by James Walsh
Likewise, the lawsuit has been a long road for wealthy investors who lost large amounts of money, another investor attorney said. “Many of the original investors are dead, so we are dealing with their children and grandchildren.”
This was part of the reason the parties were willing to settle. And they did so in 1996. According to lawyers familiar with the case, the amount of the settlement was close to the $56 million due from the three insurance companies.
Who Can Keep Ponzi Money?
Forget all the jokes you’ve heard about the definition of chutzpah. Few people are as brash as Ponzi perps...and those near or dear to them...determined to keep the money they’ve taken from trusting investors. Like case studies in a psychology textbook, these people will often convince themselves that the money is rightly theirs.
Luckily, the law—or at least the part of the law that deals with fraud— doesn’t put much stock in psychology. The 1995 federal appeals court case Scholes v. Lehmann dealt with some complicated issues of who can pursue whom in the wake of a collapsed Ponzi scheme. In the case, the receiver for several companies ruined by a Ponzi perp brought fraudulent conveyance actions against one of the investors, the perp’s former spouse and several religious organizations. All of these people or groups had received funds from the ruined companies.
The court of appeals ruled that the receiver had standing to assert the fraudulent conveyance claims. The people who’d received money from the scheme argued that the receiver was not really suing on behalf of the companies but on behalf of the investors who had invested in the corporations. They argued that a receiver cannnot sue on behalf of the creditors of the entity in receivership.
To sum up their argument, they asked the following question: How can allegedly fraudulent conveyances hurt the instrument—namely, the company—through which the Ponzi scheme was operated?
Judge Richard Posner provided the following answer:
The corporations, [the perp’s] robotic tools, were nevertheless ...separate legal entities with rights and duties. They received money from unsuspecting, if perhaps greedy and foolish, investors. That money should have been used for the stated purpose..., which was to trade commodities.... The three sets of transfers removed assets from the corporations for an unauthorized purpose and by doing so injured the corporations. Thus, it is the removal of assets that damaged the debtor, and the trustee has standing to sue for this type of injury.
So, the people who’d received money from the scheme could be forced to give it back.
In vivid language, Posner went on to explain: The appointment of the receiver removed the wrongdoer from the scene. The corporations were no longer the perp’s evil zombies. Freed from his spell they became entitled to the return of the money—for the benefit of the unsuspecting investors—that the perp had made the corporations divert for unauthorized purposes.
Civil RICO Claims
Because Ponzi schemes follow patterns of fraud and theft, many angry investors pursuing perps will try to press lawsuits which cite the Racketeer and Corrupt Organizations Act of 1970 (RICO). These can get very complicated.
A RICO claim must include seven constituent elements, namely:
1) that the defendant 2) through the commission of two or more acts 3) constituting a “pattern” 4) of “racketeering activity” 5) directly or indirectly...participates in 6) an “enterprise” 7) the activities of which affect interstate or foreign commerce.
One strength of a RICO claim is that it allows triple damages; one problem is that it can be tough to make. When investors allege predicate acts of fraud as the basis of their RICO complaint (which is always so in Ponzi scheme cases), they must plead injury and causation with particularity. This means the person making the claim has to show a direct causal link between his injury and specific acts of mail or wire fraud. To state a claim of mail fraud or wire fraud, a complaint must allege:
1) a scheme or artifice to defraud or to obtain money by means of false pretenses, representations, or promises;
2) use of the mail for the purpose of executing the scheme; and
3) a specific intent to defraud either by devising, participating in, or abetting the scheme.
And then, these charges have to be linked back to specific losses suffered by the people making the RICO claim.
Another difficulty in making a civil RICO claim is that the person doing so has to have exhausted other avenues of recouping lost investments. A federal court in New York put this point plainly:
a plaintiff who claims that a debt is uncollectible because of the defendant’s conduct can only pursue the RICO treble damages remedy after his contractual rights to payment have been frustrated....Until plaintiffs can demonstrate that the orthodox methods of recovery have failed them, and that defendants’ acts of racketeering have in fact caused them a loss, they should not be entitled to treble damages under RICO.
Finally, a loss claimed in a civil RICO suit can’t be speculative in nature. It must be definable on a factual basis—even if only approximately definable.
Burned Investors vs. Angry Creditors
When burned investors try to get their money back from other investors who got their money out, some pretty arcane parts of the law come into play. Chief among these: Passage of title.
In legal terms, a sale is defined as the “passing of title from the seller to the buyer for a price.” The passing of title to goods cannot occur before goods are identified in a contract. After this identification, title can pass in any manner and on any conditions explicitly agreed upon by the buying and selling parties. During the interval between the time the goods are identified in the contract and title passes, the buyer has a “special property” in the goods.
In the absence of explicit agreement, title passes to the buyer when and where “the seller completes his performance with reference to the physical delivery of the goods.” When people were talking about bolts of fabric or barrels of rum, these distinctions were easy enough to understand and apply. When people are talking about investments in securities, things can get a little fuzzy.
