It is fairly common, upon discovery of a Ponzi scheme, for a Court to appoint a receiver to take over the affairs of the fraudulent enterprise. The Receiver, in turn, commonly will ask investors to return any of their ill-gotten gains, because, in reality, any investor who made a “profit” really received money that was taken from another defrauded investor.
If the investor will not return the money, the Receiver will likely file a lawsuit under the Uniform Fraudulent Transfer Act (UFTA), which has been adopted by most states. 1
Where causes of action are brought under UFTA against Ponzi scheme investors, the general rule is that to the extent innocent investors have received payments in excess of the amounts of principal that they originally invested, those payments are avoidable as fraudulent transfers: The money used for the underlying investments came from investors taken in by fraudulent representations.
Even though the defendant in a UFTA claim was one of those investors, and it may seem “only fair” that he or she should be entitled to the profits on trades made with his money. That would be true as between him and the Ponzi scheme operator. It is not true as between him and either the creditors of or the other investors in the company. He should not be permitted to benefit from a fraud at their expense merely because he was not himself to blame for the fraud. All he is being asked to do is to return the net profits of his investment-the difference between what he put in at the beginning and what he had at the end.2
The policy justification is ratable distribution of remaining assets among all the defrauded investors. The “winners”in the Ponzi scheme, even if innocent of any fraud themselves, should not be permitted to “enjoy an advantage over later investors sucked into the Ponzi scheme who were not so lucky.”3
There are two theories under which a receiver may proceed under UFTA: actual fraud or constructive fraud. Under the “actual fraud” theory, the receiver alleges that the debtor (Ponzi scheme operator) made transfers to the transferee (the winning investor) “[w]ith actual intent to hinder, delay, or defraud” he creditors (the losing investors). “[T]he mere existence of a Ponzi scheme is sufficient to establish actual intent” to defraud.4
Under the “constructive fraud” theory, the receiver alleges that the transfer of “profits” to the winning investor was made “[w]ithout receiving a reasonably equivalent value in exchange for the transfer,” because profits gained through theft from later investors are not a reasonably equivalent exchange for the winning investor’s initial investment.5
Proof that transfers were made pursuant to a Ponzi scheme generally establishes that the scheme operator “[w]as engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction,” or “[i]ntended to incur, or believed or reasonably should have believed that he or she would incur, debts beyond his or her ability to pay as they became due.”
In the context of a Ponzi scheme, whether the receiver seeks to recover from winning investors under the actual fraud or constructive fraud theories generally does not impact the amount of recovery from innocent investors. Under the actual fraud theory, the receiver may recover the entire amount paid to the winning investor, including amounts which could be considered “return of principal.” However, there is a “good faith” defense that permits an innocent winning investor to retain funds up to the amount of the initial outlay.6
Under the constructive fraud theory, the receiver may only recover “profits” above the initial outlay, unless the receiver can prove a lack of good faith, in which case the receiver may also recover the amounts that could be considered return of principal.7 The Seventh Circuit has suggested that the only practical distinction between these theories of recovery is the allocation of burdens of proof.8
Drawing from these theories, federal courts have generally followed a two-step process.
First, to determine whether the investor is liable, courts use the so-called “netting rule.”9 Amounts transferred by the Ponzi scheme perpetrator to the investor are netted against the initial amounts invested by that individual. If the net is positive, the receiver has established liability, and the court then determines the actual amount of liability, which may or may not be equal to the net gain, depending on factors such as whether transfers were made within the limitations period or whether the investor lacked good faith.
If the net is negative, the good faith investor is not liable because payments received in amounts less than the initial investment, being payments against the good faith losing investor’s as-yet unsatisfied restitution claim against the Ponzi scheme perpetrator, are not avoidable within the meaning of UFTA. 10
Second, to determine the actual amount of liability, the court permits good faith investors to retain payments up to the amount invested, and requires disgorgement of only the “profits” paid to them by the Ponzi scheme.11 Payments of amounts up to the value of the initial investment are not, however, considered a “return of principal,” because the initial payment is not considered a true investment. Rather, investors are permitted to retain these amounts because they have claims for restitution or recision against the debtor that operated the scheme up to the amount of the initial investment.
Payments up to the amount of the initial investment are considered to be exchanged for “reasonably equivalent value,” and thus not fraudulent, because they proportionally reduce the investors’ rights to restitution.12 If investors receive more than they invested, “[p]ayments in excess of amounts invested are considered fictitious profits because they do not represent a return on legitimate investment activity.”13
Although all payments of fictitious profits are avoidable as fraudulent transfers, the appropriate statute of limitations restricts the payments the Ponzi scheme investor may be required to disgorge. Only transfers made within the limitations period are avoidable.14 Once the district court has identified the avoidable transfers, it has the discretion to permit the receiver to recover pre-judgment interest on the fraudulent transfers from the date each transfer was made.15