The spate of Ponzi schemes over the last few years, including those of Madoff and Rothstein, reminds us of the ormidable powers granted to bankruptcy trustees to recover fictitious profits withdrawn by investors who received more than they invested — the so-called "net winners."
The goal in every bankruptcy is to ensure "equality of distribution" to all creditors and the ability of trustees to "clawback" illusory gains and redistribute them proportionally to all victims is a major component of a trustee's arsenal in a Ponzi case.
While the same right of action exists in non-Ponzi bankruptcy cases, too, clawback suits have drawn considerable criticism as being particularly harsh in the Ponzi setting when brought against innocent investors, whose only transgression was not being more cynical about investment opportunities that proved to be too good to be true, and charitable organizations that had no reason to be anything but grateful for the munificence of their benefactors.
Trustees and scholars hold critics at bay by reminding that, however innocent, the fact remains that the "net winners" in a Ponzi scheme are often only separated from those who lost everything by dumb luck and good timing. As the trustee for Madoff explained to The Wall Street Journal, "The people who made money, who got more, have made money at the expense of the people who didn't." This same principle is applied in ordinary bankruptcy cases where a debtor, in advance of bankruptcy, repays a loan to a family member, makes a payment to a friendly vendor, or gives away an asset at a rock-bottom price, thereby benefitting one party at the expense of creditors.
There are essentially two types of clawback actions that trustees can employ.
First, there are preference actions employed to recover transfers of money or property made within 90 days (or one year in the case of insiders, including close relatives) prior to the filing of the bankruptcy case. Simply put, the trustee must demonstrate that the effect of the transfer was to permit the recipient to get more than it would have received if assets were distributed in a Chapter 7 liquidation. The recipient may defeat the claim by proving, among other things, that the transfer was made in the ordinary course of business or was part of a contemporaneous exchange. The recipient may also obtain a credit against its liability for "new value," which is the amount of any still unpaid obligations owed to the recipient that arose after the recipient got the transfer.
Second, fraudulent transfer actions may be brought under the Bankruptcy Code or under state law whether or not the recipient was complicit in the fraudulent activity. The difference between the
Bankruptcy Code and state law, generally speaking, comes down to time constraints. Under the Bankruptcy Code, the trustee may seek to recover transfers made two years before the bankruptcy. State laws often provide a longer look-back. For example, Florida law generally provides for the recovery of a transfer within four years from its occurrence.
In a fraudulent transfer action, the trustee may recover any transfer by a debtor during the applicable look-back period if (a) the transfer was a product of the debtor's actual fraud based on actual intent to hinder, delay or defraud any entity to which the debtor was or later became indebted, or (b) the transfer is constructively fraudulent if the debtor received less than "reasonably equivalent value" in exchange and was insolvent or left with "unreasonably small capital" or unable to pay its debts as they became due.
In a Ponzi case, nothing is as it appears and thus there is a presumption that distributions to investors were the product of the Ponzi schemer's actual fraud. In certain circumstances, the presumption may be rebutted by demonstrating the investor's good faith. Space limitations preclude an in-depth discussion, but suffice it to say that the good faith of an investor that makes its investment directly, as opposed to the good faith of an investor that invests through a so-called "feeder fund," are evaluated very differently. While there are no clearly defined rules and the standards of proof are not necessarily the same in every jurisdiction, at bottom the question is whether the investor had sufficient information to put it on inquiry notice that the transfer was made with a fraudulent purpose.
Some courts regard the lack of clarity as affording flexibility but flexible standards make it exceedingly difficult for investors to make real-time analyses of attendant legal risks. Indeed, flexibility may portend different results for different players. For example, more stringent duties of inquiry might be assigned to a "feeder fund," as opposed to investors that invested through a "feeder fund" that identified and evaluated the investment for its customers, so that in the same Ponzi scheme transfers to some investors may be clawed back while contemporaneous transfers to other investors may be insulated by the latter's good faith.
Ponzi schemes unravel when new investors cannot be seduced to invest. At some level, the argument is that legal liability to return the rewards paid to investors in Ponzi schemes is an effort to enlist investors in disrupting the circular flow of funds.
Scott L. Baena is a senior partner with Bilzin Sumberg Baena Price & Axelrod and chair of the firm's Restructuring & Bankruptcy Group. His practice focuses on creditors' rights, workouts, bankruptcy and commercial loan transactions. Jeffrey I. Snyder is an associate in the same group and practices in all facets of bankruptcy reorganizations and litigation.
Reprinted from Daily Business Review (February 2, 2011).