The relationship between a creditor and the Ponzi scheme company is usually pretty clear. The relationship between an investor or distributor and the company is more problematic—and determined in many cases by how title to goods has passed. In short, this issue deals with who owned the investment capital, who owned the assets of the enterprise and when did these items exchange hands.
This distinction often comes into play when commercial creditors of a Ponzi scheme company are battling with investors for who should come first in the resolution. It’s especially important when the Ponzi scheme involves multiple levels of salespeople or distributors. The result can be a complicated hash of people trying to take whatever money or goods are left when the scheme collapses.
One often-used tool for clearing up the complication is the so-called “dominion” or “control” test. This standard requires “dominion over the money or other asset, the right to put the money [or asset] to one’s own purposes” such as to “invest in lottery tickets or uranium stocks.” On this issue, one court has written:
Logic and equity require that ordinary market-price sales by retail merchants acting in good faith not be contorted beyond commercial practice for the purpose of expanding the merchant’s status as a captive risk taker.
So long as a merchant has no reason to suspect a customer’s Ponzi scheme or other skullduggery, sales made under ordinary commercial terms will usually be viewed as legitimate transactions between merchant and customer. Simply because they claim they are “owed money too,” burned investors can’t nullify the honest debts of dishonest companies.
Fraudulent Transfers
In the wake of a collapsed Ponzi scheme, people will rush to claim “fraudulent transfer” in the hope of getting some of their money back. However, the circumstances that support a fraudulent transfer are more limited than most people think. A major source of misunderstanding is that the word “fraud
ulent” has such pejorative connotations that it becomes difficult for most people to think dispassionately about it. According to federal law, fraudulent transfers are subdivided into actually fraudulent transfers and constructively fraudulent transfers. The key distinction between these two types is the intent of the transferors. Intent is essential to actually fraudulent transfers; it’s immaterial to constructively fraudulent transfers.
Bankruptcy law, which controls many of the elements of fraudulent transfer, states that a court or court-appointed trustee may:
avoid any transfer of an interest of the [bankrupt Ponzi company] that was made or incurred on or within one year before the date of the [scheme’s collapse.]
This goes for deals with creditors as well as deals with other investors. However, in order to nullify the transfer, the court has to show that the perp did one of three things:
1) made the transfer or incurred the obligation with intent to hinder, delay, or defraud any entity to which the company was or became indebted;
2) received less than a reasonably equivalent value in exchange for such transfer or obligation; or
3) became insolvent or intended to incur debts that would be beyond its ability to pay as a result of the deal.
(The first activity constitutes an actually fraudulent transfer; either the second or third constitute constructively fraudulent transfer.)
These activities are relatively difficult to prove in connection with an honest corporate debt. So, as noted previously, courts don’t often nullify deals with creditors.
On the other hand, the three standards—particularly the first and third—do fit many of scenarios offered to Ponzi investors.So, courts more often use the fraudulent transfer theory to force investors who took money out of a Ponzi scheme in its last year to give it back.
There are other legal complications. A court can find a transfer fraudulent but choose not to nullify it. And, even if a court does nullify a transfer, it can choose not to force any judgment against the transferees. The fraudulent transfer statutes provide carefully crafted remedies and limitations on remedies.
Not every transferee is liable; for example, subsequent good faith transferees often have no liability.
Many courts dealing with these issues cite the 1985 federal court decision Johnson v. Studholme as a standard of basic fairness. In the wake of a failed Ponzi scheme, the receiver for the defunct Ponzi entities filed lawsuits against all those investors who had received amounts in excess of their contributions.
The Johnson court ruled that the investors had given value for the profits they’d received and, thus, had not received fraudulent conveyances. The court held that the capital contributions made by the investors and the risk that they could lose all or part of their investments had been their contribution.
“Unjust Enrichment” and Other Notions of Fairness
Many state have laws which prohibit “unjust enrichment”—or some similar activity. For example: To prevail on a cause of action in Illinois based on a theory of unjust enrichment, a burned investor must prove that the Ponzi perp has unjustly retained a benefit to the investor’s detriment—and that the perp’s retention of the benefit violates the principles of justice, equity, and good conscience.
Because of their broad language, these laws can be a useful tool for going after people who’ve taken money out of Ponzi schemes. However, courts don’t allow broad language to turn fairness upside down.
In one Illinois case, the receiver sifting through the wreckage of a commodities investment Ponzi scheme filed a suit which argued that fairness required a redistribution of the effects of the scheme “by recovering from those who received more than their investments and paying those who participated in the fraudulent investment schemes.”
However, to decide the question of fairness, the court noted it had to keep in mind whom the parties represent. It wrote:
The Receiver does not assert the rights or claims of any investors. Rather, the plaintiff stands in the shoes of [the Ponzi perp] and the various receivership entities. So, when asserting his equity claim, the Receiver cannot personally raise those equitable considerations of the later investors that lost their money.
