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Law360 (April 8, 2020, 4:37 PM EDT) --
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| Dennis Cohen |
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| Marianne Recher |
For example, when the economy crashed in 2008, investors in Bernard Madoff's so-called investment company demanded distributions, which strained the fraud to its breaking point after decades of successful deceit.
As the major market indexes free-fall this spring, amid pandemic fears, closing borders and an oil feud between Russia and OPEC, it is worth revisiting those schemes and how to manage their fallout.
A Ponzi scheme is a particular type of fraud in which investors are promised returns based on some underlying business plan (e.g., market timing, business growth or an arbitrage opportunity), but little or no actual business is done. Instead, when redemptions must be made, investors are given the funds provided by other investors. When redemptions outpace investments, the scheme falls apart.
Typically, a court then appoints an official to manage the unwinding, recovery and distribution of assets involved in a Ponzi scheme. The nature of that official varies depending on the context in which she is appointed.
U.S. Securities and Exchange Commission
The SEC frequently investigates Ponzi schemes and sues the wrongdoers in a civil suit. If the SEC initiates a litigation, it often seeks a receiver, who will report to the court but will work closely with the SEC to identify relevant assets and work out a distribution scheme.[1] That receiver and her advisers will generally be paid from the corpus of assets collected under the supervision of the appointing court.[2]
Securities Investor Protection Act of 1970
If the scheme arises at a broker or dealer, the SIPA generally mandates that the resulting SIPA liquidation be managed in bankruptcy court under the SIPA instead of the Bankruptcy Code (except to the extent that SIPA incorporates Title 11).[3]
Where a SIPA protective decree is issued, the congressionally created Security Investor Protection Corp. specifies a trustee to be appointed by the district court, who is paid by the estate of the debtor or by the SIPC itself.[4] SIPA trustees have unwound massive frauds, including the $19 billion Madoff Ponzi scheme, as well as other large broker-dealer liquidations, such as Lehman Brothers Inc.'s.
Asset Forfeiture by the U.S. Department of Justice
Where the DOJ or another law enforcement agency is involved, as it often is (fraud, after all, is a crime), that agency will often set up its own asset-collection scheme. The DOJ's money laundering and asset recovery section relies on asset forfeiture (criminal, civil and/or administrative), an extremely powerful tool, to coordinate and effectuate the "seizure and forfeiture of assets that represent the proceeds of, or were used to facilitate federal crimes."[5]
Among other goals, the DOJ's forfeiture program aims to return assets to the victims of crime.[6] Civil asset forfeiture, an in rem proceeding, can be used to seize assets of the wrongdoer even if the government has not obtained a criminal conviction.[7]
Note, however, that asset collection does not necessarily mean asset distribution. The DOJ's policy manual dictates an order of priority in distributing forfeited property: valid owners, lienholders, federal financial regulatory agencies and victims.[8]
In addition, assets may be retained for official use, which is "a law enforcement agency's use of forfeited assets in the direct performance of law enforcement activities," or disbursed for equitable sharing, a controversial program that involves transfers to state and local law enforcement.[9] Note, however, that internal policy prohibits use of forfeited property for official use or equitable sharing until after resolution of victim interests.[10]
Claims Processes Outside of the DOJ
Receivers and trustees will set up a claims process, along with a distribution structure. If the Ponzi scheme is small, that structure could be simple enough to be scribbled on a scrap of notebook paper. However, most modern Ponzi schemes require complex claims processes managed by professional vendors, with distribution structures to match.
As all pure Ponzi schemes are insolvent on day one, most such structures follow bankruptcy principles, meaning that assets are generally distributed pro rata among victims, a principle derived from the U.S. Supreme Court decision in Cunningham v. Brown, arising from the fraud of Charles Ponzi.[11]
Special Masters
Where a fund exists to compensate victims of frauds, disasters, mass torts or other large-scale calamities, but no mechanism exists for claims evaluation or distribution, a court or an agency may appoint a special master. Some such masters are governed by Federal Rule of Civil Procedure 53. Like receivers and trustees, a special master generally must report to the entity that appointed him, but a special master usually has more leeway to manage the distribution process.
Other Considerations
Sometimes, several distribution processes run in parallel, and they may or may not be coordinated with each other. On the other hand, it can happen that no agency manages any distribution process at all. In such situations, a victim or group of victims can place the schemer into involuntary bankruptcy.[12] This is possible because, as noted above, Ponzi schemes are insolvent from the outset.
In such a case, the bankruptcy court will appoint a trustee, who will act more or less like other similarly situated receivers or trustees, although unlike those, a bankruptcy trustee will operate under the Bankruptcy Act. Some investors try to skip bankruptcy (and its accompanying focus on fairness) and instead seek to recover directly from the wrongdoer, or even from downstream transferees.
In past cases, efforts to evade a centralized process have encountered resistance, or even outright dismissal, as plaintiffs struggle to articulate the right to unwind transfers made by or at the direction of a Ponzi schemer.[13]
Practice Tips
If your client is caught up in a Ponzi scheme, the first thing you should determine is whether he or she will have a claim. Officials often set up processes that reimburse net losers while clawing back distributions from net winners. After all, most of the money probably went to investors. Then consider the following:
Establish and maintain contact.
If an agency like the SEC or DOJ is involved, and you think your client has a claim, develop a working relationship with the attorneys and agents investigating and litigating, as well as the prosecutor's victim coordinator, if one exists. Be able to reach out to them as needed to share additional information or to ask about the process.
Notify and inform in writing.
