When a Ponzi scheme collapses, there will typically be net winners and net losers. The bankruptcy trustee will often seek to force the net winners--those who received more money back from the Ponzi scheme than they invested--to disgorge their profits. Courts diverge on whether they should compel disgorgement in this instance. This Note argues that under prevailing fraudulent transfer law, net winners in a Ponzi scheme need not disgorge their profits. This is because the investor's dollar-for-dollar discharge of a preexisting debt constitutes the transfer of value in exchange for the payout. There are two exceptions to this rule: where the payouts are objectively excessive and where the investor is an equity holder rather than a debtholder. This framework is sound as a matter of policy, despite the fact that it is not always entirely fair, because it provides greater certainty in commercial transactions.
TABLE OF CONTENTS INTRODUCTION I. AVOIDING PONZI PAYOUTS A. The Ponzi Scheme and Its Types B. Actual Fraud: The Prima Facie Case II. THE ISSUE OF VALUE A. Ponzi Transfers for Value Are Generally Not Avoidable B. Ponzi Interest Is Transferred for Value III. LIMITATIONS ON THE NONAVOIDABILITY OF PONZI PAYOUTS A. Objectively Excessive Payouts B. The Equity-Type Ponzi Scheme IV. POLICY: CERTAINTY AND FAIRNESS CONCLUSION INTRODUCTION
You own a home in Exeter Township, Pennsylvania. The house is worth $200,000, and the balance on your mortgage is $120,000. A silver-haired man named Wesley A. Snyder, who in his suit and tie looks convincingly like an accomplished mortgage banker, approaches you with an enticing proposition dubbed the "Wrap-Around Equity Slide Down Discount Mortgage Program." He can reduce your annual mortgage rate by 1 percent, and you hardly have to do a thing. You will simply refinance your mortgage with a $140,000 loan from your local bank, say, Wells Fargo, and give the extra $20,000 to Snyder. He will invest that $20,000 for you and use a portion of the proceeds to reduce your monthly mortgage loan payments. Just have your bank forward all the bills to his firm, Image Masters, and you will make the reduced monthly payments to Image Masters directly.
This plan goes swimmingly. You make your reduced monthly payments to Snyder and put the savings in your children's college fund. Every month, Snyder's firm sends you a document detailing your reduced mortgage balance and the payments the firm has made on your behalf to Wells Fargo at your old interest rate. What a deal. But, as the saying goes, what seems too good to be true probably is. Two years later, you read in the newspaper that the U.S. Attorney has filed criminal charges against Snyder for the operation of a Ponzi scheme that defrauded 800 Pennsylvania residents of $29 million. Instead of investing your money in the capital markets and using the earnings to reduce your mortgage rate, Snyder used the proceeds of your investment to reduce the rates of other investors and to enrich himself. You still owe $140,000 to Wells Fargo on your mortgage plus the interest that has been compounding monthly on that sum at an increased rate for the past two years. You have no equity in your home, your credit rating is shot, and you are broke. Some investors, you learn, were luckier: Snyder really did pay the bank on their mortgages. This, or something close to it, is what hundreds of homeowners discovered on November 9, 2007. (1)
Ponzi schemes ruin lives. After the entities that operate these schemes inevitably file for bankruptcy, (2) the individual tasked in large part with mitigating the damage is the bankruptcy trustee. (3) In bankruptcy law, the trustee is the fiduciary charged with maximizing the value of the estate. (4) Frequently, the trustee seeks to retrieve or "claw back" the earnings received by investors in the Ponzi scheme who were lucky enough to escape with their shirts. (5) The trustee does so in part by filing avoidance actions against these lucky investors under the fraudulent transfer provision of the Bankruptcy Code. (6) There is a significant split of authority as to the viability of these actions. (7)
Whether the net winners--those who made more than they invested--should disgorge their profits is a difficult question. The instinct is often in favor of disgorgement, and that instinct is not unfounded: the profits of the net winners were made by defrauding the other investors. The net winners, the argument goes, should give the profits back because they were wrongfully procured. (8) As a matter of policy, the situation is little different than that of the con man who pawns a watch that he procured by defrauding the original owner. When the watch's owner comes to the pawnshop demanding the return of his watch, should the pawnshop have to give it up? Although the moral question is perhaps a close one, the law in both cases chooses certainty over fairness. (9) Arguably, the fairest remedy would be to apportion the hurt evenly among the creditors, making adjustments based on degrees of negligence. However, this system would involve substantial administrative costs and could discourage the free exchange of assets.
