The Law of Ponzi Payouts

When a Ponzi scheme collapses, there will typically be net winners and net losers. The bankruptcy trustee will often seek to force the net winners-those who received more money back from the Ponzi scheme than they invested-to disgorge their profits. Courts diverge on whether they should compel disgorgement in this instance. This Note argues that under prevailing fraudulent transfer law, net winners in a Ponzi scheme need not disgorge their profits. This is because the investor's dollar-for-dollar discharge of a preexisting debt constitutes the transfer of value in exchange for the payout. There are two exceptions to this rule: where the payouts are objectively excessive and where the investor is an equity holder rather than a debtholder. This framework is sound as a matter of policy, despite the fact that it is not always entirely fair, because it provides greater certainty in commercial transactions.IntroductionYou own a home in Exeter Township, Pennsylvania. The house is worth $200,000, and the balance on your mortgage is $120,000. A silver-haired man named Wesley A. Snyder, who in his suit and tie looks convincingly like an accomplished mortgage banker, approaches you with an enticing proposition dubbed the "Wrap-Around Equity Slide Down Discount Mortgage Program." He can reduce your annual mortgage rate by 1 percent, and you hardly have to do a thing. You will simply refinance your mortgage with a $140,000 loan from your local bank, say, Wells Fargo, and give the extra $20,000 to Snyder. He will invest that $20,000 for you and use a portion of the proceeds to reduce your monthly mortgage loan payments. Just have your bank forward all the bills to his firm, Image Masters, and you will make the reduced monthly payments to Image Masters directly.This plan goes swimmingly. You make your reduced monthly payments to Snyder and put the savings in your children's college fund. Every month, Snyder's firm sends you a document detailing your reduced mortgage balance and the payments the firm has made on your behalf to Wells Fargo at your old interest rate. What a deal. But, as the saying goes, what seems too good to be true probably is. Two years later, you read in the newspaper that the U.S. Attorney has filed criminal charges against Snyder for the operation of a Ponzi scheme that defrauded 800 Pennsylvania residents of $29 million. Instead of investing your money in the capital markets and using the earnings to reduce your mortgage rate, Snyder used the proceeds of your investment to reduce the rates of other investors and to enrich himself. You still owe $140,000 to Wells Fargo on your mortgage plus the interest that has been compounding monthly on that sum at an increased rate for the past two years. You have no equity in your home, your credit rating is shot, and you are broke. Some investors, you learn, were luckier: Snyder really did pay the bank on their mortgages. This, or something close to it, is what hundreds of homeowners discovered on November 9, 2007.1Ponzi schemes ruin lives. After the entities that operate these schemes inevitably file for bankruptcy,2 the individual tasked in large part with mitigating the damage is the bankruptcy trustee.3 In bankruptcy law, the trustee is the fiduciary charged with maximizing the value of the estate.4 Frequently, the trustee seeks to retrieve or "claw back" the earnings received by inves-tors in the Ponzi scheme who were lucky enough to escape with their shirts.5 The trustee does so in part by filing avoidance actions against these lucky investors under the fraudulent transfer provision of the Bankruptcy Code.6 There is a significant split of authority as to the viability of these actions.7Whether the net winners-those who made more than they invested-should disgorge their profits is a difficult question. The instinct is often in favor of disgorgement, and that instinct is not unfounded: the profits of the net winners were made by defrauding the other investors. …