To Claw or Not to Claw: Application of Common Law to Ponzi Scheme Restitution Strategy

Written by Noam Benavi

Edited by Grace Thomas, Hannah Fuchs, and Juliette Draper

Last April, disgraced financier Bernie Madoff died in prison at the age of 82. Of course, dying behind bars was a foregone conclusion for Madoff-a matter of when not if. In March 2009, Madoff pleaded guilty to 11 federal counts of money laundering and securities fraud, and SDNY Judge Denny Chin gave him the maximum 150-year sentence. [1] Over the course of four decades, Madoff defrauded some 37,000 investors in 136 countries for an estimated 17.5 billion dollars—by far the biggest investment fraud in U.S history. [2] Madoff quickly became one of the nation’s most reviled characters-a living, breathing distillation of white-collar crime. Former investor Tony Fitzmaurice put it best in his testimony at Madoff’s trial: “He stole from the rich, he stole from the poor, he stole from the in between. He had no values.” [3] Years from now, Madoff’s victims will still bear the fiscal wounds inflicted upon them—indeed, only a fraction of these victims have completely recovered their lost assets. [4] Yet, the fact that partial or complete restitution of loss is even a possibility illustrates the intrinsic difference between crimes of this nature and violent crimes—in the case of fraud, the crime can literally be undone (opportunity cost notwithstanding). As a result, the legal processes involved in fraud restitution extend far beyond the criminal trial itself. In the next section, I will briefly explain the structure of Madoff’s particular form of fraud (commonly referred to as a Ponzi scheme) and the associated recovery process outlined in the U.S. criminal code.

In the most fundamental sense, a Ponzi scheme is simply an exponentiating lie. In the first round of a Ponzi scheme, the schemer will obtain money from an initial round of investors and pocket it. When these investors are due their returns, the schemer will reimburse them with money obtained from a new round of investors. In time, the schemers will pocket these new investors’ money as well, and pay them with the money obtained by a new wave of victims. However, since the scheme is not supported by any actual money-producing enterprise, as more and more investors await their paychecks, the stream of new money inevitably dries up, and the house of cards comes crashing down. [5] Once the scheme is exposed, the architects will go to jail, plain and simple. The path that lies ahead for the victims is significantly less straightforward. First, a bankruptcy court will appoint a trustee on behalf of the victims. [6] This designation endows the trustee with the authority to repossess the fraudulently acquired assets from any investors who were compensated for their initial payment. [7] To recover the assets, trustees utilize either the fraudulent transfer law or preferential transfer law to initiate “claw-back” lawsuits against the lucky early investors. [8] At the end of this process, the trustee will distribute the contents of the bankruptcy estate to the victims pro rata according to their net equity (contributions minus withdrawals). [9]

The standards for establishing fraudulent transfer actions are outlined in 11 U.S.C § 548, and those for preferential transfer actions in 11 U.S.C § 547. The crucial difference between these two clawback avenues is that preference only applies to a limited class of transfers-specifically, only those payments made from the schemers (debtors) to certain investors (creditors) that occurred within ninety days of the filing for bankruptcy can be recovered by the trustee. [10] The underlying aim of preference actions, then, is not to recover the bulk of the lost assets but rather to prevent those “preferred” creditors (who were closely linked to the schemers and knew that bankruptcy was inevitable) from dominating the lion’s share of the estate. [11] The scope of fraudulent transfer law, on the other hand, is applicable to various payment circumstances. For the provisions in § 548 to be triggered, the trustee must prove that the transfer in question was made with “fraudulent intent”, which is identified by “badges of fraud”—indications that the transfer was not made in “good faith." [12] In 2008, the Ninth Circuit ruled that "the mere existence of a Ponzi scheme is sufficient to establish actual intent to defraud." [13] Thus, for every Ponzi scheme, the transfers made wherein are automatically subject to § 548, and the laborious court examination of each individual transfer for badges of fraud is no longer required. Additionally, the burden of proof will now shift to the lucky investors to show that they should not be obligated to pay into the bankruptcy estate.

