Ponzi Schemes and Claims Allowance
By now, Ponzi schemes and the bankruptcy laws have crossed paths enough times that a significant body of case law and legal commentary have developed. Most of the law and commentary discuss the Ponzi scheme in the context of fraudulent conveyances and preferential transfers. They focus on what type of payments received by the Ponzi scheme investor are recoverable under the avoidance provisions of the Bankruptcy Code.1 This article addresses a related but distinct issue of claim allowance.
The term "Ponzi scheme" was derived from the exploits of Charles Ponzi, whose "business" practices were first described by the U.S. Supreme Court in Cunningham v. Brown, 265 U.S. 1 (1924). Since that time, numerous "Ponzi" schemes have been described in bankruptcy cases involving a variety of investment "opportunities." See In re Hedged Investments Associates Inc., 84 F.3d 1267 (10th Cir. 1996) (stock options); In re M&L Business Machine Co., 59 F.3d 1078 (10th Cir. 1995) (computers); In re United Energy Corp., 944 F.2d 589 (9th Cir. 1991) (energy modules); In re Agricultural Research and Tech. Group, 916 F.2d 528 (9th Cir. 1990) (agricultural growing technics); Apostlou v. Fisher, 188 B.R. 958 (N.D. Ill. 1995) (commodities); In re Foos, 188 B.R. 239 (Bankr. N.D. Ill. 1995) (radio stations); In re Colonial Realty Co., 210 B.R. 921 (Bankr. D. Conn. 1997) (real estate partnerships); and In re Bennet Funding Group, 220 B.R. 743 (Bankr. N.D.N.Y. 1997) (office equipment). Although the "investment opportunities" varied, the essential nature of the Ponzi scheme remained consistent throughout these cases.
A Ponzi scheme begins with a promise of a lofty rate of return on an investment. But instead of paying the promised rate of return from legitimate business operations, the return is derived from the payments received from new investors. Of course, the initial investors are so pleased with their returns that new investors are not hard to find. And so the momentum builds until the supply of new investors or investment dollars fails to keep pace with the amounts owed to prior investors. Ultimately, the scheme collapses. Some Ponzi investors are fortunate and escape unscathed, perhaps even with a substantial profit. These are typically the early investors. Other investors see their entire life savings disappear in a maze of incomprehensible transactions. These are typically the investors who arrived late to the investment opportunity. That the early investors benefit by receiving the money "invested" by the late-arriving investors brings into focus the subject of this article.
The Bankruptcy Code in its present and prior forms was created for the express purpose of treating equally situated creditors equally. The Bankruptcy Code contains numerous provisions reflecting this goal. In the context of Ponzi scheme bankruptcy cases, the question is how to measure the damages suffered by its victims, recognizing the fact that damages paid to early investors, which are typically in the form of unreceived profits or interest payments, necessarily come out of the pockets of the late investors, who are typically seeking some recovery of principal.
In responding to this question, two theories of "claim allowance" have emerged. The first theory, which will be referred to as the "benefit of the bargain" theory, is supported by cases like Butner v. United States, 440 U.S. 48 (1979), which directs the bankruptcy court to look to state law to measure an investor's bankruptcy claim. Under this theory, the bankruptcy court looks to the investment contract itself and its promised rate of return to compute damages—as any state court would in a garden-variety breach-of-contract case. Under this theory, the bankruptcy court accepts the Ponzi investment contract as both lawful and consistent with public policy. It deems the fact that early investors get paid out of the losses suffered by the late investors as a fact of life that the Bankruptcy Code should not or cannot change.
The second theory, which will be referred to as the "net principal" theory or the "equity theory," espouses the idea that the measure of bankruptcy claims should be a matter of equity where illegal contracts or massive fraud is involved. The net-principal theory operates by limiting a Ponzi investor's bankruptcy claim to the principal amount invested, while treating all payments received by that investor as a return of principal. Under this theory, profit is eliminated as an element of damages, elevating the goal of returning principal above all others. This theory, in one form or another, is supported by a few older but well-known cases such as Vanston Bondholders Protective Committee v. Green, 329 U.S. 156 (1947); In re Tedlock Cattle Co. Inc., 552 F.2d 1351 (9th Cir. 1977); Young, Abrams v. Eby, 294 F.1 (4th Cir. 1923); and has been discussed and applied more recently in In re Taubman, 160 B.R. 964 (Bankr. S.D. Ohio 1993).
