recruiting participants when analyzing what was an "interest in property" of the debtor for purposes of both Darr's avoidance action claims and whether Darr has standing to recover the Contested Funds. In PIEC's view, the "victims" PIEC represents who want to exercise their "personal rights" against recruiters who "pocketed their hard-earned savings" were the persons harmed, not TelexFree. PIEC wants to recover the Contested Funds through its unjust enrichment claims, but it does not say it will prove its claims on an individual-by-individual basis. Rather, it seeks to prove its claims by reference to the fraudulent scheme.

         B. Procedural History

         When the scheme collapsed in 2014, TelexFree filed a voluntary petition for relief under chapter 11 of the U.S. Bankruptcy Code. Stephen Darr was appointed the trustee of the jointly administered estates on June 6, 2014.

         Darr sought and received two initial rulings from the bankruptcy court: (1) that TelexFree was a Ponzi and pyramid scheme, and (2) that a "net equity formula" should be used to calculate TelexFree victims' potential claims. The net equity formula, which the bankruptcy court approved on January 26, 2016, divides TelexFree participants into groups of "Net Winners" and "Net Losers." Only Net Losers will be creditors in the TelexFree bankruptcy cases.

         Under the net equity formula adopted, the unredeemed credits assigned to participants' user accounts are disregarded, and all of a participant's user accounts are aggregated. Then, "the total amount a participant paid, whether to Telex[F]ree or to a recruiting participant, minus the amount of money that the participant received, whether from Telex[F]ree or a recruiting participant, results in the amount of the participant's claim." "Net Winners," then, are participants who paid less into the scheme than they got out, including through participant-to-participant payments. "Net Losers" are those who paid more into the scheme than they got out. Similar net equity formulas based on the same "net investment method" have been adopted in other Ponzi scheme cases. See Donell v. Kowell, 533 F.3d 762, 771-72 (9th Cir. 2008); Sec. Inv'r Prot. Corp. v. Bernard L. Madoff Inv. Sec. LLC (In re Bernard L. Madoff Inv. Sec. LLC), 424 B.R. 122, 125 (Bankr. S.D.N.Y. 2010), aff'd sub nom. In re Bernard L. Madoff Inv. Sec. LLC, 654 F.3d 229 (2d Cir. 2011).

         In 2016, Darr filed two avoidance class actions in the bankruptcy proceedings against groups of foreign and domestic Net Winners, respectively, seeking to use preferential or fraudulent transfer theories under 11 U.S.C. §§ 547 and 548 (collectively, "Avoidance Actions"). Any ...


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