Even though it’s the off-season, the New York Mets have been in the news quite a bit recently—and not, to the dismay of their fans, because of any free agent signings. Instead, the team’s owners—the Wilpon family—were named in a lawsuit filed on behalf of the victims of the Bernie Madoff Ponzi scheme. Though the Wilpons are not thought to have personally aided Madoff’s fraud, they are alleged to have ignored the red flags surrounding Madoff’s operation. The legal theories that form the basis for this suit—that, essentially, the Wilpons should have known better—are the subject of “Ponzi’s Legacy,” a paper delivered by Professor Douglas Baird at a recent WIP talk.
As Professor Baird points out, Ponzi schemes present a number of puzzles, and not only for the legal profession. To begin with, they don’t make a lot of economic sense. The premise of a Ponzi scheme is that old investors are paid off with the proceeds from new investors. This means that obligations increase geometrically over time, and the swindler has to spend ever more time finding new investors. No self-respecting con artist would adopt a scheme that requires that much work, especially since so much of the money coming in has to go right back out again to perpetuate the fraud.
It is this latter feature that, as Professor Baird puts its, “makes Ponzi schemes so interesting to bankruptcy professionals.” At the time a Ponzi scheme collapses—as they almost all inevitably do—the fraudster is typically in bankruptcy. Victims may seek to recover money from anyone who participated in or aided and abetted the fraud, but they are likely to be unsatisfied. That’s because the parties with the deepest pockets—financial institutions such as investment banks—rarely have actual knowledge of the fraud, an essential element of aiding and abetting liability. As Professor Baird notes, Wall Street firms “may be greedy, but they usually are not that stupid.”
Instead, the victims’ best bet is for the bankruptcy trustee to recover any assets that were transferred out of the scheme before it collapsed. That is, new investors will seek restitution from the old investors. To do so, the trustee will rely on two bankruptcy doctrines that can be traced back to the 16th century and Lord Coke—preference and fraudulent conveyance.
A preference is any payment outside the ordinary course of business made to a creditor in a 90-day window before a debtor enters bankruptcy. It could be argued that no payment made in furtherance of a Ponzi scheme is in the ordinary course of business since, after all, there was no business. But creditors subject to a preference claim have an available defense—that the fraudster was holding the investor’s money in a constructive trust, a legal theory by which someone can enjoy the possession of property, but not ownership of it. As Professor Baird illustrates, if a fraudster swindles you out of a $100 bill, and that same bill is in the fraudster’s pocket when the scheme collapses, other creditors cannot reach that bill because you still retain ownership of it. Among the difficulties with constructive trusts is accurately tracing the origin of commingled monies. If an investor can do so, her money is outside the reach of other victims; if not, then her preference is voided and she becomes “simply one creditor among many who was paid on the eve of bankruptcy.”
The “main event” of legal recourse for victims of Ponzi schemes, as Professor Baird puts it, is a fraudulent conveyance attack. For one thing, fraudulent conveyance applies even to money transferred outside of the 90-day preference window. Typically, fraudulent transfers are separated into two types: “constructive,” where the transfer was made for less than reasonably equivalent value while the debtor was insolvent; and “actual,” where there is an “intent to delay, hinder, or defraud.” As Professor Baird argues, this is something of a false distinction. To begin with, while the “actual intent” language is in the bankruptcy code, judges frequently overlook actual intent and instead require only that there are sufficient badges of fraud—that is, actual fraud can occur without “an outright lie or willful deception.” Typically, it is enough to qualify as actual fraud if there is a particular closeness between transferor and transferee, or if the debtor retains control after the conveyance, or if the transfer is concealed.
This is particularly relevant for Ponzi schemes, where nearly every payment is made in order to keep investors in the dark and perpetuate the fraud. As Professor Baird concludes, “[a]s long as Ponzi is making these transfers solely to sustain the illusion that profits exist when they do not, the transfers are voidable.” Often, as was the case with both Ponzi and Madoff, there is no underlying business, so any transaction—including paying rent or buying postage—is a fraudulent conveyance. This could spell trouble for Mets fans. As the Wilpons are reasonably sophisticated investors—and long-time family friends with the Madoffs—the bankruptcy trustee will argue that the money they withdrew from the scheme (reputedly more than $50 million) was a fraudulent transfer.
To defeat fraudulent transfer, a transferee has to show both that “she gave value and that she acted in good faith.” Good faith was once judged by the “pure heart and empty head test”—or, as Professor Baird reformulates it, “[y]ou could be as stupid as you wanted,” so long as you subjectively did not know a fraud was going on. Modern courts tend to focus more on objective indices of good faith, such as whether an investor ought to have realized that a deal was too good to be true. This is a troubling test, however, since, as Professor Baird notes, even perfectly legitimate investment schemes are growing increasingly incomprehensible to even sophisticated investors. Furthermore, even honest investment managers are often reluctant to divulge their strategy for fear that rivals will mimic it, which makes distinguishing them from those who can’t divulge their strategy because they don’t have one near impossible. Last, Ponzi schemes, for a time at least, appear to work—early investors are paid off. Many legitimate funds beat the market year to year (and, in fact, Madoff’s mythical 10% was not the highest rate of return during the period of his fraud, though it was suspiciously stable). Given this context, is it reasonable to expect an average investor to ferret out a scam?
When an early investor gives a fraudster $100 and receives a payment of $150, it is often said that she did not provide “reasonably equivalent value” for the $50 since the debtor was insolvent throughout the entire scheme. But, as Professor Baird notes, this is at tension with our normal understanding of the time-value of money—a loan today for $100 in exchange for a promise of a future $150 is acceptable. So why should it matter if the borrower is a swindler? Perhaps the terms of the transaction are so unbelievable as to raise suspicion—but Professor Baird points out that this is a question of good faith, not reasonably equivalent value. Similarly, when the transfer is for an equity stake in an enterprise, the transferee gets to keep the value of the initial investment, and very often gets to keep whatever interest has accrued. These principles suggest that fraudulent conveyance would only provide limited relief to fraud victims from the early investors.
Thanks to technological advances, con artists today can more easily find new marks and can concoct increasingly inscrutable scams. Complicated schemes can now reach into the tens of billions of dollars, with devastating repercussions for hundreds upon hundreds of investors. The aftereffects of a Ponzi scheme can impact retirement funds, charitable institutions, and National League pennant races. Unfortunately, the questions Professor Baird grapples with in “Ponzi’s Legacy” are only likely to take on ever-greater importance. Thankfully, the clarity and concision with which Professor Baird tackles these age-old doctrines should give us some measure of confidence in addressing this looming risk.