PONZI SCHEMES AND CLAWBACKS

Defending the Victims, Not the Perpetrators

By Michael A. Hackard

Something’s been proliferating across America – something that has at times shaken investor confidence and at others made financial investors feel like there is a war against them. That which has been proliferating – Ponzi schemes – is of course well exemplified by the Bernie Madoff matter. Madoff is the largest Ponzi scheme in history with an estimated $20 billion “invested” into the scheme over a period of years by over 15,000 “investors.”

While Madoff makes front page news, there are hundreds of other Ponzi schemes that might only draw local attention. A 2011 study did an overview of Ponzi schemes that included 329 major investment fraud cases.[1] A judicial tongue-in-cheek observation is that the “essence of a Ponzi scheme is to use newly invested money to pay off old investors and convince them that they are earning profits rather than losing their shirts.” (Citation omitted). Tens of thousands of investors throughout the land have been duped into “investing” into Ponzi schemes fully believing that they were earning profits. This colossal misunderstanding is often not clarified until some judicial action has been pursued against the perpetrators – whether criminal prosecution, bankruptcy or state court litigation.

In Spring, 2012 the United States Court of Appeals for the Fifth Circuit had occasion to help define a Ponzi scheme.

[A] Ponzi scheme is a ‘fraudulent investment scheme in which money contributed by later investors generates artificially high dividends or returns for the original investors, whose example attracts even larger ‘investments.’ The American Cancer Society v. Cook, 2012 WL 919674 (5th Cir. 3/20/12) (Jones, Ch. J.).

Ponzi scheme victims often learn that disengaging from the investment can be very painful, surprisingly protracted and expensive. It is well settled law that when a debtor in bankruptcy has operated a Ponzi scheme, the court appointed bankruptcy trustee may institute actions seeking to avoid and recover payments made to the scheme’s investors.  This is often referred to as a “clawback” claim, which essentially is an adversarial claim pursued by the trustee to seize illicit profits from knowledgeable investors.

Receiving a letter from a bankruptcy trustee demanding the repayment of any funds returned to the investor can create a pretty scary atmosphere. With their investment gone, the Ponzi defendant in jail, bankrupt and/or missing, the investor is left with a problem that at times can seem insolvable.

Ponzi victims often ask their attorneys how it is possible that the victim can be sued by the bankruptcy trustee. Without addressing all the legal theories that make up the right of recovery as well as defenses to recovery, it is more economical to reference some general rules.

The general rule in several jurisdictions that has been evolving judicially is that a defrauded Ponzi investor is recognized as having given “value” to the extent of his or her principal invested. This “value” supports a section 548(c) affirmative defense to a clawback claim.

The theory behind the rule is that the investor has a right of action for fraud against the Ponzi perpetrator equal to the amount invested. Repayment of principal is essentially payment on the antecedent debt that accrued from the fraud. That said, the amount in excess of principal that was repaid to the investor is deemed not to have been given for value and may be recovered by the bankruptcy trustee.

The Ponzi investor who is subject to an adversary claim needs to know that such clams are normal and often required by a bankruptcy trustee to satisfy his or her fiduciary obligations. While normal, so are the defenses that apply to such claims. Investor’s complaints that the claims strike at the jugular and are not calibrated to ferret out the innocent must be tempered by the reality that bankruptcy trustees often have little in the way of records and must rely upon bits and pieces of data that may not be accurate.  In these cases the ultimate resolution of the claim can be accomplished by “showing the proof.”  An effective defense to avoidance or “clawback” claims requires this showing of proof.


[1] Christopher T. Marquet, The Marquet Report on Ponzi Schemes, A White Collar Fraud Study of Major Ponzi-Type Investment Fraud Cases Revealed from 2002-2011, June 2, 2011. Available at http://www.marquetinternational.com/pdf/marquet_report_on_ponzi_schemes.pdf .

© Copyright Michael A. Hackard, 2012. All rights reserved

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