Ponzi, Property, and Luck

• Author: Andrew Kull
• Position: Distinguished Senior Lecturer, University of Texas School of Law; Reporter, Restatement Third, Restitution and Unjust Enrichment
• Pages: 291-322

Ponzi, Property, and Luck Andrew Kull  “Ignorance is the best of law reformers. People are glad to discuss a question on general principles, when they have forgotten the special knowledge necessary for technical reasoning.” 1 I. INTRODUCTION ............................................................................. 291 II. SPECIAL KNOWLEDGE: FIVE PROPOSITIONS .................................. 294 III. MOVING THE PROPERTY BASELINE ................................................ 298 A. O WNERSHIP OF I DENTIFIABLE P ROPERTY .................................. 298 B. O WNERSHIP OF AN I DENTIFIABLE P RODUCT . .............................. 302 C. O WNERSHIP OF F UNDS W ITHDRAWN FROM THE S CHEME ............ 306 IV. GENERAL PRINCIPLES .................................................................... 312 A. I NCENTIVES ............................................................................. 313 B. L OSS S HARING ........................................................................ 315 C. L UCK AND B LAME ................................................................... 318 V. CONCLUSION: A THOUGHT EXPERIMENT ..................................... 320 I. INTRODUCTION Swindler is running a Ponzi scheme. Two or more victims invest with Swindler in the hope of turning a profit. The scheme eventually collapses. Some residue of the victims’ investments is found in the ruins, and the question is how to divide it between the victims. The basis of the division is a claim in restitution or unjust enrichment that is now asserted, explicitly or otherwise, by one fraud victim against another. Remedies in such cases are  Distinguished Senior Lecturer, University of Texas School of Law; Reporter, Restatement Third, Restitution and Unjust Enrichment. The encouragement of Ralph Brubaker, Ward Farnsworth, Henry Smith, and Lionel Smith is gratefully acknowledged. 1. OLIVER WENDELL HOLMES, THE COMMON LAW 54 (1881). 292 IOWA LAW REVIEW [Vol. 100:291 predominantly equitable, and the question of allocation between victims is sometimes described by comparing their “competing equities” or by asking “what equity requires.” Courts have recently been giving new answers to this old question. My topic is to ask why equity now seems to require something different from what it required in the past. The traditional answers came from the property-rights end of the equity spectrum, the part that depends least on “equitable discretion.” But during the second half of the 20th century, for a variety of reasons, the law of equitable interests in property (as part of the law of restitution generally) suffered a dramatic decline in professional attention and awareness—a story that is old news by now. 2 Propositions that were once part of what everyone knew became doctrine that could only be found in the library, and then only if one knew where to look. While this law was being forgotten, United States courts were encountering an extraordinary upsurge in Ponzi-type cases. 3 As it happened, these cases fell to be litigated and decided by a new group of American lawyers and judges: the first professional generation—roughly speaking, of course—to attend law school after the courses dealing with equitable interests in property had been dropped from the standard curriculum. Lack of awareness of the established rules has given courts an unusual freedom to decide for themselves and afresh what equity requires between victims of a common fraud. In three recurrent settings—all of them familiar locations within the landscape where exploded Ponzi schemes fall to Earth— recent decisions reach outcomes different from those that traditional authority would dictate. Ignorance has not produced a random redistribution, because the new results in victim v. victim cases have all been pushed in the same direction. Courts spread losses more widely by refusing to recognize the effects of fortuitous circumstances—luck—that by standard property rules would occasionally permit a few relatively fortunate victims to lose proportionately less than others. The move has been away from a view that takes victims as it finds them, toward one that seeks to rationalize and to equalize, so far as possible, the consequences of a casualty to which multiple victims are thought to have been uniformly subject. This shift in outcomes has redrawn the established map of property rights by shortening the reach of legally protected ownership. By traditional rules, 2. See, e.g. , Douglas Laycock, How Remedies Became a Field: A History , 27 REV. LITIG. 161, 173–74 (2008) (“As the [20th] century wore on, equity casebooks focused more on equitable remedies and less on substantive equity.”). See generally John H. Langbein, The Later History of Restitution , in RESTITUTION: PAST, PRESENT, AND FUTURE 57 (W.R. Cornish et al. eds., 1998); Andrew Kull, Rationalizing Restitution , 83 CALIF. L. REV. 1191 (1995). 