Who Are the Victims in the Bernard Madoff Ponzi Scheme?

Posted by Kathy Bazoian Phelps

   People lose money in Ponzi schemes. They may have invested directly, or perhaps through a feeder fund. Or maybe they invested in a limited partnership that itself invested in the Ponzi scheme. When the Ponzi scheme implodes, people want their money back.

   Recent activity in the Bernard Madoff scheme raises the question of the best methodology to get money back to the people who have been defrauded. The various agencies of the U.S. government operate under different statutory authorities with varying objectives and sometimes competing methodologies for reimbursing the defrauded.

   SIPA Payments to “Customers”

   In a proceeding under the Securities Investor Protection Act (SIPA) – which the Madoff scheme is – “customers” of the Ponzi scheming entity are entitled to protection and payment from the Securities Investor Protection Corporation (SIPC), administered by the appointed trustee. In the case of Madoff, the SIPA Trustee is Irving Picard, who has been reimbursing customers as statutorily required and pursuant to the court approved parameters of who is a “customer.” SIPA, 15 U.S.C. § 78lll(2)(A), defines a "customer" of a debtor as follows:

[A]ny person (including any person with whom the debtor deals as principal or agent) who has a claim on account of securities received, acquired, or held by the debtor in the ordinary course of its business as a broker or dealer from or for the securities accounts of such person for safekeeping, with a view to sale, to cover consummated sales, pursuant to purchases, as collateral, security, or for purposes of effecting transfer.

   The Second Circuit, has narrowly interpreted “customer,” finding that "the critical aspect of the 'customer' definition" to be "the entrustment of cash or securities to the broker-dealer for the purposes of trading securities." In re Bernard L. Madoff Inv. Sec. LLC, 654 F.3d 229, 236 (2d Cir. 2011); see also Kruse v. SIPC (In re Bernard L. Madoff Inv. Sec. LLC), 708 F.3d 422 (2d Cir. 2011). This means that the feeder funds that directly invested in the Madoff scheme are customers, but not the individuals who invested in the feeder funds. The Trustee has collected about $9.5 billion, of which more than $5.4 billion has already been distributed to customers. Information about claims and his distribution plan can be found at his website at www.madofftrustee.com/claims-03.html.

   Forfeited Funds to “Victims”

   In the meantime, the U.S. government has forfeited about $2.35 billion of additional funds, which can now be distributed to those who were defrauded. Under a variety of criminal and civil forfeiture statutes, payment of forfeited property is to be made to “victims” under the supervision of the Department of Justice (DOJ). Richard Breeden has been appointed as Special Master for the purposes of distributing this forfeited property. His website is at www.madoffvictimfund.com.

   The Special Master will be paying the money to “victims,” which are a different set of claimants from the “customers” who are receiving payments from the Trustee, although there may be some overlap. The Special Master explains on his website that:

Federal law defines a "victim" as "any person" who suffered a "pecuniary loss" as a "direct result" of crime. “Those who invested directly with Madoff or in one of the feeder funds – those who “lost your own money” - will be entitled to a distribution. There may be 10,000 or more “victims” who otherwise are not receiving a payment directly from the Madoff Trustee.

      The Special Master’s website also attempts to explain the differing approaches as between the distribution of the forfeited funds and the distributions being made in the SIPA proceeding:

[T]hese two programs exist to pursue different objectives. The forfeiture program is designed to help all persons who suffered a pecuniary loss as a direct result of criminal activity. It is a very broad program designed to help the victims of crime recover a portion of their pecuniary losses resulting from the criminal activity giving rise to the forfeiture of assets. The MVF and similar forfeiture programs are an integral part of the Department's efforts to deter criminal activity by taking away its profits. Beyond deterring crime, the program also provides a measure of "justice," or fairness, to the victims of crime when it does take place. The ultimate policy objectives of the forfeiture laws are promoting law enforcement and providing recoveries for crime victims.