This Note argues that the Bankruptcy Code does not and should not permit the bankruptcy trustee to claw back payouts to Ponzi investors except in limited circumstances. Part I defines the Ponzi scheme and lays out the basic fraudulent transfer avoidance framework under the Bankruptcy Code. Part II argues that the avoidability of Ponzi payouts normally turns on whether the Ponzi investor has transferred reasonably equivalent value in exchange for her payout. In the typical case, the investor transfers precisely equivalent value in the form of a dollar-for-dollar reduction in the Ponzi scheme's debt to the investor. Part III argues that there are two important limitations on this framework: when the payouts are objectively excessive or when the Ponzi scheme is an equity-type Ponzi scheme, the Code may permit clawbacks. Finally, Part IV argues that although the instinct is often that courts should compel disgorgement of Ponzi payouts, the current Ponzi scheme framework is justified as a matter of policy because it protects the free exchange of assets.
AVOIDING PONZI PAYOUTS
This Section defines the Ponzi scheme and sets forth the basic framework under which a bankruptcy trustee will normally have a prima facie transfer avoidance claim against net winners in a Ponzi scheme. Section I.A defines the Ponzi scheme generally and explains two Ponzi subtypes that dictate the avoidability of payouts: fixed-income Ponzi schemes and equity-type Ponzi schemes. Section I.B sets forth the Bankruptcy Code's transfer avoidance framework and argues that a bankruptcy trustee will normally have a prima facie avoidance claim against net winners.
The Ponzi Scheme and Its Types
Although other definitions are more restrictive, this Note proposes that a Ponzi scheme is, at a minimum, an entity or group of entities that routinely finances its obligations to claimholders with the proceeds from newly issued liabilities but deceives its claimholders as to the source of the financing. A typical, more restrictive definition of the Ponzi scheme is as follows:
A fraudulent investment scheme in which money contributed by later investors generates artificially high dividends or returns for the original investors, whose example attracts even larger investments. Money from the new investors is used directly to repay or pay interest to earlier investors, [usually] without any operation or revenue-producing activity other than the continual raising of new funds. (10) Not all Ponzi schemes, however, promise artificially high rates of return. (11) Some even conduct real business operations in addition to defrauding their investors. (12) Thus, the fact that an entity routinely finances its obligations by issuing new liabilities while representing otherwise to its claimholders is sufficient to qualify that entity as a Ponzi scheme. (13)
It is critical to the arguments set forth in this Note to subdivide the Ponzi scheme into two types: the fixed-income Ponzi scheme and the equity-type Ponzi scheme. The eponymous Ponzi scheme, carried out by Charles Ponzi, typifies the fixed-income Ponzi scheme, wherein the debtor issues fixed-income securities to finance the illegal scheme. (14) Fixed-income securities are debt instruments, the interest rates of which are either static (e.g., 10.00% per annum or 8.00% semiannually) or pegged to some benchmark (e.g., 2.00% over the prime rate). (15) Charles Ponzi issued unsecured notes promising 50.00% interest per quarter. (16) He represented to his creditors that he was purchasing international postage stamps at a deep discount and selling them in other markets for a massive profit. (17) He raised almost $10 million. (18)
The Ponzi scheme carried out by Snyder, as described in the Introduction, (19) was also a fixed-income Ponzi scheme, although harder to recognize as such. One may question whether it was a Ponzi scheme at all or just a sophisticated form of fraud. It was, however, a Ponzi scheme because Snyder asked for an investment from his victims and promised them a return thereupon, which he paid out from the investments of other victims. The investment he requested and received was the equity that the homeowners "cashed out" of their homes by refinancing. (20) For example, a homeowner with a $120,000 loan on a $200,000 house might have refinanced with a $140,000 loan, given $120,000 to her old creditor, and remitted the extra $20,000 to Snyder. The homeowner might have had a $570 monthly payment on the old loan and, after refinancing, had a $670 monthly payment on the new loan. Snyder would then assume the obligation of paying the new loan, (21) $670 a month. In return, the victim would pay Snyder a lower rate than she had been paying on her home loan previously, (22) maybe $500 a month. In theory, Snyder would try...