The companies which were the “receivership entities” had been established to perpetrate fraud. Thus, to the extent that the receiver sought recovery in equity on behalf of the companies, “it is difficult to imagine a less deserving entity.”
The defendants in the case were “innocent investors” who had accepted their payments as legitimate returns on their investments. The court noted that the receiver had made no allegation that the defendants committed fraud or participated in the Ponzi scheme. “The evidence therefore supports the proposition that the defendants received these conveyances in good faith,” the court concluded.
If the investors had cited the “unjust enrichment” language in a suit against the receiver, the court might have been more inclined to agree. The “Special Status” of Ponzi Schemes
Transfers made as part of Ponzi schemes have achieved a special status in fraudulent transfer law. Proof of a Ponzi scheme is sufficient to establish the perp’s intent to defraud creditors for purposes of actually fraudulent transfers. As one federal appeals court noted:
The fraud consists of funnelling proceeds received from new investors to previous investors in the guise of profits from the alleged business venture, thereby cultivating an illusion that a legitimate profit-making business opportunity exists and inducing further investment.
Smart Ponzi perps—or merchants who’ve dealt with perps—faced with fraudulent transfer claims from angry investors will usually make a so-called “good faith defense.” Basically, they will claim that they entered the business honestly and that whatever trouble followed was simply the unpredictable course of business.
Legally, the good faith claim places the burden of proof on the person making it. The main stumbling block: A person lacks the good faith essential to the defense if he or she possessed enough knowledge of the facts to induce a “reasonable person” to inquire further about the transaction.
Reasonable person standards can be complicated. But one court considering a collpased Ponzi scheme offered this common-sense guideline: “some facts suggest the presence of others to which a transferee may not safely turn a blind eye.”
A Ponzi perp who’s able to sustain the good-faith defense avoids claims of actually fraudulent transfer. The easiest way to avoid claims of constructively fraudulent transfer is to show that disputed deals involved reasonably equivalent value.
Reasonably equivalent value can be established in a number of ways. Two of the simplest: to show that the sale was made in a retail environment and to enlist a recognized expert to broker the sale. This is why smart Ponzi perps will be finicky sellers—it gives them credibility in the moment and deniability later.
Case Study: Stanley Cohen’s Bogus Benzes
Going after people who get money out of a Ponzi scheme can be difficult—especially if the people are vendors or creditors rather than investors. One colorful car scheme shows why this is.
Ponzi perps love driving Mercedes Benzes. Once in a while, a perp will try to make money from this passion. Stanley Cohen concocted a not very clever, I-can-get-it-for-you-wholesale Ponzi scheme in which he accepted money from prospective buyers of premium cars and used it to buy the things at full retail. Because he was losing money—in some cases, quite a bit—on each sale, the scheme headed for collapse more quickly than most.
Cohen’s investors were entertainment industry figures whom he reckoned were greedy enough to want the most expensive cars on the road...and not quite rich enough to afford them. There is no shortage of people like that in the entertainment industry.
In the typical transaction, Cohen would explain that he could get a Mercedes Benz 500SL for $80,000, even though the car had a retail sticker price of almost $115,000. He claimed that he had some heavy connections in the auto industry; but he remained vague about detail
s. If a person wanted the hard-to-get model cheaply, he or she had to give Cohen the $80,000 quickly, in cash and up front.
Like in all Ponzi schemes, this promise was too good to be true. Several people would each pay Cohen $80,000. Cohen would then go to a dealer, say that he was an agent for some Hollywood high-roller, sign contracts to purchase as many vehicles as his funds allowed, and write checks for the full $114,500 for each vehicle.
The dealer, confirming that Cohen had sufficient funds on deposit to honor the check but not otherwise investigating Cohen’s bona fides, would prepare the cars for delivery. Cohen would then tell the dealer to whom to deliver (and place in title on) the vehicles.
Neither the numbers of vehicles involved nor the method of payment were, in the experience of the dealers, extraordinary. However, if the dealers had investigated Cohen’s creditworthiness in greater detail, they would have discovered that he had a checkered financial past— including at least one previous personal bankruptcy and involvement in financial frauds dating back to the 1940s.
Since Cohen was losing $34,500 per vehicle (or more, because he was also taking money for himself), the number of cars he bought was always lower than the number of people who’d paid him $80,000. Other people’s payments were used to make up the shortfall.
Cohen was no stranger to financial frauds. He knew that as he continued to buy high and sell low with the funds provided by the scheme participants that it was doomed to collapse. He knew that his “investors” were his creditors because he owed them either a vehicle or their money back. And he knew that when it collapsed there would be no vehicle and no money left for refunds.
The inevitable collapse landed Cohen in prison and left a number of burned customers—they didn’t think of themselves as scheme participants—who’d paid Cohen money and received nothing. The trustee who took over the pieces of Cohen’s operation sued the scheme participants (that’s what they were, no matter what they considered themselves) who’d taken possession of the cars and the dealers who’d gotten full retail price. He argued that a federal court should avoid all seventeen sales because they were fraudulent transfers.