By contrast, the Bankruptcy Code and the Securities Investor Protection Act (or "SIPA") (which overlays the Bankruptcy Code in the case of Madoff Securities) are narrower sets of laws designed to establish the relative priorities of "customers" and "creditors." Bankruptcy proceedings are enormously important to the U.S. economy, but the goals of bankruptcy are commercial. The two programs have different objectives, and so they may have different results. 

   The inconsistent distributions plans are causing some confusion and consternation. 

• Are the right people being paid? 
• Can all of the “victims” even be located?
• Are the Trustee and the Special Master calculating claim amounts in a similar and consistent fashion, or might different mathematical calculations lead to inconsistent results?
• As between the payments made by the Trustee and the payments to be made by the Special Master, will anyone examine whether there is any duplication or overpayments to any particular individual? 
• What happens to victims’ claims that have been purchased in the claims trading process? 

   The good news is that both the Trustee and the Special Master appear to be calculating claims using the same or similar net investment method. Under that method, they will calculate the net equity amount of the claim by deducting withdrawals and redemptions received by investors from the amount of their investments made. They just may not be dealing with the same creditor body in doing the math, however.

   The bad news is that the different definitions of “customer” and ‘victim” will lead to very different and potentially inconsistent results. Someone who is a “customer” for the Trustee’s purposes might not be a “victim” entitled to the forfeited funds, e.g., a feeder fund or a family partnership, but the individual investor in such an entity would be a “victim.” 

   There is an obvious mountain of work ahead of the Special Master in trying to identify the massive number of individual “victims.” This seems a virtually impossible task at this point. Some feeder funds have gone out of business, and it is unclear whether the Special Master has access to the databases of investor names who had their money invested in the Madoff scheme, whether directly or indirectly. It is also not entirely clear that the victims themselves necessarily know that their money was invested in the Madoff scheme if their funds were placed in the scheme through a feeder fund.

   In one other complication, the Special Master has announced that he will not make a distribution to claims purchasers. Once a victim, always a victim, says the Special Master, meaning that purchasers of claims will not be entitled to payment of the forfeited funds from the Special Master. Presumably the “victims” who are contractually obligated to transfer their rights in their claims, including rights to forfeited property, to the purchaser will still be obligated to pass on any distribution received to the claims purchaser.

   One has to wonder whether this will spawn the next layer of litigation in the unraveling of the Madoff Ponzi scheme. Reports are that the inconsistent distribution plans and the Special Master’s recent disclosure of his plan have caused a decline in the price of Madoff claims on Wall Street – about a 5% decline in the price for victims’ claims and as much as a 15% drop in the claims of feeder funds. 

   Is one distribution plan right, and one wrong? Both the Trustee and the Special Master appear to be doing their jobs. By statute, they just have different jobs to do. Let’s just hope that the people who were defrauded can ultimately get their money back through what has become a very complicated and cumbersome process. At least there is a decent amount of money to distribute – almost $12 billion – on about $19.5 billion in losses. What’s a $6.5 billion deficiency among friends? Hopefully more is to come. 

To avoid investing in a Ponzi scheme in the first place, read about my new book Ponzi-Proof Your Investments: An Investor’s Guide to Avoiding Ponzi Schemes and Other Fraudulent Scams at www.ponzi-proof.com. 

Upcoming International Contracts Conference at St. Thomas University School of Law

I just wanted to encourage those who are considering proposals for presentation at  the 9^th International Conference on Contracts to be held at St. Thomas University in Miami February 21-22, 2014 to send them on to me in the coming weeks.  The Call for Papers is already out and the Conference website is at http://www.contractsconference.com/kcon/KCON9__Miami.html.  Our Law Review is doing a Symposium around the Conference and still has a few spots for papers that it will consider for publication no later than January 15, 2012.  Please let me know if you're interested in the symposium issue and I will put you in contact with the symposium editors. If you are not interested in presenting, but would like to moderate a panel, please let me know as I am in need of moderators as well.

