Claw Back Claims in Ponzi Schemes
Bernard Madoff’s $65 billion investment scheme has made the term “Ponzi scheme” the water cooler topic of 2009. These types of fraudulent schemes are run under the pretense of a legitimate profit-making business where funds are solicited, often by broker-dealers, from new investors. The new funds are used to pay earlier investors, thereby inducing further investments. The Ponzi-scheme operator all the while siphons off funds for his or her own use, engaging in a scheme that is destined to fail and land in some sort of formal dissolution proceeding. Most, if not all, such Ponzi schemes ultimately end up in a bankruptcy proceeding or receivership.
As a Ponzi scheme progresses, the earlier investors often withdraw more money than they invested, thereby receiving fictitious profits. Broker-dealers are often paid handsome commissions for soliciting the investments. When the Ponzi scheme has failed and it is time to unwind the tangled financial web, questions then arise on the part of bankruptcy trustees and receivers as to how or whether they can recover funds transferred. Claims for recovery of funds are made against: (1) the investors (for both principal repayments and fictitious profits); and (2) the broker-dealers for return of commissions paid for soliciting the investments on behalf of the Ponzi debtor. Use of the fraudulent transfer laws in both the Bankruptcy Code and state statutes is the most common mechanism to seek to “claw back” the transfers made by the Ponzi debtor.
Claw back claims can be based on either an actual fraud theory (where the actual fraudulent intent of the Ponzi debtor is sufficient to establish the claim to recover the funds transferred), or a constructive fraud theory (where it must be established that the Ponzi debtor did not receive reasonably equivalent value in exchange for the transfers made at a time when the Ponzi debtor was insolvent). Under either theory, the good faith of the transferee is relevant, establishing a partial or complete defense depending on the circumstances.
The United States Court of Appeals for the Ninth Circuit has generated three significant opinions in the last year providing further guidance for bankruptcy trustees and receivers in their pursuit of these “claw back” claims. These cases distinguish between transfers that constituted a return of the principal amount originally invested versus profits or “interest” which might have been paid to an investor. In re AFI Holding, Inc., 525 F. 3d 700 (9th Cir. 2008)(repayment to investor as return of principal was not recoverable since the payment partially or fully extinguished the investor’s restitution claim, but “profits” paid to investor are recoverable); In re Slatkin, 525 F.3d 805 (9th Cir. 2008)(prejudgment interest may be awarded on recovery of profits from investors); and Donell v. Kowell, 533 F.3d 762 (9th Cir. 2008)(investors’ good faith may be relevant as a defense regarding a return of principal, but will not protect them from claims to recover profits).
A particular category of transfers subject to avoidance claims in Ponzi scheme cases are the transfers made by the Ponzi debtor to its broker-dealers as commissions in order to solicit new investments. Some courts have found that, because a Ponzi enterprise has no legitimate purpose, there can be no value provided by a broker in furthering or assisting the debtor in perpetrating the fraud. Therefore, the commissions paid to them are recoverable by a trustee or receiver. See, e.g., Warfield v. Byron, 436 F.3d 551, 560 (5th Cir. 2006)(“It takes cheek to contend that in exchange for the payments he received, the [debtor’s] Ponzi scheme benefited from his efforts to extend the fraud by securing new investments”).
Other courts have looked more narrowly at the relationship between the debtor and the broker. They measure “what was given and received” by the debtor and the broker, looking at the market commission rates versus what was paid, finding that, “Money is valuable even when used for illegal purposes.” In re Churchhill Mortgage Inv. Corp., 256 B.R. 664 (Bankr.S.D.N.Y. 2000)(court should focus not the consequence of the debtor-broker transaction in the context of the entire Ponzi scheme, but “on a comparison of the values of the mutual consideration actually exchanged in the transaction between the Broker and the Debtor. . .”).
The bottom line is that both investors and broker-dealers may be subject to claw back claims in bankruptcy and receivership proceedings of Ponzi debtors. Their good faith status may or may not rescue them from litigation, depending on the type of claim brought and the precedent or opinion of the presiding court.
Kathy Phelps is a Partner at Danning, Gill, Diamond & Kollitz LLP in Los Angeles
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