In Young, for example, the equity theory was applied when the Fourth Circuit determined that an investor could not have a bankruptcy claim for return of principal until the investor accounted for all the profits he had received. Relying on the notion that all Ponzi investors were part of a common fund or common enterprise, the Fourth Circuit ruled that all sums paid as "profits" to one (investor) from the common fund unjustly enriched that investor at the expense of other investors who were merely seeking some return of principal.
In Young, the investor made a principal investment of $4,000, and then received interest or profit payments of $2,800 and a return of principal payment of $2,000. The investor then filed a bankruptcy claim of $2,000, representing the principal balance of his investment that remained unpaid. The Fourth Circuit held that the investor was not entitled to receive any distribution in the bankruptcy case until he accounted for his profits, reasoning that the profits could not be retained since they were paid at the expense of the other equally innocent victims. The Young court noted: "[a]ll [investors] must stand on equal footing, as stupid victims of a transparent fraud." Young, 294 F. at 3.
In Vanston, the Supreme Court held that in certain situations, equitable principles could override state law to provide the means for measuring bankruptcy claims. In Vanston, the issue was whether a creditor could claim interest on unpaid interest that was due under the debtor's mortgage bonds. If that added interest was allowed and paid, it would limit the return to other creditors. Citing the need in bankruptcy proceedings to "balance the equities" between creditors, the Supreme Court held that the additional interest could not be allowed. Vanston, 329 U.S. at 162.
Thirty years later, the principles in Young and Vanston were applied in the Tedlock Cattle Co. bankruptcy case. In Tedlock, investors sought to become millionaires by investing in cattle feed and cattle feed lots. Directly at issue was whether the claims of the investors should be measured under the "benefit of the bargain" theory in which profits could form part of the claim, or the equity theory wherein claims would be measured by the difference between the amounts "cashed in" and "cashed out." The Ninth Circuit held that the equity theory could be used, in part, "because of the promotional relationships early investors [had] in building up the momentum and volume of [the later] investments of others..."
Similar to the "common enterprise" rationale used in Young, the Tedlock court appeared to consider the bankruptcy trustee's position that the later investors may have had claims against the early investors based on principles of subrogation, since the early investors got paid from funds "stolen" from the late arriving investors. Tedlock, 552 F.2d 1352-1353.
The measure of investor claims in Ponzi bankruptcy cases was tested in the modern case of In re Taubman, 160 B.R. 964 (Bankr. S.D. Ohio 1993). In Taubman, the debtor entered into approximately 200 investment contracts promising tax-free rates of return between 12 and 24 percent. As in all Ponzi schemes, newly invested funds were used to pay amounts owed under the existing investment contracts. When the scheme collapsed, about 50 investors had at least been repaid the amount of their principal investments, while about the same number of investors received absolutely nothing. The remaining investors fell somewhere in between.
Applying a novel approach to the problem of claim allowance, the Taubman court struck a balance between the two theories of measuring investor claims by allowing each investor to hold two claims, each representing one of the two alternative theories. The "A" claims, representing the "net equity" approach, were measured by the difference between the principal amount invested and the monies repaid, treating all repayments as return-of-principal payments. The "B" claims, representing the "benefit-of-the-bargain approach," included claims for interest, punitive damages and other amounts not related to actual pecuniary loss.
After the "A" and "B" claims were established, the Taubman court subordinated the "B" claims to the "A" claims, holding that the "B" claims could not get paid until the "A" claims were satisfied. The Taubman court ordered subordination because to do otherwise "would be to further the debtor's fraudulent scheme at the expense of other investors, particularly newer investors. An investor in a Ponzi scheme is not only a victim but at the same time a perpetrator, for without the continued influx of new funds, the scheme quickly collapses and the [d]ebtor is unable to perpetrate the scheme and create harm to new creditors." Taubman, 160 B.R. at 981.
In reaching its conclusion, the Taubman court also suggested that investment contracts furthering a Ponzi scheme may be challenged, and perhaps rendered unenforceable on public-policy grounds. Taubman, 160 B.R. at 983. If bankruptcy courts refuse to enforce investment contracts on this basis, then measuring investor claims in bankruptcy may well favor the equity approach.
In conclusion, bankruptcy courts will continue to be confronted by the challenges posed by collapsed Ponzi schemes. When they do, it will become apparent that almost all investors will have suffered—but that the late-arriving investors will have suffered more. Because the investor is both a victim and a perpetrator in a Ponzi case, bankruptcy courts should seriously consider whether claims for lost profits should be treated on par with claims for lost principal.
1 See "Ponzi Schemes and the Law of Fraudulent and Preferential Transfers," 72 Am. Bankr. L.J. 157, for an excellent discussion of these issues. Return to article