So, what defenses are the lucky investors equipped with against this “Ponzi presumption?” The range of options is limited, but of these, the “good faith” defense is by far the most effective. As put forth in § 548(c), if a transfer was made in “good faith,” then the investor can retain the full amount of their principal and need only return the fictitious profits. While this may seem fair, it is important to note that the unlucky investors, who have already lost most or all of their principal, often face a meager bankruptcy estate to divide between them. [14] Furthermore, bankruptcy courts do not consider relevant external factors such as the absolute and relative financial circumstances of each creditor. The crux of this issue, then, can be summed up in this ethical question: when all investors are technically victims, how can a just distribution be achieved? For an answer, I will look to the British common law. The term “common law” refers specifically to the decisions rendered in informal courts of law in England since the middle ages and generally to the body of customary, semi-statutory law based on these court decisions. More than any other historic legal tradition, the common law has influenced the core ideals of American criminal law. It makes sense, then, to examine some of the most significant common law records pertaining to the moral calculus of fraud in a future effort to tweak the minutiae of the criminal code. For our own moral calculus, let us consider the Statute of Elizabeth and the Restatement of Restitution and Unjust Enrichment.

First enacted in 1571, the Statute of Elizabeth is unquestionably an antiquated law. Yet it is crucial to our topic because it is the earliest example of formal fraudulent conveyance law. [15] According to the edict, “any transfer made for the purpose of hindering, delaying, or defrauding creditors” was to be considered illegal. [16] This text is nearly identical to that of § 548(e)(1)(D), which indicates “actual intent to hinder, delay, or defraud any entity to which the debtor was or became...indebted” as a sufficient condition for the corresponding transfer to be considered fraudulent. Despite this overall alignment with U.S fraudulent transfer law, the Statute does conflict with modern court interpretations of the crucial phrase “good faith.” In the seminal case Tacoma Association of Credit Men v Lester (1967), the Washington Supreme Court defined “good faith” as “an honest belief in the propriety of the activities in question." [17] Today, most courts still utilize this broad reading of the “good faith” clause, which places a premium on the transferee’s knowledge (or lack thereof) concerning the nature of the transfer. [18] Yet the Statute of Elizabeth says nothing about the state of mind of either party-rather, the only consideration explicitly mentioned in its text is the nature of the transfer itself. Not so coincidentally, the Uniform Fraudulent Conveyance Act (essentially the blueprint to § 548) also does not cite a lack of good faith as an “objective” component of fraud, instead basing most elements of constructive fraud around the concept of “fair consideration,” which de-emphasizes intent-based judgements. [19]

The de-emphasis of intent in the Statute of Elizabeth requires further examination, because intent is embedded in the fabric of statutory criminal law. After all, intent can be the deciding factor between certain charges, such as third-degree vs. second-degree murder. Yet, given the centuries-long prevalence of the Elizabethan interpretation of Fraud preceding the Tacoma case, it is worth questioning the veracity of the courts’ recent pivot to good faith as the pre-eminent defense for lucky investors. As mentioned in the opening paragraph, it is immediately apparent that white-collar crimes are of a different intrinsic nature than crimes of passion, which is why these crimes are treated with different guidelines under criminal law. With violent crimes, it is easier to chart the course of harm, with some cases being as simple as one party attacking another. And when the roadmap of harm is relatively simple, the application of intent considerations to this roadmap is often similarly simple. As a test case, let us take a situation where one man stabs another and runs off with his wallet, completely unprovoked In this situation, harm is unidirectional, from one man to another, and has no confounding variables (other actors, coercion, etc.). Thus, regarding the question of intent, the answer is easy—one man intended to harm another. Not only is the answer simple, it is relevant. If the stabbing was somehow accidental or coerced, it would make a significant difference to the case. Yet, for white-collar crimes such as Ponzi schemes, the roadmap of harm is really more of a densely tangled spider’s web. The schemers harm all of the investors in one sense by obscuring the fraudulent workings of their investment mechanism but harm some investors in a quantitatively worse sense than others. At the same time, the net winners harm the net losers, as their fictitious profits are paid through the net losers’ investments. Thus, when we consider intent, the result is equally tangled. Though the lucky investors can say they made the transfer in good faith, can they just as easily say that their desire to shield their assets from the net losers is also in good faith? I would say that the answer is no. Once the Ponzi scheme is revealed, it makes no sense to consider any further action on the part of the net winners to protect their assets to be a “good faith” action. The truth is that making any decision, financial or otherwise, in good faith does not guarantee that any attempt to salvage undeserved rewards gained from that decision is also made in good faith.

