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Ponzi Scheme Avoidance Law and the Inequity of Clawbacks

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Ponzi Scheme Avoidance Law and the Inequity of Clawbacks Note Turning Winners into Losers: Ponzi Scheme Avoidance Law and the Inequity of Clawbacks Karen E. Nelson∗ On June 29, 2008, a federal district judge sentenced the man who had committed the most extensive and destructive Ponzi scheme in history to 150 years in prison.1 Bernard L. Madoff defrauded investors of up to $64.8 billion2 in a decades- long scheme3 in which supposed profits came not from the mar- ket, but from subsequent investors.4 When new investors ran out, these “profits” dried up and the fraud was exposed.5 At Madoff’s final sentencing hearing, devastated investors lined up to tell their stories of savings lost and dreams destroyed.6 For some of these investors, however, the financial ruin may be just beginning. Under federal and state fraudulent transfer law and traditional Ponzi scheme jurisprudence, the appointed trustee in a bankruptcy may “clawback” returns conveyed to ∗ J.D. Candidate 2011, University of Minnesota Law School; B.A. 2006, St. Olaf College. Thanks to Law School Professors Edward Adams and Fran- cesco Parisi for key ideas and feedback, as well as to University of Alberta Pro- fessor Emeritus Glen Mumey for inspiriting interest and commentary. Special thanks to Minnesota Law Review Editors Theresa Nagy and Joseph Hansen for many valuable perceptions and edits. Finally, deepest thanks to my par- ents, Pete and Laurie Nelson, for generous support and great newspaper ar- ticles; my sister Kim, for continuous encouragement and academic inspiration; and my fiancé, Kyle Wenzel, for constant patience (and love). Copyright © 2011 by Karen E. Nelson. 1. E.g., Diana B. Henriques, Madoff, Apologizing, Is Given 150 Years, N.Y. TIMES, June 30, 2009, at A1, available at 2009 WLNR 12446925. 2. Martha Graybow, Madoff Mysteries Remain as He Nears Guilty Plea, REUTERS, Mar. 11, 2009, available at http://www.reuters.com/article/2009/03/ 11/us-madoff-idUSTRE52A5JK20090311. 3. See Robert Frank, Madoff Jailed After Admitting Epic Scam, WALL ST. J., Mar. 13, 2009, at A1, available at 2009 WLNR 4866802 (noting that prosecutors believe Madoff’s fraud began in the 1980s). 4. See BLACK’S LAW DICTIONARY 1278 (9th ed. 2009) (defining “Ponzi scheme”). 5. Id. 6. See Henriques, supra note 1. 1456 2011] CLAWBACKS 1457 certain investors prior to the fraud’s exposure.7 Investors vul- nerable to this process, often called “winners” because they re- ceived an amount larger than their principal balance from the scheme,8 likely lost their balances left with Madoff as did “los- ers” who made no profit from the scheme.9 However, trustees may also require that winners pay back any interest extracted from their accounts from up to six years prior to discovery of the fraud.10 This power is allowed whether or not such inves- tors still have funds to pay, and despite their lack of culpabili- ty.11 The magnitude of Madoff’s scandal highlights the major equitable dilemmas arising from the clawback aspect of Ponzi scheme avoidance law. Fraudulent transfer laws impose strict liability on initial transferees of fraudulent transfers,12 which has long been deemed unfair and punitive to innocent recip- ients of such transfers.13 Jurisprudence specific to Ponzi schemes has exacerbated this inequity. Subjecting winning in- vestors to clawbacks of their “fictitious profits”14 can impose in- surmountable financial burdens on innocent victims of the fraud.15 Such a consequence encourages ethically questionable 7. See, e.g., Jeff Benjamin, Madoff Investors May Face Clawbacks, INVESTMENT NEWS, Feb. 10, 2009, http://www.investmentnews.com/article2009 0210/REG/902109979. 8. See, e.g., Josh Nathan-Kazis, Should Madoff’s Winners Give Back to Losers?, JEWISH DAILY FORWARD (Oct. 16, 2009), http://www.forward.com/ articles/116262/. 9. Id. 10. See Paul Hinton & Jan Larsen, Clawbacks from Madoff Investors: Questions of Economics, Equity, and Law, NERA ECON. CONSULTING, 1 (Apr. 28, 2009), http://www.nera.com/extImage/PUB_Madoff_Investors_Clawbacks_ 0409_final.pdf. 11. See, e.g., Bliese v. McCarn’s Allstate Fin., Inc. (In re McCarn’s Allstate Fin., Inc.), 326 B.R. 843, 852 (Bankr. M.D. Fla. 2005). 12. 11 U.S.C. § 550(a)(1) (2006); UNIF. FRAUDULENT TRANSFER ACT § 8(b)(1), 7A U.L.A. pt. II, at 179 (2006). 13. See, e.g., In re McCarn’s Allstate, 326 B.R. at 852 (noting that “unfair- ness in result” is not a defense to § 550’s initial transferee provisions); First Commercial Mortg. Co. v. Circuit Alliance, Inc. (In re Circuit Alliance, Inc.), 228 B.R. 225, 233 (Bankr. D. Minn. 1998) (arguing that prohibiting exceptions to § 550’s “unqualified” language leads to “basic fairness” and equity issues); Craig H. Averch, Protection of the “Innocent” Initial Transferee of an Avoidable Transfer: An Application of the Plain Meaning Rule Requiring Use of Judicial Discretion, 11 BANKR. DEV. J. 595, 623 (1995). 