For many investors, the challenge of investing in the financial markets contains enough risk without the additional concern that one’s investment might be eliminated in a Ponzi scheme. Yet that is the sad result many investors face when, often years after investing a sizeable portion of their life savings, they receive a notice that the entity in which they invested was a Ponzi—specifically, that it made payments in whole or in part from the payments of earlier investors, rather than from the profits of an underlying business venture. Such investors can expect, at the very minimum, years of delay while a court-appointed trustee or receiver attempts to recover transfers and make a final distribution to investors. In many cases, investors also may receive a second letter, this time from the trustee, demanding that money received from the Ponzi be returned.
In California, the mechanism for recovering transfers made from a Ponzi scheme is the Uniform Fraudulent Transfer Act (Cal. Civ. Code §3439.04) which states, in part, that a transfer is fraudulent if made with the intent to defraud a creditor. Courts have routinely applied this language to allow receivers or trustees in bankruptcy to recover monies lost by Ponzi scheme investors.
A trustee can recover from innocent investors only amounts paid in excess of the original investment—investors “in” on the Ponzi are liable for all payments received. Once a Ponzi scheme is found to exist, all transfers made in connection with that Ponzi are deemed intentionally fraudulent. Nevertheless, recipients of those payments possess the same defense they would possess in any fraudulent transfer action: the “good faith” defense which in California is codified in Cal. Civ. Code. §3439.08(a). This will permit an investor to retain funds up to the up to the amount of the amount of their initial outlay. Thus a Trustee must “net out” investments against payouts to determine if liability exists. If an investor is a “net loser” in the Ponzi, then the investor possesses a full defense to any fraudulent transfer action. For this reason, a trustee has an interest in quickly determining how many “net winners” are likely to exist. Typically, that percentage will be small compared to the total number of all investors.
Only the actual amount of an investor’s payment into the Ponzi is calculated in determining whether the investor is a net winner. This is because at the time an investment is made, the investor is not actually an “investor” (because there is no legitimate investment vehicle in which to invest), but rather a tort creditor with a fraud claim for restitution equal to the amount given. As the investor receives payments back from the debtor, her fraud claim for restitution is reduced dollar-for-dollar. At the point when such investor ever receives an equal number of dollars back as she invested, she is no longer a creditor of the debtor—rather, her fraudulently obtained payment has been restored.
Often, Ponzi schemes start out as legitimate investment vehicles, and become a true Ponzi at some later date. There is no Ninth Circuit guideline as to how to determine the specific date an investment became a Ponzi, or how to treat in investor who received payment in both time periods. Case law suggests that a court would look to the date a legitimate investment turns into a Ponzi and determine each investor’s restitution claim as of that date. From that day forward, payments from the Ponzi will reduce that claim dollar for dollar, and any excess is recoverable.
There are several seemingly “unfair” results that can occur from this, but courts have ruled that those unfair results are simply fallout from the distasteful business of Ponzi schemes, and must be endured. One unfair result is that early investors receive the same “restitution claim” as later investors who invest the same amount, regardless of the opportunity cost to the early investor in terms of loss of interest. Another result is that investors who received 100% of their initial investment will not be required to return a portion of that amount, even if other investors only received a 10% return. Creditors who pay taxes on monies paid out of a Ponzi do not receive an offset as to any liability. Costs incurred in connection with making or maintaining an investment in a Ponzi cannot be used to offset liability, either.
Fraudulent transfer litigation is never easy for a trustee, or pleasant for a defendant, and when the transfer is from a Ponzi the agony is increased for both sides: on the one hand, the trustee may have significant difficulty in locating documents identifying which investors received which payments, and on the other hand, defendants may have lost significant amounts of their investment, and received almost no documentation themselves from the fraudulently-run scheme. Careful pre-litigation planning on behalf of the trustee can serve to significantly reduce the amount of wasteful litigation initiated against parties who likely may end up to be “net losers” who possess a full defense. This will free the trustee’s resources to pursue the true bad parties in any Ponzi: the parties who knew of the Ponzi and knowingly received transfers of innocent investors’ funds.