This is going to be a really wonderful conference this year all-conference honoree is Linda Rusch. Prof. Robin West (Georgetown) will be giving the planetary speech on Saturday and Kingsley Martin (KM standards) will be giving the talk at Friday's luncheon. 

Confirmed Participants include:

Kristen  Adams – Stetson University

Bader Almaskari - University of Leicester, England

Reza  Baheshti - University of Leicester, England

Wayne Barnes –  Texas A&M University

Daniel  Barnhizer – Michigan State University

Thomas Barton  – California Western School of Law

Shawn Bayern –  Florida State University

Amy Boss – Drexel University

Steve   Callandryllo – University of Washington

Miriam Cherry –  University of Missouri

Kenneth Ching – Regent University

Neil Cohen      –  Brooklyn Law

Gerrit   De Geest  – Washington University School of Law

Sidney Delong –  Seattle University

Scott Devito  –  Florida Coastal School of Law

Zev Eigen –  Northwestern University School of Law

Larry   Garvin –  Ohio State University

 Katie Gianasi –  Husch Blackwell L.L.P.

Jim Gibson –  University of Richmond

Ariela  Gross   –  USC Gould

Nancy  Kim     –  Cal Western University

Christina Kunz –  William Mitchell College of Law

Lenora  Ledwon – St. Thomas University

Joasia   Luzak  –  University of Amsterdam

Kingsley Martin  –  KM Standards

Jennifer Martin –  St. Thomas University

John Mayer     –  CALI

Murat  Mungan –  Florida State University

Dr. John Murray – Duquense University

Marcia Narine –  St. Thomas University

Wendy Netter Epstein – DePaul University

Karl Okamoto – Drexel University

Joe Perillo –  Fordham University

Amir    Pichhadze – University of Michigan (SJD Student)

Michael Pinsof - Attorney

Lucille Ponte   – Florida A&M University, College of Law,

Deborah Post –  Touro Law Center

Michael Pratt –  Queens University, Canada

Cheryl Preston  –  Brigham Young University

Val Ricks  –  South Texas College of Law

Roni Rosenberg –  Carmel Academic Center, Law School, Israel

Linda Rusch    –  Gonzaga University

Mark Seidenfeld – Florida State University

Gregory Shill – University of Denver

Frank   Snyder –  Texas A&M University

Jeremy Telman –  Valparaiso University

David  Tollen  – Adili & Tollen, L.L.P.

Manuel Usted – Florida State University

Robin  West    –  Georgetown University

Robert Whitman – University of Connecticut

Eric Zacks – Wayne State University

Deborah Zalesne  – CUNY School of Law

Candace Zierdt  –  Stetson University

I look forward to seeing many of you in February.  Please direct any paper proposals or questions to me at JMartin@STU.edu.

 

-JSM

Receiver First, Bankruptcy Second: No In Pari Delicto Bar in a Ponzi Scheme Case

Posted by Kathy Bazoian Phelps

   In Pari Delicto – “in equal fault.” This is a powerful defense that can completely bar a plaintiff’s claims against a third party where both the plaintiff and defendant were engaged in wrongful conduct.

   A recent bankruptcy decision ratified an infrequently used tactic to avoid the bar of in pari delicto to a trustee’s claims – the appointment of a receiver before the bankruptcy is filed. See In re NJ Affordable Homes Corp., 2013 Bankr. LEXIS 4798 (Bankr. D.N.J. Nov. 8, 2013).

   Generally speaking, bankruptcy trustees, standing in the shoes of the collapsed Ponzi schemer, are subject to the defenses that existed as of the date of the bankruptcy filing under § 541(a) of the Bankruptcy Code, including the in pari delicto defense. See The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes at § 14.04.

   In NJ Affordable Homes, the court acknowledged that the Third Circuit, in Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 354 (3d Cir. 2001), had adopted that widely-held view. 