14. In re Bayou Grp., LLC, 372 B.R. 661, 663 (Bankr. S.D.N.Y. 2007). 15. See, e.g., Alex Berenson, Even Winners May Lose Out with Madoff, N.Y. TIMES, Dec. 19, 2008, at A1, available at 2008 WLNR 24370521. 1458 MINNESOTA LAW REVIEW [95:1456 attorney advice,16 causes conflict among victims,17 and strays from America’s fundamental tenets of capitalism. Further, Ponzi scheme avoidance law causes economic inequities among victims despite purporting to seek equality.18 Due to these ram- ifications, many analysts foresee years of protracted litigation related to clawbacks in Ponzi scheme cases.19 This Note argues that Ponzi scheme avoidance law must be aligned with a more equitable outcome for so-called winning investors. Part I outlines the federal and state fraudulent transfer laws relevant to Ponzi schemes, and the way courts have interpreted and applied these laws to winning Ponzi scheme investors. Part II analyzes the legal, personal, social, and economic inequities that arise from this application. Part III recommends that courts update their definition of “value” under Ponzi scheme avoidance law to allow for a more expan- sive and economically equitable defense for winning investors. Specifically, investors should be able to retain the time value of their initial investment and a certain degree of opportunity costs. This Note concludes that treating victimized investors more uniformly in Ponzi scheme cases will better serve the fundamental equitable purpose of fraudulent transfer law. I. FRAUDULENT TRANSFER AND PONZI SCHEME LAW IN THE UNITED STATES The body of law applicable to Ponzi schemes is a mixture of both state and federal statutes and court jurisprudence devel- oped over time.20 Understanding the current state of this law— referred to as “Ponzi scheme avoidance law” for purposes of this Note—requires an overview of the background and growth of federal and state fraudulent transfer law, as well as court- made Ponzi scheme law. 16. See, e.g., H.R. REP. No. 108-40, pt. 1, at 593–97 (2003) (admonishing the “notorious ‘financial planning’ strategy” that utilizes Bankruptcy Code § 522’s exemption rules); Asher Rubinstein, Madoff Jailed, What’s Next? Pro- tecting Assets from Clawbacks, RUBINSTEIN & RUBINSTEIN, LLP (Mar. 18, 2009), http://www.assetlawyer.com/wordpress/?p=149 (counseling liable clients to redirect assets into, among other things, exempt homes). 17. See, e.g., Nathan-Kazis, supra note 8. 18. See, e.g., Cunningham v. Brown, 265 U.S. 1, 13 (1924) (“[E]quity . is the spirit of the bankrupt law.”). 19. E.g., Benjamin, supra note 7. 20. See, e.g., 11 U.S.C. §§ 546–550 (2006); N.Y. DEBT. & CRED. LAW §§ 270–281 (McKinney 2009); Bear, Stearns Sec. Corp. v. Manhattan Inv. Fund Ltd. (In re Manhattan Inv. Fund Ltd.), 397 B.R. 1, 8 (S.D.N.Y. 2007). 2011] CLAWBACKS 1459 A. FRAUDULENT TRANSFER LAW Both state and federal fraudulent transfer laws apply in the context of a Ponzi scheme allegation. This section outlines the fundamental parts of each body of law that affect the out- come for victimized Ponzi scheme investors. 1. Federal Fraudulent Transfer Law—The Bankruptcy Code The U.S. Constitution vests Congress with the power to es- tablish federal bankruptcy laws,21 and the Bankruptcy Reform Act of 1978 (the Bankruptcy Code or the Code) is the law gov- erning bankruptcy in the United States today.22 The current federal structure consists of a united jurisdictional arrange- ment of courts and judges that solely hear and determine bank- ruptcy-related matters.23 Under the U.S. Trustee System, a third party is injected into bankruptcy litigation in certain cir- cumstances24 to oversee the “administrative and supervisory” issues in bankruptcy cases.25 Understanding the unique bank- ruptcy litigation process is integral to a thorough appreciation of the issues related to fraudulent transfers that can arise in these proceedings. One of a trustee’s key duties in a bankruptcy proceeding is to recapture the value of any fraudulent or preferential trans- fers for the bankruptcy estate.26 Hence, the Bankruptcy Code gives trustees “avoiding powers” to void certain transfers the bankrupt entity (the debtor) made to the transferee before the debtor went bankrupt.27 Code § 548 details the situation under which trustees may avoid conveyances due to fraud.28 Specifi- cally, trustees may recapture the value of any transfer made within two years of the bankruptcy petition filing and with “ac- tual intent to hinder, delay, or defraud any entity to which the 21. U.S. CONST. art. I, § 8, cl. 4. 22. See Charles Jordan Tabb, The History of the Bankruptcy Laws in the United States, 3 AM. BANKR. INST. L. REV. 5, 32 (1995). 23. Id. at 34. 24. See 11 U.S.C. § 1104(a) (“[T]he court shall order the appointment of a trustee (1) for cause, including fraud, dishonesty .
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