Midnight in the garden of good faith: using clawback actions to harvest the equitable roots of bankrupt Ponzi Schemes.

Author:Gabel, Jessica D.
 
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CONTENTS INTRODUCTION: TOO GOOD TO BE "GOOD FAITH" I. THE PONZI KINGDOM: STITCHING THE EMPEROR'S NEW CLOTHES A. Ponzi Construction Codes B. Historic Ponzi Schemes II. THE CLAWBACK CROWD: IN PURSUIT OF PONZI PAYOUTS A. Ponzi Scheme Definition and Its Players B. Ponzi Payouts: Fraudulent or Preferential? 1. Defining and Differentiating Fraudulent Transfers 2. Ponzi Schemes: Fraud in the Making 3. The Displeasure of Preferences: Timing is Everything III. FRAUDULENT TRANSFERS IN PONZI SCHEMES: THE CHANGING FACE OF GOOD FAITH A. Into the Bayou and Beyond B. The Third Time's a Charm: Bayou III and the Good Faith Deviant 1. An Easy Hunt for Intent 2. The Boundaries of Good Faith a. Inquiring Minds Need to Know b. C.Y.A. Analysis c. Objectifying Good Faith C. Battle over Bayou D. Calculating "Value" into the Good Faith Equation of Section 548(c) IV. DIMINISHING RETURNS OF GOOD FAITH A. Picking the Carcass: Madoff Math B. Supersizing SIPA and Section 548(c) C. Criminal Competition D. Clawback Chaos: Striking a Balance Between Cause and Effect 1. Ponzi Policy 2. Innocent Investor v. Hungry Financier CONCLUSION INTRODUCTION: TOO GOOD TO BE "GOOD FAITH"

The unmasking of a Ponzi scheme usually means that the seam has run its course and the jig is up. A receiver boards the windows and changes the locks, broke investors sue, lucky investors get sued, and the bad guys go to jail. (1) Indeed, in the two years since the Madoff scandal broke, there is no shortage of candidates for the Ponzi flavor of the month, but the fifteen minutes of fame fade as fast as the fictitious profits. (2) As bankruptcy courts encounter more fraudulent investment schemes, avoidance actions brought by the trustee have become more common. Accordingly, victims and claimholders remain in limbo while courts attempt to preserve and allocate whatever may remain.

The first decade of the twenty-first century exemplifies the macroeconomic boom-bust-boom cycle. By 2007 and 2008, the economy dropped to historic lows last seen during the Great Depression. (3) In the drama that unfolded as the "Great Recession," banks, Wall Street executives, government officials, investors, and home buyers were all eventually cast as both villain and victim. (4) In the ensuing mess of finger-pointing, bailouts, and cries for reform, the arch-villain emerged: Bernie Madoff. He bilked thousands of investors out of billions of dollars. Madoff certainly was not the only Ponzi architect, though he was perhaps the biggest. Since Madoff's scheme collapsed, authorities have uncovered Ponzi schemes of all shapes and sizes (5) Unfortunately, for those who fell under the Ponzi spell, their ability to seek restitution is both incomplete and inconsistent.

Once Ponzi schemes are exposed, the tattered remains often run to bankruptcy court, where the court appoints a trustee to reassemble the pieces and maximize any remaining assets for the benefit of creditors, including investors. (6) Since few assets usually remain, the trustee steps in as the repo-man to bring property back into the bankruptcy estate--either through a preferential transfer action or a fraudulent transfer action. In this article, I focus on the latter as applied to Ponzi investments. In particular, I examine the good faith defense to fraudulent transfer actions.

The term "Ponzi scheme" is synonymous with fraud. Ponzi transactions are simple in the execution: the fraudsters retain the investors' capital in exchange for empty promises of high returns. (7) Once the investor seeks to withdraw her returns (as opposed to principal), it triggers fraudulent transfer liability under section 548 of the Bankruptcy Code, because the investor receives fictitious profits. On the other hand, repayment of principal arguably calls in an actual pre-existing debt, yet it too can give rise to fraudulent transfer liability. (8) Section 548(c) of the Bankruptcy Code does, however, provide a "good faith" defense to an investor to the extent value was given. In this article, I argue that such defenses should not be available in federal Ponzi cases.

