Using Clawback Actions to Harvest the Equitable Roots of Bankrupt Ponzi Schemes Jessica D

Georgia State University College of Law Reading Room Faculty Publications By Year Faculty Publications 1-1-2011 Midnight in the Garden of Good Faith: Using Clawback Actions to Harvest the Equitable Roots of Bankrupt Ponzi Schemes Jessica D. Gabel Georgia State University College of Law, [email protected] Follow this and additional works at: https://readingroom.law.gsu.edu/faculty_pub Part of the Accounting Law Commons, Bankruptcy Law Commons, and the Legal Ethics and Professional Responsibility Commons Recommended Citation 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). This Article is brought to you for free and open access by the Faculty Publications at Reading Room. It has been accepted for inclusion in Faculty Publications By Year by an authorized administrator of Reading Room. For more information, please contact [email protected]. ARTICLES MIDNIGHT IN THE GARDEN OF GOOD FAITH: USING CLAWBACK ACTIONS TO HARVEST THE EQUITABLE ROOTS OF BANKRUPT PONZI SCHEMES JessicaD. Gabelt CONTENTS INTRODUCTION: Too GOOD TO BE "GOOD FAITH"....................20 I. THE PONzI KINGDOM: STITCHING THE EMPEROR'S NEW CLOTHES ................................................................... 25 A. Ponzi Construction Codes ............................................ 25 B. Historic Ponzi Schemes.........................26 11. THE CLAWBACK CROWD: IN PURSUIT OF PONZI PAYOUTS .... 30 A. Ponzi Scheme Definition and Its Players................ 31 B. Ponzi Payouts:"Fraudulent or Preferential?.............. 32 1. Defining andDifferentiating Fraudulent Transfers..... 34 2. Ponzi Schemes: Fraud in the Making................ 36 t Assistant Professor of Law, Georgia State University College of Law. J.D., University of Miami School of Law; B.S., University of Central Florida. Clerk, the Honorable Peter T. Fay, Circuit Judge for the United States Court of Appeals for the Eleventh Circuit. The author would like to thank Nancy Rapoport, Jack Williams, and Michele Murray for their ongoing advice and support. My eternal thanks to my friend and mentor, Patricia Redmond, who has inspired and shaped my bankruptcy experience since law school. Finally, sincere appreciation to my intrepid research assistants Christopher DcNeve and Andrew Fleischman for their superb research and dedicated editing. 19 20 CASE WESTERN RESERVE LA W REVIEW [Vol. 62:1 3. The Displeasureof Preferences: Timing is Everything .............................................................. 38 1II. FRAUDULENT TRANSFERS IN PONZI SCHEMES: THE CHANGING FACE OF GOOD FAITH........................ 41 A. Into the Bayou and Beyond .......................................... 42 B. The Third Time's a Charm: Bayou III and the Good Faith Deviant .............................................................. 44 1. An Easy Hunt for Intent............................ 45 2. The Boundaries of Good Faith.................... 46 a. Inquiring Minds Need to Know................... 47 b. C.Y.A. Analysis .................................................. 47 c. Objectifying Good Faith........................48 C. Battle over Bayou ........................................................ 49 D. Calculating "Value" into the Good Faith Equation of Section 548(c) ............................................................ 53 IV. DIMINISHING RETURNS OF GOOD FAITH................... 58 A. Picking the Carcass: Madoff Math..................... 60 B. Supersizing SIPA and Section 548(c).................. 64 C. Criminal Competition ................................................... 70 D. Clawback Chaos: Striking a Balance Between Cause and Effect ................................................................... 71 1. Ponzi Policy ............................................................ 72 2. Innocent Investor v. Hungry Financier................ 74 CON CLUSION ........................................................................... 78 INTRODUCTION: TOO GOOD TO BE "GOOD FAITH" The unmasking of a Ponzi scheme usually means that the scam 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.' 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 I See generally Mark A. McDermott, Ponzi Schemes and the Law of Fraudulent and Preferential Transfers, 72 AM. BANKR. L.J. 157 (1998) (providing a general overview of Ponzi schemes). 2 See Diana B. Henriques, Proposed Tax Breaks for Ponzi Victims, N.Y. TIMES BUCKS BLOG (March 25, 2010, 7:19 PM), http://bucks.blogs.nytimes.com/2010/03/25/proposed-new- tax-breaks-for-ponzi-victims/ (stating that Ponzi losses have become so common that a tax break for victims may be necessary). 2011] MIDNIGHT IN THE GARDEN OF GOOD FAITH 21 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 Madoffs 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 3 See Enrique Martinez-Garcia & Janet Koech, A Historical Look at the Labor Market During Recessions, FED. RES. BANK OF DALL. ECON. LErTER, Jan. 2010, at 1, 2 (comparing the Great Recession to other economic downturns, including the Great Depression). 4 See Mark Landler & Sheryl Gay Stolberg, As Fingers Point in the Financial Crisis, Many of Them Are Aimed at Bush, N.Y. TIMES, Sept. 20, 2008, at A15 (detailing all the parties that people blamed as the market collapsed). 5 Leslie Wayne, The Mini-Madoffs: Troubled Times Are Bringing More Ponzi Inquiries to Light, N.Y. TIMES, Jan. 28, 2009, at B 1. 6 McDermott, supra note 1, at 158. 7See id. (discussing the anatomy of a Ponzi scheme). 22 CASE WESTERN RESERVE LA W REVIEW [Vol. 62:1 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. § 547(b)) provides an easy-to-follow roadmap in proving that a preferential transfer occurred. ° 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.'1 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.' 2 Those investors must 8 Note, however, that in some cases preferential transfer

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