3. Anyone who reads the newspapers will share this impression, though I am not aware of actual statistics. As a crude proxy, Westlaw reports that the name “Ponzi” appeared in 535 state and federal decisions during the first 65 years of Charles Ponzi’s notoriety—or before January 1, 1985—and in approximately ten times as many since then. Decisions referring to “Ponzi” have recently been added to the list at a rate of more than 600 per year. 2014] PONZI, PROPERTY, AND LUCK 293 the owner of an asset lost to fraud can retake it so long as it can be identified— unless and until it comes into the hands of a bona fide purchaser. Protected ownership thus extends beyond a misappropriation, ending only when (1) the misappropriated asset can no longer be identified or (2) the rights of a protected purchaser intervene. Because they deny the owner’s usual right to restitution in such circumstances, recent decisions terminate ownership earlier: at the point where the asset first leaves the owner’s hands. Most of the recent victim v. victim decisions do not see the problem in property terms. If they do, they assert—in the name of “equitable discretion”—an overriding authority to reallocate whatever entitlements might exist. 4 More commonly, the courts—and the receivers whose rulings the courts approve—see themselves as writing on a blank slate, subject to a single guideline: a duty to divide contested property in whatever manner seems best under the circumstances. 5 My intention is not to criticize the courts for ignoring the rules. 6 My proposition is rather that the new outcomes in victim v. victim restitution cases make a striking instance of Holmes’ law reform by ignorance. If we observe that some “special knowledge” has evidently been forgotten, and that old questions are being decided instead on “general principles”— and coming out 4. See, e.g. , SEC v. Credit Bancorp, Ltd., 290 F.3d 80, 88 (2d Cir. 2002) (finding that the existence of a constructive trust at state law “does not defeat the equitable authority of the District Court to treat all the fraud victims alike (in proportion to their investments) and order a pro rata distribution”); United States v. Vanguard Inv. Co., 6 F.3d 222, 226 (4th Cir. 1993) (finding entitlement to restitution at state law, assuming it exists, may be disregarded by a court exercising its “discretionary power” of equitable receivership). Invoked in this way, the asserted discretion to reallocate state-law entitlements in the context of a federal receivership strongly resembles the “free-wheeling equitable discretion to cut down entitlements when they are sought to be enforced in a bankruptcy proceeding”—a discretion that does not exist: Bankruptcy is an equitable procedure, and “equality is equity” (and vice versa), as numerous bankruptcy cases intone. These truisms have a particular appeal for those bankruptcy judges who would like to administer the bankruptcy laws in accordance with their personal notions of fairness. But it is now well settled that although the origins, procedures, and many of the remedies of bankruptcy are indeed equitable, a bankruptcy judge has no authority to cut down the entitlements that creditors seek to enforce in bankruptcy, except as provided by the Bankruptcy Code itself. In re Stoecker, 179 F.3d 546, 551 (7th Cir. 1999) (Posner, C.J.) (citations omitted). If the idea of the present discussion were to criticize the recent Ponzi cases on the ground that they were incorrectly decided, a good way to start would be to demonstrate that a federal equity receiver has no more power to cut down state-law property entitlements than does a bankruptcy judge. My present purpose is different, as I am about to explain. 5 . “ There are no hard rules governing a district court’s decisions in matters like these. The standard is whether a distribution is equitable and fair in the eyes of a reasonable judge.” SEC v. Enter. Trust Co., No. 08 C 1260, 2008 WL 4534154, at *3 (N.D. Ill. Oct. 7, 2008). 6. For criticism along these more traditional lines see, for example, RESTATEMENT (THIRD) OF RESTITUTION & UNJUST ENRICHMENT § 59 & cmt. g and accompanying Reporter’s Note (2011); Chaim Saiman, Restitution and the Production of Legal Doctrine , 65 WASH. & LEE L. REV. 993, 998 (2008). 294 IOWA LAW REVIEW [Vol. 100:291 differently —it follows that the currently applicable “general principles” must be different from those that informed the older “special knowledge.” Different assumptions about what makes a desirable result have led new judges to new conclusions, and the question is what those different assumptions might be. II. SPECIAL KNOWLEDGE: FIVE PROPOSITIONS The rules of property law relevant to this discussion are those that determine the degree to which ownership of some asset is protected against involuntary dispossession. That the law gives some such protection is possibly the core idea of “property”—it would be hard to define “property” without it—but obviously such protection is not absolute. The question is how far this protection goes, against whom...