The Rise and Fall of a Ponzi Scheme: The Ideal Illustration of the Law and Ethics of the Federal Bankruptcy Code

• Date: 01 July 2011
• DOI: http://doi.org/10.1111/j.1744-1722.2011.01092.x
• Author: Sandra S. Benson,Wade M. Chumney
• Published date: 01 July 2011

The Rise and Fall of a Ponzi Scheme:

The Ideal Illustration of the Law and

Ethics of the Federal Bankruptcy

Code

Sandra S. Benson

n

and Wade M. Chumney

nn

It is a case the circumstances of which call for the principle that equality is

equity, and this is the spirit of the bankrupt[cy] law.

1

I. INTRODUCTION

The news is rife with Ponzi schemesFnamed after Charles Ponzi, who

enticed investors with promissory notes paying an above-market return.

2

r2011 The Authors

Journal of Legal Studies Education r2011 Academy of Legal Studies in Business

273

Journal of Legal Studies Education

Volume 28, Issue 2, 273–330, Summer/Fall 2011

n

Assistant Professor Business Law, Jennings A. Jones College of Business, Middle Tennessee

State University. I am grateful to my undergraduate assistant Travis Kmita for help with

research and editing of this article.

nn

Cecil B. Day Assistant Professor of Business Ethics and Law, Georgia Institute of Technology

College of Management.

1

Cunningham v. Brown, 265 U.S. 1, 13 (1924).

2

Curt Anderson, Ponzi Schemes’ Collapses Nearly Quadrupled in ’09,LAW.COM (Dec. 29, 2009),

http://www.law.com/jsp/article.jsp?id=1202437299784. This source provides the following

statistics: almost four times as many investment scams unraveled in 2009 as compared to

2008; the Securities & Exchange Commission (SEC) issued 82 percent more restraining or-

ders against Ponzi schemes and other securities fraud cases; the SEC’s enforcement workload

investigating Ponzi schemes has increased from 9 percent in 2005 to 21 percent in 2009; and

FBI securities fraud investigations were up 20 percent in 2009 over 2008. Id. Other unrav-

eling scams are frequently in the news. See, e.g., John Waggoner, Madoff’s Gone but Ponzis Go on,

U.S.A. TODAY, Oct. 2, 2009, at B1 (observing that Ponzi schemes are easy to start but hard to

stop); Ken Whitehouse, Another Day, Another PonziIndictment from Williamson County,N

ASHVILLE

POST,Apr. 6, 2010, http://www.nashvillepost.com/news/2010/4/6/another_day_another_ponzi_

indictment_from_williamson_county; Mitchell Zuckoff, A Parade of Ponzis, CNN (Jan. 28,

2009), http://money.cnn.com/2009/01/28/news/newsmakers/ponzis.fortune/index.htm (dis-

cussing recent arrests of Nicolas Cosmo of Long Island, New York and ArthurNadel of Sar-

asota, Florida, and a Wall Street Journal report on SEC’s upward trend in filing new cases).

The denouement of a roughly $65 billion scheme run by Bernard Madoff

in December 2008 made international news due to its massive size, the

dazzling reputation of investment advisor and Wall Street darling Bernie

Madoff,

3

and the failure of both auditors

4

and regulators

5

to uncover the

scam. Following the demise of a Ponzi scheme, a federal bankruptcy matter

is often initiated by the victims

6

to provide for fair and equitable distribu-

tion of the fraudster’s limited assets to creditors.

7

Ponzi schemes present a

unique opportunity to bring to life the federal Bankruptcy Code

8

by

illustrating the requirements for commencing a voluntary or involuntary

bankruptcy case, the broad avoidance powers of the trustee to recover

3

Securities Investor Prot. Corp. v.Bernard L. Madoff Inv. Sec. LLC (In re Bernard L. Madoff

Inv. Sec. LLC), 424 B.R. 122 (Bankr. S.D.N.Y. 2010) (describing Madoff’s fraud).

4

See Sandra S. Benson, Recognizing the Red Flags of a Ponzi Scheme, C.P.A. J., June 1, 2009, at 18.

5

OFFICE OF INVESTIGATIONS,U.S.SEC.&EXCH.COMM’N,REP.NO.OIG-509,INVESTIGATION OF FAI-

LURE OF THE SEC TO UNCOVER BERNARD MADOFF’SPONZI SCHEME -PUBLIC VERSION (Aug. 31, 2009)

(Office of the Inspector General’s report of its investigation into the SEC’s shortcomings).

6

See generally Paul W. Bonapfelet al., The Business Bankruptcy Panel: PonziSchemesFBankruptcy

Court v. Federal Court Equity Receivership,26E

MORY BANKR.DEV. J. 207 (2010); Patrick M.