   However, the court found that Lafferty only partly controlled because “Lafferty did not involve a pre-petition receiver.”  The court cited language from Lafferty itself that distinguished trustees from receivers: “These cases are easily distinguishable, however; unlike bankruptcy trustees, receivers are not subject to the limits of Section 541.” NJ Affordable Homes at *101 (citing Lafferty, 267 F.3d at 358).

   The NJ Affordable Homes court found, “[I]t remains an open question in the Third Circuit whether a trustee is barred from suit, under 11 U.S.C. § 541 as well as his avoidance powers, pursuant to the in pari delicto defense and the parallel doctrine of unclean hands when he succeeds a pre-petition receiver.”

   In resolving that question, the court relied heavily on two other circuit decisions, FDIC v. O’Melveny & Myers, 61 F.3d 17, 18 (9th Cir. 1995), and Scholes v. Lehmann, 56 F.3d 750 (7th Cir. 1995).

   Scholes is often cited for the proposition that a receiver is an innocent successor and that “the defense of in pari delicto loses its sting when the person who is in pari delicto is eliminated.” O’Melveny is cited to emphasize that a receiver is appointed “as part of an intricate regulatory scheme designed to protect the interests of third parties who also were not privy to the [entity’s] inequitable conduct.”  

   The court also considered it important that the earlier appointment of a receiver further removed the trustee from the debtor’s wrongful conduct. It cited In re Edgewater Med. Ctr., 332 B.R. 166, 170-72 (Bankr. N.D. Ill. 2005), in which a receiver had been appointed pre-petition, followed by a custodian, and then ultimately by the trustee in that case, leaving the trustee in that case “two levels removed from any wrongful acts.”

   Stressing the significance of the pre-petition appointment of a receiver, the NJ Affordable Homes court held that the trustee’s action was not barred by in pari delicto: 

[T]he in pari delicto defense and the doctrine of unclean hands [are] inapplicable to causes of action that could have been brought by the Receiver under the circumstances sub judice.

From this holding, it is only a short step to the conclusion that the Trustee as a successor-in-interest stands in a similar position. For the purposes of 11 U.S.C. § 541, the Receiver was in place at the commencement of this bankruptcy case. The Trustee took cleansed causes of action, limited to those provided to the Trustee under the Bankruptcy Code, as an innocent successor.  

   Although the court did not cite it, Kirschner v. Wachovia Capital Markets, LLC (In re Le-Nature’s Inc.), 2009 U.S. Dist. LEXIS 98700 (W.D. Pa. Oct. 23, 2009), came to the same result and determined that there was nothing to impute from the debtor to the trustee.

   In seeking a way “to promote the equitable distribution in bankruptcy,” the NJ Affordable Homes court used the pre-petition appointment of a receiver as the hook to get to the result it thought was equitable – to allow the trustee to bring claims by declining to apply the in pari delicto doctrine as a bar. 

   So why does the case law generally refuse to apply an equitable rationale to bankruptcy trustees? Trustees are innocent successors. They are removed from the debtor’s wrongful acts, and they seek to bring claims against third parties for the purpose of benefitting the creditors, not the debtor. Applying in pari delicto to a trustee only serves to harm the creditors of the estate.

   Historically, a trustee’s main hope in dodging in pari delicto was to find an equitable loophole under state law since in pari delicto is a state law defense which courts find applicable to a trustee under § 541. However, the approach taken in NJ Affordable Homes and Le-Nature’s Inc. – crediting the pre-petition appointment of a receiver with washing claims of the in pari delicto defense – gives creditors an alternative path to create distance from the wrongful conduct of the debtor and the in pari delicto bar. Creditors should seriously consider a receiver pit stop on the road to the debtor’s bankruptcy.

A Catch 22 for Banks? SARs and Ponzi Scheme Cases

Posted by Kathy Bazoian Phelps

   What is a bank’s worst nightmare? High on the list has to be the balancing act between (a) compliance with suspicious activity reporting, on the one hand, and (b) protection of information that could lead to civil liability for having become aware of suspicious activity, on the other hand. 

