Ponzi Schemes Revisited

The Madoff Case

As late as November of last year, Madoff was the highly respected operator of one of the most sought-after investment advisory firms in the world, Bernard L. Madoff Investment Securities LLC (BMIS). He was a Wall Street innovator, the former chairman of the NASDAQ market, and leader of a tremendously successful investment firm that he founded in 1960. Most importantly, to the outside world, Madoff made money consistently for his investors, so much so that other investment firms apparently took large parts of their own clients' money and just turned it over to Madoff. As details of Madoff's Ponzi scheme continue to come to light, it is apparent that these so-called “feeder funds” ' and their clients ' have lost billions.

On Dec. 11, 2008, Madoff was arrested on a criminal complaint filed in the Southern District of New York that alleged one count of securities fraud. On the same day, the SEC filed an enforcement action against Madoff and BMIS, alleging violations of the Investment Advisers Act as well as securities fraud, and moved to freeze BMIS's assets and appoint a temporary receiver. Judge Lewis Stanton granted the SEC's motion and subsequently appointed a trustee pursuant to the Securities Investor Protection Act of 1970 (SIPA) to oversee the liquidation of BMIS and the distribution of its assets.

Fraud Claims

Perpetrators of Ponzi schemes face serious criminal and civil penalties. Criminal charges may include securities fraud, mail fraud, bank fraud, wire fraud, money laundering, and conspiracy charges. As with all fraud claims, criminal and civil, the defendant must have actually intended to defraud the victims (among other elements). But in a Ponzi scheme, one often encounters the assertion, which might even have the virtue of truth, that the accused operator of the scheme truly intended, at some unspecified point in the future, to repay the funds. After all, Ponzi himself did not think he was doing anything wrong; he always thought he would repay his investors. David Margolick, “His Last Name is Scheme,” N.Y. Times, April 10, 2005. Ponzi was convicted anyway, but can it be a valid defense if the accused holds the honest belief that he would pay back his investors?

Such a defense would undoubtedly fail. First, although a good-faith belief in the truth of the representations made is a defense to fraud, a belief that investors will ultimately be repaid by one who knowingly misrepresents the nature of the scheme is no defense. Second, in addition to the standard “badges of fraud” from which intent may be inferred, both criminal and civil courts have held that intent to defraud may be inferred from the Ponzi scheme itself and the accused's involvement with it. See, e.g., United States v. Gravatt, 280 F.3d 1189 (8th Cir. 2002); Drenis v. Haligiannis, 452 F. Supp. 2d 418 (S.D.N.Y. 2006). Thus, as one court explained, “no other reasonable inference is possible” because:

A Ponzi scheme cannot work forever. The investor pool is a limited resource and will eventually run dry. The perpetrator must know that the scheme will eventually collapse as a result of the inability to attract new investors. The perpetrator nevertheless makes payments to present investors, which, by definition, are meant to attract new investors. He must know all along, from the very nature of his activities, that investors at the end of the line will lose their money. Knowledge to a substantial certainty constitutes intent in the eyes of the law. In re Indep. Clearing House Co., 77 B.R. 843, 860 (D. Utah 1987).

Although Madoff has not yet revealed what defense, if any, he might proffer to the fraud charges against him, it is reasonable that any protestations that he always intended to make his investors whole would fall on deaf ears if the admissions specified in both complaints ' that “it's all just one big lie,” and his operation was “basically, a giant Ponzi scheme” ' turn out to be the devastating pieces of evidence that they appear to be.

Clawback from Early Redeemers?

After a Ponzi scheme has been discovered, the clear priority is to determine where the money went in order to recover as much of it as possible to give back to the victims. In the Madoff case, the SIPA trustee overseeing the liquidation of BMIS will be leading the restitution efforts. Additionally, for direct customers of Madoff, the Securities Investor Protection Corporation (SIPC) provides protection up to $500,000. However, many of Madoff's investors were not Madoff clients and apparently do not have this protection, but Judge Stanton was recently asked to extend SIPC protection to the clients of Madoff feeder funds.

