The public has most recently been exposed to the concept of a Ponzi scheme by way of a former NASDAQ chairman named Bernard "Bernie" Madoff. While Ponzi schemes on a scale as large as Madoff's may be rare, Ponzi schemes in general are more common than one might think.
Ponzi schemes are fraudulent operations because the returns are paid from money obtained through subsequent investors, rather than any actual profits earned. Due to this structure, Ponzi schemes require an ever-increasing flow of new money, and ultimately collapse because the earnings are less than the returns paid out to investors.
At the end of a Ponzi scheme, investors can be grouped into two separate and distinct categories. The Winning Investors are those who received a positive return on their investment, meaning they took more money out than they ever put in. The Losing Investors are those who received a negative return on their investment; meaning they paid more into the scheme than they ever received.
When a Ponzi scheme ultimately collapses, a Receiver is typically appointed to recover the assets fraudulently transferred by the investment company to the Winning Investors. The goal is to return said assets to the Losing Investors in an attempt to make everyone whole. The Winning Investors are placed in a position where they must return all of the money they earned through the investment, even if that money was earned and spent years earlier. Moreover, the Receiver will not make any consideration for a reasonable rate of return.
When faced with a recovery action by the Receiver, Winning Investors should consider whether one or more the following defenses apply:
- A transfer is not avoidable if the Winning Investor is a subsequent transferee who took the proceeds in good faith ("good faith transferee");
- A transfer is not avoidable if the Winning Investor is a good faith transferee who paid a reasonable equivalent value for his or her returns; or
- A transfer is not avoidable if it is beyond the statute of limitations.
Good faith transferees are entitled to keep their earnings and investment. A problem with this theory, however, is the determination of whether one has paid a "reasonably equivalent value" so as to qualify as a good faith transferee.
Winning Investors should also consider the statute of limitations imposed under both State and Federal law. In California, an action with respect to any fraudulent transfer must be brought within four years after the transfer was made, or within three years after the transfer is reasonably discovered, whichever is later; except that no actions may be brought more than seven years after the transfer.
At the end of the day, everyone loses in a Ponzi scheme. The Receiver is unlikely to recover more than a small percentage of the Losing Investors' initial investment, and the Winning Investors will be forced to return all profits in excess of their initial investments, regardless of their innocence or whether this money was spent in years past.
Timothy J. Broussard is a Partner with Kring & Chung, LLP's Irvine office. He can be contacted at (949) 261-7700 or firstname.lastname@example.org.
June Yang Cutter is an Associate with Kring & Chung, LLP's Irvine office. She can be contacted at (949) 261-7700 or email@example.com.