The quest of defrauded investors in Ponzi schemes to be
made whole is ongoing. To recover their funds in the resulting bankruptcy and
receivership cases of the Ponzi debtor, investors file proofs of claim to seek
reimbursement of their unpaid principal investments and the promised but unpaid
interest on their investments.
But all investors are not created equal, and the manner
in which investor claims are allowed in a case can have a huge impact on the ultimate
payout. Different categories of investors - "net winners" and "net losers" -
may find themselves doing battle with each other in an effort to be repaid a
larger portion of their claims.
Net winner investors may have invested money earlier in
the scheme and actually received profits that exceed the amount they originally
invested. However, those net winners still want to be paid the unpaid interest
promised to them - the time-value of their money that was tied up in the Ponzi
scheme, often for much longer than the net losers' investments.
On the other hand, the net losers have either recouped
nothing, or some amount less than that originally invested. Net losers also
want to be paid the handsome profits that they were promised, in addition to
their unreturned principal investment. Net losers, therefore, want the cash
available for distribution to repay their principal before the net winners are
paid anything.
Academics, courts, and others have considered different
methodologies to balance the rights and claims of net winners and net losers. Some
say neither net winners nor net losers should be allowed claims for unpaid
interest because the entire enterprise was a fraud. Others conclude that net
losers should be repaid the full amount of their principal investment before net
winners are paid anything.
Another line of thinking
on the subject has been gaining traction, however. What if investors are
allowed some standardized amount of interest for the time period that their
funds were invested in the fraudulent scheme? Essentially, all investors would
be allowed an imputed interest amount for the time-value use of their funds. Investors
who invested earlier in the scheme and, therefore, for a longer period of time,
would be allowed a greater amount of interest than those who had invested more
recently.
Pending before the Second Circuit is a case involving this
exact issue in a challenge to a receiver's distribution plan. In the Stephen
Walsh, Paul Greenwood Ponzi scheme, the SEC appointed receiver, Robb Evans
& Associates LLC, proposed a distribution plan to distribute the assets on
a pro rata basis. Several investors
objected to the distribution plan, but the district court approved the plan
over the objections. One investor appealed because its proposed distribution
plan (which differentiated between classes of investors based upon the type of
investment the investor had purchases) was rejected. Another investor, the Kern
County Employees' Retirement Association, cross-appealed, seeking an adjustment
to the pro rata plan to account for
the time-value of money, stating:
KCERA's cross-appeal asks this Court to adjust the pro rata distribution for inflation
under the well-established economic principle that a dollar in 1995 has a
different value than a dollar today. Such an adjustment is a commonplace
Economics 101 calculation that results in the fairest distribution.
Kern County argued in its cross-appeal that it was unfair
for an investor like itself, who had invested funds in the scheme for over a
decade, to be treated the same as an investor who had only been invested for
one year. Kern County argued, "Without this inflationary adjustment, short-term
investors are favored at the expense of long-term investors when there is
absolutely no need or justification for such a disparity."
Of course, making an adjustment for the time-value of
money will enhance the claims of earlier investors, who are more likely to be
net winners that have already received back their principal investment, and
thereby dilute the claims of later investors who are more likely to be net
losers. Net losers, therefore, have a different sense of "the fairest outcome."
In response, the receiver argued:
With respect to factual
findings, the District Court correctly determined that KCERA's inflation
adjustment would not be fair to the investors. For example, as a result of
KCERA's proposed adjustment, some of the investors (including KCERA) would
receive millions of dollars over and above their net investments (i.e., the
investor's total contributions, minus total withdrawals, unadjusted for
inflation or fictitious earnings) before other investors recovered their net
investments. An inflation adjustment could also seriously jeopardize the Receiver's
efforts to recover, or "claw back," fictitious earnings that were paid to
former investors in the Westridge Entities, further putting at risk the same
current investors who would suffer most at the hands of KCERA's proposed
inflation adjustment.
Treatment of investor claims in Ponzi cases is definitely
a balancing act where everyone feels that they have lost. Net losers have
suffered actual losses and at a very minimum, should certainly be allowed
claims for their unpaid principal. Whether investors should be allowed claims
for the unpaid fictitious interest is a more complicated question. It seems
that, on a basic level, both net winners and net losers should either be
allowed or disallowed interest, but that the same basic rule should be applied
to both categories of investors.
The good news is that courts are starting to look more
closely at these nuanced issues. The bad news is that there are a lot of
lingering and unanswered questions.
Should net winners have to wait to be paid interest until
net losers are repaid principal in full? And should net winnings be "clawed
back" from net winners for purposes of redistribution to all investors after
net losers have been repaid principal?
If interest is allowed for investors, should both net
winners and net losers be paid at the same rate, and should that rate be the
fictitious promised rate, the prime rate, some other imputed rate? And for what
period of time?
Should a net loser's actual damages of its unpaid
principal be treated differently than a net winners damages from the loss of
use of its money for a long period of time? Are those two types of losses the
same, or should they be treated differently?
The argument for imputed interest to compensate for the
time-value of money is gaining ground, although no prior decisions appear to
have seriously considered it. We will await the Second Circuit's decision on
Kern County's cross-appeal to see whether there will finally be some court setting
some guidelines to establish an equitable solution to a very inequitable
situation. For copies of the briefs
filed with the Second Circuit, go to www.theponzibook.blogspot.com.
There are, of course, many other moving parts in the
dialogue of claims allowance and claims distribution in Ponzi cases. An entire
chapter of The Ponzi Book: A Legal
Resource for Unraveling Ponzi Schemes by Kathy Bazoian Phelps and Hon.
Steven Rhodes addresses these issues. The
Ponzi Book is available for purchase at www.lexisnexis.com/ponzibook,
and more information about the book can be found at www.theponzibook.com.
Read additional articles at The Ponzi Blog
Kathy Bazoian Phelps is the co-author of The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes
available for purchase at www.lexisnexis.com/ponzibook.
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