The second piece of common law evidence against the overuse of the “good faith” defense is the Restatement of Restitution and Unjust Enrichment, a publication by the American Law Institute initially written in 1937 and revised in 2011. The primary purpose of this lengthy manuscript was to establish the concept of restitution and unjust enrichment as a central category of law alongside and akin to contracts and torts. [20] To accomplish this goal, the restatement “reporter” Andrew Kull organizes the restatement around the cornerstone principle that “[a] person who is unjustly enriched at the expense of another is subject to liability in restitution." [21] In a Ponzi scheme, the net winners are enriched at the expense of the net losers, so if this principle is applicable, restitution would be owed to the net losers. Like the Statute of Elizabeth, the Restatement has no mention of a “good faith” caveat. The other important element of this principle is a tacit approval of strong clawback powers to combat abuse of the good faith clause. One clue to this support lies in the phrase “liability in restitution,” which refers to both a debt to be owed (liability) and an obligation to repay the debt (restitution). The presence of both conditions is significant because net winners may agree with the first condition that there is indeed a debt owed to the net losers but will not agree or admit that it is their responsibility to pay the debt. Additionally, the Restatement gives greater weight to what the defendant (net winner) received than what the plaintiff (net loser) lost, [22] further de-emphasizing the intent with which the transaction was made. The strongest implicit indication of the current bankruptcy law’s inadequacy lies in section 4, which asserts that a claimant entitled to a remedy for unjust enrichment need not demonstrate the inadequacy of available remedies at law. [23] Though this claim is clearly an ideal rather than a practical suggestion (after all, any substantive change in the law must occur through demonstrating the deficiency of the existing law), it still expresses sympathy for the position of the net losers. And more importantly, many of our most widely accepted provisions of criminal law started in the exact same way—as nothing more than ethereal ideals.

I would like to conclude this discussion with an important qualification pertaining to personal responsibility. Namely, I do not want to discount personal responsibility as a significant consideration in our assignment of blame and liability. Though I believe the “good faith” defense needs to be more narrowly construed, it is not necessarily because the net losers are blameless. Every investor made a choice-a choice that was both ill-founded and wholly their own. And when an adult makes such a choice, they must bear the consequences, whatever they may be. For net losers, the consequences are simply the financial struggles that await them after the bankruptcy estate has been picked clean. For the net winners, it is the obligation to return at least the fictional profits. The sooner both parties face these consequences, the sooner this fruitless energy can be shifted to making life as difficult as possible for the schemer-the biggest loser of all.


 

[1] Marty Steinberg & Scott Cohn, Bernie Madoff, Mastermind of the Nation’s Biggest Investment Fraud, Dies at 82, CNBC (Apr. 14, 2021), https://www.cnbc.com/2021/04/14/bernie-madoff-dies-mastermind-of-the-nations-biggest-investment-fraud-was-82.html.

[2] Id.

[3] Michael Balsamo & Tom Hays, Ponzi Schemer Bernie Madoff Dies in Prison at 82, AP News (Apr. 14, 2021), https://apnews.com/article/bernie-madoff-dead-9d9bd8065708384e0bf0c840bd1ae711.

[4] Aaron Smith, Five Things You Didn't Know About Bernie Madoff's Epic Scam, CNN Business (Dec. 11, 2021), https://apnews.com/article/bernie-madoff-dead-9d9bd8065708384e0bf0c840bd1ae711.

[5] David R. Hague, Expanding the Ponzi Scheme Presumption, 64, DePaul L. Rev. 867 (2015).

[6] Jessica D. Gabel, Midnight in the Garden of Good Faith: Using Clawback Actions to Harvest the Equitable Roots of Bankrupt Ponzi Schemes, 62 Case W. Res. L. Rev. 19 (2011).

[7] Saul Levmore, Rethinking Ponzi-Scheme Remedies in and out of Bankruptcy, 92 BU L. Rev. 969 (2012).

[8] Id 4

[9] Id 6

[10] Id 5

[11] Id

[12] Id 6

[13] Barclay v. Mackenzie, 525 F.3d 700, 704 (9th Cir. 2008).

[14] Id 5

[15] Douglas G. Baird & Thomas H. Jackson, Fraudulent Conveyance Law and Its Proper Domain, 38 Vand. L. Rev. 829 (1985).

[16] Fraudulent Conveyances Act, 1571, 13 Eliz. 1, c. 5 (Eng.)

[17] Tacoma Ass’n of Credit Men v. Lester, 72, Wn.2d 453, 433 P.2D 901 (Wash. 1967).

[18] Paul Sinclair, The Sad Tale of Fraudulent Transfers, American Bankruptcy Institute Journal (Apr. 2009), https://www.polsinelli.com/-/media/files/articles-by-attorneys/sinclair_part1.pdf

[19] Id

[20] Michael Traynor, The Restatement (Third) of Restitution & Unjust Enrichment: Some Introductory Suggestions, 68 Wash. & Lee L. Rev. 899 (2011).

[21] RESTATEMENT (THIRD) OF RESTITUTION & UNJUST ENRICHMENT § 1 (2011)

[22] Id 19

[23] Id 20 (§ 4)



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