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Charities Face Greater Threat From Ponzi Schemes Than Lost Investments

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The Country Music Hall of Fame received a valuable addition to its permanent collection when a mandolin and guitar used by legendary musicians Maybelle Carter and Bill Monroe were donated by an ostensibly successful businessman. But when the donor was accused of operating a Ponzi scheme and a bankruptcy trustee was appointed, the gift became a costly one. The trustee sued the Hall of Fame to recover the value of the donated instruments, and the Hall of Fame in late 2008 ended up settling for $750,000.

The same lesson is being learned by other nonprofits and charities as the troubled economy triggers the unraveling of many fraudulent schemes: those organizations can be required under the law to pay back donations received in perfect innocence from Ponzi scheme operators.

With last year's collapse of perhaps the largest Ponzi scheme in history, Bernard Madoff's, many people, including charities, became aware that trustees or receivers of failed companies can bring lawsuits to "claw back" distributions of fictitious profits to help offset losses by other investors.

The publicized clawback actions in the Madoff case involve recouping distributions of bogus returns on invested funds. The Country Music Hall of Fame's experience illustrates a risk that is much less well-known but equally real: even simple donations from perpetrators of fraudulent investment schemes can be subject to these same "clawback" lawsuits.

These suits, based on the legal theory of fraudulent transfer, allow for the recovery of transfers of funds by companies engaged in frauds where the transferor -- i.e., Madoff's company -- did not receive "full value" when it paid out cash to an investor liquidating his or her supposed investment. Since, as we now know, there was no investment, Madoff's company was just transferring the money of other investors, and getting nothing in return.

In the case of a charitable donation, it is relatively easy to show a lack of full value, since a donation is by definition a gift rather than an exchange for value.

As a result, trustees and receivers, who have a duty to try to recover as much as they can to compensate a creditor, have brought lawsuits to recover donations made by architects of Ponzi schemes. In one case, a court required a religious organization named Campus Crusade and other religious groups to return all of the $1.7 million they received from the architect of a Ponzi scheme and suggested that the donations were "part of the fraudulent scheme to impress investors."

Another court required several religious organizations to give back the full amount received from a Ponzi scheme, even though the religious organizations had already spent the donations on missionary endeavors and other charitable purposes in the United States and abroad. The court explained why the charities had no right to keep money donated by the perpetrator of a fraud: "A thief rushes into a church, and unobserved by anyone drops the money he has stolen from his victim into the collection plate. Does the church obtain good title as against the thief's victim? It does not. The case is only slightly more difficult if the 'thief' obtained the money by fraud rather than by larceny."

There is something curious about these kinds of cases. They involve suits against charities and other nonprofits, who are generally using the donation to further a charitable or educational mission. And they typically do not involve any wrongdoing by the recipient of the gift. While there have been cases where the charities were in some way connected to the operator of the fraudulent scheme, there is no legal requirement that such a connection or knowledge of the fraud be shown. A charity can be sued for a fraudulent transfer where it has acted in complete innocence.

For this reason, some courts have considered whether there should be a defense available to nonprofits that have acted in good faith. But they have uniformly rejected such a defense, finding no basis in the law to support it. As Judge Richard Posner of the U.S. Court of Appeals for the Seventh Circuit explained, charities must return donations because the law "makes no distinction among different kinds of recipient of fraudulent conveyances. Every kind is potentially liable."

With courts unwilling to interpret the law as affording some defense for charities, there have been efforts to persuade legislators to amend existing laws to provide such a defense. But little has come of these efforts.

In the Religious Liberty and Charitable Donations Act passed in 1998, Congress amended the definition of fraudulent transfer in the U.S. Bankruptcy Code to provide protection to charitable contributions made by people who later go bankrupt. But the reach of that provision is quite limited: it does not apply where the donor is engaged in a fraud.

Moreover, many clawback cases are brought not under the federal bankruptcy law's fraudulent transfer provision, but under state laws, and state legislatures have not taken any action to protect nonprofits.

Unless the legislative climate changes, then, nonprofits will have to do what they can to protect themselves. How much to do is up to the particular charity. Conducting background checks on most donors, for example, seems impractical. Where large donations are involved, however, charities should consider conducting some basic due diligence on the donor. A charity's officers should also consider seeking the advice of its board of directors, attorneys and accountants when a significant donation has been offered, regardless of how well-known the potential donor may be.

Insurance may provide another kind of protection, but to date there is no broadly available insurance product that meets this need. The Madoff case and the recent attention focused on risks to charitable institutions should prompt insurers to consider entry into this market.

Until further protection is provided, nonprofit organizations that receive charitable contributions -- large ones in particular -- should be aware that sometimes such gifts can have hugely uncharitable consequences.