Academic journal article Boston University Law Review

Rethinking Ponzi-Scheme Remedies in and out of Bankruptcy

Academic journal article Boston University Law Review

Rethinking Ponzi-Scheme Remedies in and out of Bankruptcy

Article excerpt


A conventional Ponzi scheme, which temporarily sustains extraordinary returns by drawing on newly invested funds to make payouts to earlier investors, is normally a subject for criminal law.1 If the prospect of criminal penalties has not deterred the mastermind of such an enterprise, then, when the scheme runs its course, it is normally mopped up by bankruptcy law.2 The scheme lives longer and allows the perpetrator to extract and waste greater resources the more investors plow back their "profits" and the less intensely anyone investigates its details. As is often the case following large-scale tortious activity, legal remedies will be aimed beyond the primary wrongdoer to other parties.3 Thus, after Bernard Madoffstole, lost, and gave away about $18 billion, in what might have been the largest Ponzi scheme in history, a court-appointed trustee aggressively pursued second-best cost avoiders, including investors who might have suspected that fraud was in progress.4 Some of the facts and lessons of that case are discussed below.

In dealing with Ponzi schemes, bankruptcy law conceives of defrauded investors as armed with restitution claims, so that they become creditors of the estate, able to recover some of their principal in proportional fashion.5 If, however, there are investors who were in bad faith, the new Restatement (Third) of Restitution and Unjust Enrichment confirms and advances the notion that a claim might run in the other direction, so that the debtor's estate can recapture, or claw back, these investors' earlier withdrawals.6

The discussion in Part I begins with a review of, and some context regarding, current law. I argue that bankruptcy law might reinvent itself. Defrauded investors might be depicted not as creditors unable to collect their full restitution claims, but rather as equity investors. Some past payments to these investors might then be subject to recapture, not just as fraudulent conveyances but as mistaken distributions. The larger point is that bankruptcy law needs a reason to choose between competing characterizations of what transpired. I suggest that the right choice is the one that deters Ponzi schemes or minimizes losses. Part II goes a step further and argues that the harm done by Ponzi schemes might be minimized not by clawing back from investors who should have known better but rather by rewarding those who exited, inasmuch as it is exit that hastens the scheme's collapse. It turns out that each of these three legal strategies makes use of restitution and that each creates problems for courts. Part III carries the loss-minimization goal, as well as the restitution remedy, to frauds that I label semi-Ponzis. In such a scheme there is a Ponzi-esque collective action problem without the likelihood of a geometric expansion and then collapse of a fraud.


A. Current Law

There are many kinds of fraud, and it is unlikely that each requires a distinct remedy. Moreover, most wrongdoers who use new investors' money to satisfy or make good ambassadors of old investors - a pattern that complies with the usual definition of a Ponzi scheme - will have dissipated a fair portion of the funds contributed by investors. Presumably, the primary target of a fraud investigation and claim is the wrongdoing organizer of the fraud. If this primary wrongdoer's resources have been exhausted, and a prison term or disappearing act is in the picture, then investors can expect no more than a fraction of their invested principal.7 If all those who suffered losses are in identical positions, the cleanup process known as bankruptcy is fairly straightforward. A court will assemble and assess the available assets, require proof of the original investments, and then distribute the available assets in pro rata fashion.8

In most cases the investors are not all alike. Some will have extracted all or a portion of their original investment. Some may be labeled as "winners" because they have withdrawn more than they invested. …

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