Part of the recovery efforts can lead to the awkward scenario of the trustee suing investors who received payments from the scheme or redeemed principal prior to the scheme's unraveling. After all, these investors have, in effect, received money that the defendant stole in order to repay a debt. The Bankruptcy Code permits “fraudulent transfers” by the perpetrator of a Ponzi scheme to be avoided (i.e., clawed back) if made within two years of the commencement of the liquidation. 11 U.S.C. ' 548. Many states, including New York, have similar provisions; in New York, the clawback period is six years. See N.Y. DEBT. & CRED. LAW ” 273-76. Part of the rationale for recovery is that the actual value of the assets, securities, and funds of the perpetrator were less than the value represented to investors and utilized in redeeming the investments. Notably, “actual intent” on the part of the perpetrator is needed for certain elements of these statutes, but, based on the rationale explained above, there is a presumption of intent to defraud with Ponzi schemes. See In re Manhattan Investment Fund Ltd., 2007 U.S. Dist. LEXIS 92194, at *24-*32 (S.D.N.Y. Dec. 17, 2007).

Thus, some Madoff investors who breathed a sigh of relief when the unraveling of the scheme became public because they had “gotten their money out in time” may be in for a rude awakening when the trustee comes knocking. Counsel representing such investors should be thoroughly familiar with the clawback provisions of the Bankruptcy Code and understand that the trustee's fiduciary duties will lead him to want to minimize the costs of litigation. Thus, even an early redeemer might be able to negotiate a favorable settlement rather than risk losing the entire amount to the trustee.

Conclusion

Although the Madoff scheme is no longer operating, its after-effects are just beginning for the hundreds of investors who lost money. And don't be surprised if the current financial crisis brings other Ponzi schemes out of the woodwork.

Lee M. Cortes, Jr. is an associate in the White Collar Litigation and Internal Investigations Group at Kaye Scholer LLP. He wishes to thank Keith Murphy, also an associate at the firm, for his assistance with this article.

The unraveling of a $50-billion dollar Ponzi scheme allegedly perpetrated by Bernard L. Madoff has brought a new magnitude to an old but hardy scam. Although Ponzi schemes are all too familiar, the size, longevity, and global reach of the alleged Madoff fraud has broken all records. The list of potential victims spans the globe and ranges from individuals who invested their life savings to charities and educational institutions like Yeshiva University.

The basic structure of a Ponzi scheme (one common type is referred to as a “pyramid scheme”) is that the perpetrator entices a group of investors ' typically with the promise of unusually high profits ' who are then paid at least some part of their principal or profits from the deposits of other, later investors. Because of the continuing need to pay investors profits or principal as the scheme progresses, the perpetrator must continue to bring in more and more investors to keep it going. A Ponzi scheme relies on a strong illusion of profitability in order to attract additional victims. Madoff appears to have been a master of this illusion. As long as investors continue to join the scheme and not too many withdraw, the scheme keeps growing and growing. Until it all falls apart.

The scheme takes its name from Charles Ponzi, who sold investments in postal coupons in 1920s Boston until he was sent, predictably, to prison. Ponzi's scheme eventually collapsed under its own weight when he could no longer afford to pay his “investors.” Some Ponzi schemes are outright frauds from the start, with no part of the principal put into legitimate investments. Others, apparently including Madoff's, start out just misrepresenting what actual investments were being made but later ' usually when the market stalls ' begin to divert new investments to pay off old investors.

The Madoff Case

As late as November of last year, Madoff was the highly respected operator of one of the most sought-after investment advisory firms in the world, Bernard L. Madoff Investment Securities LLC (BMIS). He was a Wall Street innovator, the former chairman of the NASDAQ market, and leader of a tremendously successful investment firm that he founded in 1960. Most importantly, to the outside world, Madoff made money consistently for his investors, so much so that other investment firms apparently took large parts of their own clients' money and just turned it over to Madoff. As details of Madoff's Ponzi scheme continue to come to light, it is apparent that these so-called “feeder funds” ' and their clients ' have lost billions.

On Dec. 11, 2008, Madoff was arrested on a criminal complaint filed in the Southern District of New York that alleged one count of securities fraud. On the same day, the SEC filed an enforcement action against Madoff and BMIS, alleging violations of the Investment Advisers Act as well as securities fraud, and moved to freeze BMIS's assets and appoint a temporary receiver. Judge Lewis Stanton granted the SEC's motion and subsequently appointed a trustee pursuant to the Securities Investor Protection Act of 1970 (SIPA) to oversee the liquidation of BMIS and the distribution of its assets.