In addition to the fraudulent transfer action, the bankruptcy trustee can assert preferential transfer actions, which are typically easier to prove than fraudulent transfer actions. Indeed, the Bankruptcy Code allows the trustee to recover the full amount of all investor withdrawals--whether of principal or profit--made within ninety days prior to the date of the filing of the bankruptcy petition. (9) Referred to as "preferences," these payments carry a legal presumption that they have "preferred" the interests of the withdrawing creditor over the interests of other creditors at a time when bankruptcy was all but a foregone conclusion. This policy attempts to level the playing field among creditors. Moreover, the statute itself (11 U.S.C. [section] 547(b)) provides an easy-to-follow roadmap in proving that a preferential transfer occurred. (10)

But the ninety-day window limits the reach of preference actions, and, there may be no transactions within the window to avoid, depending upon the delay between the discovery and shutdown of the scheme and the corresponding bankruptcy filing. (11) While the Bankruptcy Code extends the ninety-day window to one year in cases of insider withdrawals, most investors who unwittingly contributed to the scheme are subject to the ninety-day rule. (12) Those investors must return the funds withdrawn, and will then receive an unsecured claim against the bankruptcy estate in the amount of their principal. (13) Most courts will not include any alleged profit in the claim amount since the profit was the product of an illegal scheme. (14)

Investors can assert statutory defenses to protect their withdrawals from preference actions provided for under section 547(c). One of the most common of these defenses is the "ordinary course of business" defense. (15) The Bankruptcy Code provides that a trustee may not avoid an otherwise preferential transfer if the transaction related to the ordinary course of the debtor's business. (16) Courts, however, have been reluctant, if not hostile, to find that a debtor made a transfer in the ordinary course of business when the "business" is a Ponzi scheme. (17) After all, a Ponzi scheme by its nature is neither ordinary nor legal. (18)

Other defenses to a fraudulent transfer action, however, do achieve some success in a Ponzi scheme. Section 548(c) of the Bankruptcy Code and similar provisions of equivalent state laws provide a defense for a transferee who has received the transfer "in good faith" and "for value." (19) For purposes of fraudulent transfer actions, "value" includes "satisfaction ... of a present or antecedent debt." (20) Fraudulent transfers in Ponzi schemes operate under the general rule that a defrauded investor receives "value" up to the principal amount of the investment but not "in excess of principal" (i.e., interest). (21) The justification is that the investor technically has a fraud claim against the debtor for the false promise of profits based on the actual investment of principal, but the same is not true for an investor's "fictitious, nonexistent 'profits.'" (22) Consequently, if the debtor transfers all or a portion of the principal back to the investor, then that transaction satisfies the fraud claim (an antecedent debt) and achieves section 548(c)'s "for value" requirement. (23) As a corollary, an investor's fraud claim cannot encompass payments that outstrip the principal because the manufactured profits are not a genuine "value" that the investor can realize. (24)

Lucky investors who pulled out early--and are therefore able to retain their principal--benefit at the expense of later investors, who face a possibly empty bankrupt estate from which to recover their principal. This lopsided situation contradicts bankruptcy policy, which aims to treat similarly-situated creditors equally. (25) In this article, I test the utility and reach of section 548(c)'s good faith defense in the confines of a Ponzi scheme and argue that it should be unavailable as a defense in Ponzi cases before federal bankruptcy courts. (26) Limiting the application of the good faith defense in these circumstances would allow trustees to recover all of the debtor's payments to investors--whether principal or interest--and distribute the funds equally among all defrauded investors.

  1. THE PONZI KINGDOM: STITCHING THE EMPEROR'S NEW CLOTHES

    Ponzi schemes are a unique bankruptcy beast. Creditors become crime victims instead of debt collectors. The average bankruptcy case winds its way through proceedings designed to balance various interests. (27) The Bankruptcy Code itself maintains two distinct goals: to provide a "fresh start" for the debtor, (28) whereby the bankrupt party is kept under the protection of the bankruptcy court as it unburdens some of its debt load, (29) and to treat creditors fairly. (30) While not all creditors are treated equally (either in or out of bankruptcy), the Bankruptcy Code endeavors to level the playing field. For the most part, the Bankruptcy Code is uncompromising about these two basic principles. (31) In Ponzi schemes, however, that foundation is somewhat fractured.

    1. Ponzi Construction Codes

      Ponzi schemes arise out of fraud. The deceit required to maintain them results in a complex maze of people, funds, and transactions, and a culprit sprinting to stay ahead of the pack. In short, a perpetrator lures victims to put money into some sort of investment device (stocks, property, commodities) with the promise of an "extraordinary return on the investment." (32) But the enterprise lacks any legitimacy. (33) Rather, the culprit operates a vicious cycle using funds obtained from the newest investors to pay "profits" to earlier ones. (34) The perpetrator may even return principal to those who request it. (35) Maintaining the fraud requires a revolving door: that those pleased with their investment gains...

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