   Banks are required to report fraud and are subject to criminal and civil penalties if they do not. 31 U.S.C. § 5318. The government - and society - encourages banks to report fraud. As reported in an earlier blog post, “Banks, Please File Your Suspicious Activity Reports to Help Stop Ponzi Schemes,” governmental agencies are imposing hefty fines for the failure of banks to file SARs, and proposals are being floated in the government to ask for more accountability and prison terms for the bankers themselves.

   One would think that banks would be tripping over themselves to get SARs on file – immediately and frequently. Yet, the act of putting together a report that admits knowledge of suspicious activity could lead to civil liability on the part of the bank for having that knowledge. What is a bank to do?

   In Wiand v. Wells Fargo Bank, N.A., 2013 U.S. Dist. LEXIS 159756 (M.D. Fla. 2013), the receiver of the Arthur Nadel $168 million Ponzi scheme sued Wells Fargo Bank, alleging that the bank failed to comply with federal banking regulations and the bank’s own internal procedures, which allowed the Ponzi scheme to flourish. The receiver sought turnover from Wells Fargo Bank of certain documents that the bank had withheld from discovery on the basis of the SAR privilege. Wells Fargo sought to keep privileged a broad category of documents that extended well beyond the SAR itself.

   The SAR privilege provides that SARs filed by banks are confidential and subject to an “unqualified discovery and evidentiary privilege that courts have held cannot be waived.” Id. at *3 (citations omitted). Wells Fargo argued that “the SAR privilege covers not only a SAR and any information that could reveal the existence of a SAR, but also material prepared by the bank to detect suspicious activity, regardless of whether a SAR was ultimately filed or not.” Id. at *2. The documents that Wells Fargo sought to withhold from discovery were categorized as: (1) listings of transactions or copies of certain transactional documents relating to bank accounts, some with highlighted notations; (2) internal bank emails and reports; and (3) a series of email communications between another financial institution and the bank.

   The federal regulations are express and serious in protecting SARs from disclosure and providing assurances to banks in protecting that information. 31 U.S.C. § 5318 states:

Suspicious activity reports are confidential. Any bank subpoenaed or otherwise requested to disclose a suspicious activity report or the information contained in a suspicious activity report shall decline to produce the suspicious activity report or to provide any information that would disclose that a suspicious activity report has been prepared or filed citing this part, applicable law (e.g., 31 U.S.C. 5318(g)), or both, and notify the appropriate FDIC regional Office (Division of Supervision and Consumer Protection (DSC)).

   However, how far does that protection extend? Wells Fargo sought a broad interpretation of the statutory language, citing to comments in the Federal Register that the SAR privilege applies to "material prepared by the financial institution as part of its process to detect and report suspicious activity, regardless of whether a SAR ultimately was filed or not." 

   After in camera review of Wells Fargo’s privilege log and documents, the court permitted a few documents that were “evaluative” in nature and that were “intended to comply with federal reporting requirements,” including communications with another financial institution, to remain subject to the SAR privilege, but required turnover of the balance of the documents. 

   It was not clear from the decision whether Wells Fargo was seeking protection of these documents solely for purposes of complying with the Bank Secrecy Act’s secrecy requirements, or whether it was seeking to protect information that might lead to later civil liability for the bank. Regardless, the fight over how far the SAR privilege extends is an important high stakes battle, reminding banks to tread very carefully in these waters.

   Read about my new book, Ponzi-Proof Your Investments: An Investor’s Guide to Avoiding Ponzi Schemes and Other Fraudulent Scams, at www.ponzi-proof.com. 

Radio Show on Banks, Bankers, Investors: The Consequences of Knowing a Ponzi Schemer

Posted by Kathy Bazoian Phelps

   Listen to Kathy Phelps on Radio Shalom on November 13, 2013 at 4 p.m. Eastern discussing consequences for banks, bankers and investors involved in Ponzi schemes. 

   Have we seen any slowdown in Ponzi scheme activity since Madoff and the other larger Ponzi schemes unwound in 2008 and 2009? 