Fraud Claims

Perpetrators of Ponzi schemes face serious criminal and civil penalties. Criminal charges may include securities fraud, mail fraud, bank fraud, wire fraud, money laundering, and conspiracy charges. As with all fraud claims, criminal and civil, the defendant must have actually intended to defraud the victims (among other elements). But in a Ponzi scheme, one often encounters the assertion, which might even have the virtue of truth, that the accused operator of the scheme truly intended, at some unspecified point in the future, to repay the funds. After all, Ponzi himself did not think he was doing anything wrong; he always thought he would repay his investors. David Margolick, “His Last Name is Scheme,” N.Y. Times, April 10, 2005. Ponzi was convicted anyway, but can it be a valid defense if the accused holds the honest belief that he would pay back his investors?

Such a defense would undoubtedly fail. First, although a good-faith belief in the truth of the representations made is a defense to fraud, a belief that investors will ultimately be repaid by one who knowingly misrepresents the nature of the scheme is no defense. Second, in addition to the standard “badges of fraud” from which intent may be inferred, both criminal and civil courts have held that intent to defraud may be inferred from the Ponzi scheme itself and the accused's involvement with it. See, e.g., United States v. Gravatt , 280 F.3d 1189 (8th Cir. 2002); Drenis v. Haligiannis , 452 F. Supp. 2d 418 (S.D.N.Y. 2006). Thus, as one court explained, “no other reasonable inference is possible” because:

A Ponzi scheme cannot work forever. The investor pool is a limited resource and will eventually run dry. The perpetrator must know that the scheme will eventually collapse as a result of the inability to attract new investors. The perpetrator nevertheless makes payments to present investors, which, by definition, are meant to attract new investors. He must know all along, from the very nature of his activities, that investors at the end of the line will lose their money. Knowledge to a substantial certainty constitutes intent in the eyes of the law. In re Indep. Clearing House Co., 77 B.R. 843, 860 (D. Utah 1987).

Although Madoff has not yet revealed what defense, if any, he might proffer to the fraud charges against him, it is reasonable that any protestations that he always intended to make his investors whole would fall on deaf ears if the admissions specified in both complaints ' that “it's all just one big lie,” and his operation was “basically, a giant Ponzi scheme” ' turn out to be the devastating pieces of evidence that they appear to be.

Clawback from Early Redeemers?

After a Ponzi scheme has been discovered, the clear priority is to determine where the money went in order to recover as much of it as possible to give back to the victims. In the Madoff case, the SIPA trustee overseeing the liquidation of BMIS will be leading the restitution efforts. Additionally, for direct customers of Madoff, the Securities Investor Protection Corporation (SIPC) provides protection up to $500,000. However, many of Madoff's investors were not Madoff clients and apparently do not have this protection, but Judge Stanton was recently asked to extend SIPC protection to the clients of Madoff feeder funds.

Part of the recovery efforts can lead to the awkward scenario of the trustee suing investors who received payments from the scheme or redeemed principal prior to the scheme's unraveling. After all, these investors have, in effect, received money that the defendant stole in order to repay a debt. The Bankruptcy Code permits “fraudulent transfers” by the perpetrator of a Ponzi scheme to be avoided (i.e., clawed back) if made within two years of the commencement of the liquidation. 11 U.S.C. ' 548. Many states, including New York, have similar provisions; in New York, the clawback period is six years. See N.Y. DEBT. & CRED. LAW ” 273-76. Part of the rationale for recovery is that the actual value of the assets, securities, and funds of the perpetrator were less than the value represented to investors and utilized in redeeming the investments. Notably, “actual intent” on the part of the perpetrator is needed for certain elements of these statutes, but, based on the rationale explained above, there is a presumption of intent to defraud with Ponzi schemes. See In re Manhattan Investment Fund Ltd., 2007 U.S. Dist. LEXIS 92194, at *24-*32 (S.D.N.Y. Dec. 17, 2007).

Thus, some Madoff investors who breathed a sigh of relief when the unraveling of the scheme became public because they had “gotten their money out in time” may be in for a rude awakening when the trustee comes knocking. Counsel representing such investors should be thoroughly familiar with the clawback provisions of the Bankruptcy Code and understand that the trustee's fiduciary duties will lead him to want to minimize the costs of litigation. Thus, even an early redeemer might be able to negotiate a favorable settlement rather than risk losing the entire amount to the trustee.

Conclusion

Although the Madoff scheme is no longer operating, its after-effects are just beginning for the hundreds of investors who lost money. And don't be surprised if the current financial crisis brings other Ponzi schemes out of the woodwork.

Lee M. Cortes, Jr. is an associate in the White Collar Litigation and Internal Investigations Group at Kaye Scholer LLP. He wishes to thank Keith Murphy, also an associate at the firm, for his assistance with this article.