O’Keefe et al., Ponzi Schemes in Bankruptcy,A

M.BANKR.INST. (July 2007), http://www.abi

world.org/committees/newsletters/CFTF/vol4num4/index.pdf. Technically, Madoff ’s liquida-

tion is proceeding under the provisions of the Securities Investor Protection Act of 1970

(SIPA), 15 U.S.C. §§ 78aaa-lll (2006), which generally governs failed brokerage firms. See

Bankruptcy Basics, U.S. COURTS (Apr. 2006), http://www.uscourts.gov/FederalCourts/

Bankruptcy/BankruptcyBasics.aspx.

7

Following the demise of a Ponzi scheme, there are generally few assets to pay the victims.

The ‘‘aftermath of a Ponzi scheme is a little like the remains of nuclear explosion. After

the mushroom cloud dissipates few, if any, assets exist.’’ O’Keefe et al., supra note 6,

at 2.

8

11 U.S.C. §§ 101–1527 (2006). In general, the same provisions of the federal Bankruptcy

Code govern Ponzi scheme matters. Thus, trustees administering the estates of fraudsters

have the duties and powers to collect property for the estate; challenge transfers of property

that occurred prior to the bankruptcy filing; employ accountants, auctioneers, and other

professionals; and object to improper claims from creditors. Ultimately,the trustee distributes

the estate to unsecured creditors after secured and priority claims are satisfied. Note that

following the demise of Madoff’s scheme, the provisions of the SIPA governed because his

firm, Bernard L. Madoff Investment Securities LLC, was a brokerage firm. This act provides

that the federal Bankruptcy Code applies, unless specific provisions of the SIPA govern. 15

U.S.C. §§ 78aaa-lll (2006).

274 Vol. 28 / The Journal of Legal Studies Education

assets into the bankruptcy estate (reaching even the victims

9

and

charities

10

who received monies from the fraudster), and the distribution

of the estate and the concrete effects of being a secured versus an unse-

cured creditor in a bankruptcy proceeding.

11

While the Madoff scheme may be familiar to students, an earlier, less fa-

miliar Ponzi scheme, run by Robert McLean, may also be particularly instruc-

tive.

12

Prior to his fraud, McLean crafted a reputation as a successful investor,

advisor, and philanthropist.

13

To expand his reputation and his network of

9

See, e.g., Cunningham v. Brown, 265 U.S. 1 (1924) (trustees filed claims against six investors

for redemptions of their own principal as preferences); Bayou Group. v. Redwood Growth

Partners (In re Bayou Group), 396 B.R. 810 (Bankr.S.D.N.Y. 2008) (Chapter 11 debtors filed

thirty-three adversary actions against investors who had redeemed investments within one

year prior to debtors’ collapse as fraudulent conveyancesunder federal Bankruptcy Code and

New York Debtor and Creditor Law); In re Taubman, 160 B.R. 964 (Bankr. S.D. Ohio 1993)

(transfers made to investors within one year prior to Chapter 7 filing were avoidable as

fraudulent transfers). See also Madoff Trustee Could Sue 1,000 Ponzi Victims,R

EUTERS, July 26,

2010, http://www.reuters.com/article/idUSTRE66K2S720100726; E. Thomas Wood, Hanover

Trustee Sues Dozens of Investors,NASHVILLE POST, Nov. 25, 2008, http://www.nashvillepost.com/

news/2008/11/25/hanover_trustee_sues_dozens_of_investors. See generally David F. Kurzawa

II, When Fair Consideration Is Not Fair,11CORNELL J.L. & PUB.POL’Y461 (2002) (trustee filed

lawsuits against 3,000 investors by trustee looking back seven years to recoup payments to

investors); Mark A. McDermott, Ponzi Schemes and the Law of Fraudulentand Preferential Trans-

fers,72A

M.BANKR. L.J. 157 (1998) (discussing that the largest source of funds for victims is

often in the hands of the victims themselves.).

10

See, e.g., Christians v. Crystal Evangelical Free Church, 521 U.S. 1114 (1997) (mem.), va-

cating and remanding Christians v. Crystal Evangelical FreeChurch (In re Young), 89 F.3d 494

(8th Cir. 1996). Forarticles discussing fraudulent avoidance powers and the Constitution, see

generally Julianne Belaga, Now You See It, Now You Don’t: The Impact of RFRA’s Invalidation on

Religious Tithes in Bankruptcy,14B

ANKR.DEV. J. 343 (1998).

11

See, e.g., Order Granting Motion to Sell Property re Stock and Determining Amount of the

Secured Claim of MidSouth Bank, In re McLean, No. 07-05054-GP3-7 (Bankr. M.D. Tenn.

Oct. 17, 2007), ECF No. 145 (on file with authors) [hereinafter Order Granting Motion to Sell]

(MidSouth, a secured creditor, was able to sell its collateral to satisfy its debt on its secured

loan; its unsecured credit will be administered as other unsecured claims.).

12

Like Charles Ponzi, McLean enticed investors with promissory notes paying an above-mar-

ket return, and thus, the instructor can correlate the facts of the more recent McLean scheme

with the facts and outcome of the first scheme addressed by the U.S. Supreme Court.

13

See Theo Emery,Illusion of Success Gives Wayto Suits and Suicide, N.Y. TIMES, Nov.10, 2007, at

A12.

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