The Collapse of Financial Fraud: Measuring Bankruptcy Avoidance Action

Ponzi schemes lay their foundation on fraud. Once the con is exposed, the culprits are usually stripped of their pilfered millions and sent off to jail. Unfortunately for the victims, the process of recovering any portion of the money they lost in the scam is, to put it mildly, complicated. The challenge rests, in part, in differences between federal forfeiture statutes and Bankruptcy Code principles in determining what assets can be recovered and who is entitled to a portion of the Ponzi pie. What is a Ponzi scheme (as defined by the courts rather than the media)? The Second Circuit defines a Ponzi scheme as a “fraudulent investment scheme in which money contributed by later investors is used to pay artificially high dividends to the original investors, creating an illusion of profitability, thus attracting new investors.” The Ninth Circuit has embraced an arguably broader description: “any sort of fraudulent arrangement that uses later acquired funds or products to pay off previous investors.” Other courts add that the scheme did not “conduct legitimate business as represented to investors.” In essence, a Ponzi scheme is a “money in, money out” con game. After the scheme collapses, as it inevitably does, Ponzi investors fall into two broad categories. The first is the “net losers” – investors who failed to receive a full return, or in many cases any return, on their principal investment, because their contributions were used to satisfy other investors’ expectations. The other broad category is “net winners” – “lucky” investors who received redemption payments that exceed the value of their principal investments. Recoupment of fictitious profits may subject the net winners to disgorgement of those profits and, in some instances, even disgorgement of principal (although this largely applies only to net winners). Beyond these broad categories, there often are “feeder funds” – various hedge funds, brokerage houses, and banks that steered large pools of investors into the Ponzi scheme. Relationships with feeder funds enable the Ponzi schemer to sustain the scam over a longer period of time by sweeping in thousands of smaller investors. These victims may find two areas of law interacting to determine recovery and distribution of the Ponzi scheme assets. Cite as 42 Golden Gate U. L. Rev 587 (2012)