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The Defining Characteristics of a Ponzi Scheme

By Lou Caputo

A Ponzi scheme, simply put, is a business model that promises to pay out more money than it takes in. New investors are generally promised a relatively very high return on their investment.  The returns, though, are dependent upon the operator/debtor being able to find new sources of income perpetually.  This will often come from deposits by subsequent investors because the business itself does not generate sufficient profits.   Depending on the nature of the operation, new investors may be more likely to lose larger sums of money because they will not have a chance to recoup even their initial investment before the operation collapses from the weight of their downward spiral.  One expert has described a Ponzi scheme to include three elements, regardless of where the Ponzi scheme is carried out: (1) the promise of a return on investment to induce the participant to put money into the program; (2) the lack of any underlying legitimate product or service or asset sufficient to sustain the promised payouts; and (3) the necessity of a continuing flow of new investors/participants to fund the payouts.” United States v. 8 Gilcrease Lane, Quincy Fla. 32351, 587 F. Supp. 2d 133, 142 (D.D.C. 2008).

The collapse of the largest of these operations are covered in the media because of the high dollar amounts involved and the identity of particular, well-known groups of investors.  Examples include those operations headed by Bernard Madoff and Allen Stanford.  As recently as last week, Michael E. Kelly pled guilty for reportedly defrauding more than 7,000 people in a scheme that garnered around $500 million.

Given the structure of a Ponzi scheme, an investor’s losses are generally sought from the scheme’s operator.  A surprise to many, investors who recover profits above their initial investment may be held liable to new investors who lost money.  A good example of that situation is the Ninth Circuit decision Donell v. Kowell, 533 F.3d 762 (9th Cir. 2007).

In Donell v. Kowell, the operator of the scheme promised a 20% return to investors by purportedly using the money to provide for working capital for a foreign manufacturer, in return for which the operator would purchase the manufacturer’s accounts receivable at a discount and enjoy the ultimate return.  In fact, the investors’ money was allocated to pay the returns of earlier investors among other expenses. Id at 767-768.

The SEC ultimately brought a civil enforcement action against the operator, and the company was placed into receivership.  The receiver sent a letter to investors, including the defendant appellants, explaining that he had been authorized by a federal court to recover money paid by the company to the investors that were considered to be the investors’ “profits.”  The defendants refused and ultimately the matter was tried in federal district court.  The court granted a slightly lower judgment to the receiver, and the defendants appealed.  The Ninth Circuit upheld the judgment of the district court, explaining how investors can be liable under California’s Uniform Fraudulent Transfer Act.

The Court explained that, “the general rule is that to the extent innocent investors have received payments in excess of the amounts of principal that they originally invested, those payments are avoidable as fraudulent transfers.” Id. at 770.  In the view of the Court an investor who receives a return above their initial investment must “return the net profits of his investment.”  Id. (citing Scholes v. Lehman, 56 F.3d 750, 757-58 (7th Cir. 1995)).

The Court reviewed two theories by which a receiver can recover against an investor who realizes a profit: “actual fraud” and “constructive fraud.”   Under “actual fraud,” the investor can be liable for all amounts that he or she received, including the amount initially invested.  The investor can claim a “good faith” defense that permits the investor to keep the funds up to the amount of the initial investment.  For “constructive fraud,” investors are liable for their “profits” from their initial investment.  Under a theory of constructive fraud, it is the plaintiff receiver who must prove an absence of good faith; if the receiver does, he or she may then also recover the principal amount of the initial investment.

The Court discussed the two-part test to determine if a receiver can recover from an earlier investor: first, determine if the investor is liable; second, if liability exists, determine the amount of liability. Courts use the “netting rule” to establish liability, which dictates that:

“Amounts transferred by the Ponzi scheme perpetrator to the investor are netted against the initial amounts invested by that individual.  If the net is positive, the receiver has established liability, and the court then determines the actual amount of liability, which may or may not be equal to the net gain, depending on factors such as whether transfers were made within the limitations period or whether the investor lacked good faith.  If the net is negative, the good faith investor is not liable because payments received in amounts less than the initial investment, being payments against the good faith losing investor’s as-yet unsatisfied restitution claim against the Ponzi scheme perpetrator, are not avoidable within the meaning of the UFTA.”

Id. at 771.

One argument advanced by the defendant was, and undoubtedly shared by those who have been investors of such operations is, that it is “inequitable” to recover profits from a party who is as innocent as another investor who ultimately lost money.  The Ninth Circuit responded rejected this argument:

“We are aware that it may create a significant hardship when an innocent investor…is informed that he must disgorge profits he earned innocently, often years after the money has been received and spent. Nevertheless, courts have long held that it is more equitable to attempt to distribute all recoverable assets among the defrauded investors who did not recover their initial investments rather than to allow the losses to rest where they fell.”

Id. at 776.

As the Donell v. Kowell decision makes clear, there can be serious penalties not only for the primary operators of a business that is deemed to be a Ponzi scheme, but also for even those individuals who innocently become involved in such a scenario and by no fault of their own receive the exact benefit for which they bargained.  The Ninth Circuit explained that, “Those who receive gains from innocent participation in the scheme may be required to disgorge those amounts, long after the money has been spent.” Id. at 779.  There are few more profound financial burdens imposed by courts these days than this: years after an investment is made, the innocent investor who becomes a target of a Ponzi scheme prosecution can be made to pay a Hood-like legal remedy that may seek substantial sums of money, including sums no longer held.  For those who believe they may be involved in such a scenario, proceed with caution and realize that, depending on the circumstances, the government may seek to recoup all profits from Ponzi scheme investors.

This article is the first in a series concerning Ponzi operations.  In subsequent postings, I will discuss the differences between Ponzi and pyramid schemes and multi-level marketing platforms, as well as review the losses, seizures, and forfeitures of property that the government can initiate if it alleges that a business is operating in a fraudulent manner.


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