   Why are people still investing in Ponzi schemes? 

   Why are bankers not going to jail for their role in these schemes? 

   Are we any further ahead 5 years after Madoff in detecting and combating these types of fraudulent schemes? 

   To listen to the show, go to www.radio-shalom.ca/site/emissions-1042 and click on Listen Live.

   Read about Ponzi-Proof Your Investments: An Investor’s Guide to Avoiding Ponzi Schemes and Other Fraudulent Scams at www.ponzi-proof.com. 

Ponzi Schemes Are an International Problem

Posted by Kathy Bazoian Phelps

   Courts across the globe are dealing with the peculiar issues arising in the administration of Ponzi scheme cases, struggling to do equity and to get the defrauded victims at least some of their money back. 

   The purported business operations of these Ponzi schemes are as varied and diverse as the countries in which they proliferate. The schemes range from securities trading to goat rearing scams and tend to take on the character and customs of the local culture. What remains a constant in all varieties of Ponzi schemes, however, is that the investors lose money. Defrauded victims then seek compensation from the resulting insolvency proceedings of the perpetrator.

   The Eastern Caribbean Supreme Court of Antigua and Barbuda recently issued a decision in the Stanford International Bank liquidation regarding the issue of how to fix the investors’ claim amounts. The decision is here. The Court ultimately approved the modified net investment methodology for allowance of claims for Ponzi scheme investors. The net investment method was the methodology used in the Bernard Madoff case, as affirmed by the Second Circuit in In re Bernard L. Madoff Investment Securities, LLC, 654 F.3d 229 (2d Cir. 2011). However, the Court also took the time to analyze competing claims allowance methodologies such as the Last Statement Method and the Rising Tide Method.

   The Court relied heavily on U.S. law in reaching its conclusion, noting that:

It is clear that the United States’ legal system, covering a vast economy, has developed very sophisticated remedial measures to deal with this unfortunately persistent form of fraud. Such measures include numerous instruments of primary legislation as well as case law jurisprudence. There are even practitioners’ text books, such as “The Ponzi Book, A Legal Resource for Unraveling Ponzi Schemes”, by Phelps and Rhodes, published by LexisNexis.

   In carefully considering the consequences of the different claims allowance methodologies, the Court relied heavily on The Ponzi Book, describing it as “that most helpful work” and quoting from Chapter 20.04 extensively in its evaluation of the competing methodologies. The Court dismissed the Last Statement Method, finding that it was “equally absurd for SIB as it was for Madoff.” The Court observed, “In both cases the investors were duped by a falsely represented investment strategy[,]” and “In both cases the profits or interest respectively which was credited or paid to investors derived directly from deposits from subsequent investors, and not from legitimate investment returns.”

   The law coming out of Ponzi scheme cases continues to evolve on a nearly daily basis. The Eastern Caribbean Supreme Court of Antigua and Barbuda aptly noted, “It is . . . clear that [the U.S.] great legal system continues to develop rational solutions to do equity for the innocent victims of Ponzi schemes, but with painful difficulty, precisely because ‘Ponzi schemes’ have no inherent integrity.”

“Ponzi-Proof Your Investments: An Investor’s Guide to Avoiding Ponzi Schemes” Just Released

Posted by Kathy Bazoian Phelps

   The ongoing losses from Ponzi schemes are extraordinary (over $22 billion reported in related cases just this year). “Ponzi-Proof Your Investments: An Investor’s Guide to Avoiding Ponzi Schemes and Other Fraudulent Scams” provides a comprehensive, but easily understandable, description of the all-too-common pitfalls of Ponzi schemes, the psychology of the schemer, and the warning signs of a fraud, along with lists of specific due diligence questions to ask. 

   See www.ponzi-proof.com for more information and read the press release at www.prnewswire.com/news-releases/new-book-provides-guidance-to-help-investors-spot-and-avoid-ponzi-schemes-and-other-fraudulent-scams-230647751.html.