Notify in writing the attorneys in charge (and the victim coordinator) the amount of your client's loss. Once a receiver or trustee is appointed, do the same. If the DOJ is involved, reach out to its office for victims of crime, and register for the victim notification system. Know your client's rights under the Victims' Rights and Restitution Act[14] and the Crime Victims' Rights Act.[15]
Run your own investigation.
Collect and preserve relevant evidence, as if preparing for a civil litigation: all evidence of transfers, investment agreements, communications with the wrongdoer and anything else of note.
Collect evidence of waste.
Collect any evidence your client has of spending of the corpus of the scheme, in case your client can recommend, or act as, a witness.
Track the litigation.
If a litigation is initiated, sign up for alerts about the case and share any notable developments with your client.
Follow the claims process.
When submitting a claim in connection with one of these processes is it important to follow the claim procedures and to familiarize yourself with the court-approved distribution plan. The receiver or trustee will often set up a website containing instructions and, crucially, deadlines.
Challenge clawbacks.
If you think that the clawback scheme is unfair or that your client should be excepted, you can tell the official, particularly if you can demonstrate hardship. But be prepared to take your case to the courts. When challenging a clawback, you must also carefully review the distribution plan, the order appointing the official, the authorizing statutes and case law concerning subsequent transfers, international transfers and other details. Most challenges fail, but those that succeed do so based on thoughtful analysis of each step of the process.
Manage expectations.
All of these processes are time-consuming — expect years, not months, for resolution — and they incur varying levels of expense for victims already bearing the strain of losing an investment (and often in a bear market). But if managed properly, these are usually the best chances for a fraud victim to recover at least a portion of their investment from a bad actor.
Dennis O. Cohen is the founder of the Law Office of Dennis O. Cohen.
Marianne Recher is an attorney at the Law Office of Marianne Recher.
Disclosure: Dennis Cohen represented the trustee in the Madoff scheme mentioned in this article.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] Although "neither the Securities Act of 1933 nor the Securities Exchange Act of 1934 explicitly vests district courts with the power to appoint trustees or receivers, courts have consistently held that such power exists." Eberhard v. Marcu
, 530 F.3d 122, 131 (2d Cir. 2008) (internal citations and quotations omitted). [2] SEC's Office of Investor Education and Advocacy, Investor Bulletin: 10 Things to Know About Receivers, Aug. 27, 2015, available at https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins-87.
[3] See generally 15 U.S.C. §78aaa-lll. If certain preconditions exist, SIPC may bypass a trustee and liquidation through the courts and instead pursue a direct payment procedure to the customers of a debtor. Among other conditions, the claims of all customers must aggregate less than $250,000, the debtor must be financially distressed as defined in the law, and the cost to SIPC for direct payment process must be less than for liquidation through the courts. 15 U.S.C. §78fff-4(a).
[4] 15 U.S.C. §78eee(b)(3) and (b)(5); 15 U.S.C. §78fff.
[5] Asset Forfeiture Policy Manual (2019), Chap. 1, Sec. I, available at https://www.justice.gov/criminal-afmls/file/839521/download.
[6] See The Attorney General's Guidelines on the Asset Forfeiture Program (July 2018), Sec. II, available at https://www.justice.gov/criminal-mlars/file/1123146/download. In DOJ's words, "[r]emission and restoration are discretionary procedures for victim recovery from forfeitures for persons who have incurred a pecuniary loss from the offense underlying the forfeiture, or a related offense." Asset Forfeiture Policy Manual (2019), Chap. 14, Sec. I.
[7] See United States v. One-Sixth Share
, 326 F.3d 36, 40 (1st Cir. 2003) ("Because civil forfeiture is an in rem proceeding, the property subject to forfeiture is the defendant.").[8] Asset Forfeiture Policy Manual (2019), Chap. 14, Sec. II.A.3, Chap. 15, Secs. I.D and II.
[9] Asset Forfeiture Policy Manual (2019), Chap. 15. Although the DOJ suspended its equitable sharing program in 2015, it was revived under the Trump administration in 2017. Christopher Ingraham, The Justice Department Just Shut Down a Huge Asset Forfeiture Program, Wash. Post (Dec. 23, 2015), https://www.washingtonpost.com/news/wonk/wp/2015/12/23/the-feds-just-shut-down-a-huge-program-that-lets-cops-take-your-stuff-and-keep-it/; see also U.S. Dep't of Justice, Ord. No.3946-2017,Federal Forfeiture of Property Seized by State and Local Law Enforcement Agencies (July 19, 2017).
[10] Asset Forfeiture Policy Manual (2019), Chap. 14, Sec. II.A.3, Chap. 15, Secs. I.D and II.
[11] Cunningham v. Brown
, 265 U.S. 1, 13 (1924); see also SEC v. Credit Bancorp, Ltd. , 290 F.3d 80, 89 (2d Cir. 2002) ("[T]he use of a pro rata distribution has been deemed especially appropriate for fraud victims of a 'Ponzi scheme.'").[12] See, e.g., Hill v. Kinzler (In re Foster)
, 275 F.3d 924 (10th Cir. 2001).[13] See, e.g., Krasner v. Rahfco Funds LP
, No. 11 CV 4092(VB), 2002 WL 4069300 at *9-10 (S.D.N.Y. Aug. 9, 2012); McBride v. KPMG Intern. , 135 A.D.3d 576, 579-80 (Sup. Ct. App. Div. 2016).[14] 34 U.S.C. § 20141 et seq.
[15] 18 U.S.C. § 3771.
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