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Note: Turning Winners into Losers: Ponzi Scheme Avoidance Law and the Inequity of Clawbacks

By Karen E. Nelson. Full text here.

The sentencing of Bernard Madoff in 2008 closed a chapter in the saga of one of the most extensive and destructive Ponzi schemes in American history. But the fallout from the fraud is just beginning. While every investor in a Ponzi scheme suffers financially once the fraud is exposed, media scrutiny surrounding the Madoff catastrophe has helped highlight a unique legal consequence of Ponzi scheme bankruptcy proceedings: the “clawback.” Stemming from federal, state, and court-made ju­risprudence, the clawback is a mechanism by which bankruptcy trustees can recoup funds from investors who “won” through the fraud to repay those who “lost.” With equity at the heart of fraudulent transfer and bankruptcy law, such a solution may seem appropriate.

Unfortunately, the legal, personal, social, and economic premises upon which clawbacks rest are faulty at best and destructive at worst. The federal bankruptcy laws’ imposition of strict liability on transferees of fraudulent conveyances is intrinsically inequitable, and such inequity is magnified by courts who apply misguided economic principles in the context of Ponzi schemes. Requiring “winners” to pay all profits back to “losers” not only spurs social evils such as dubious attorney advice and strife among Ponzi scheme victims, it also grates against fundamental precepts of capitalism and economics.

The Note agrees that reaching a truly equitable solution in the aftermath of a Ponzi scheme requires recognizing that winning investors gave real value for their investments, and that clawing back the interest they received victimizes them twice over. Clawbacks fully disregard the time-value and opportunity costs of winners’ investments, and thus have the potential to harm winning investors to an even greater extent than losers. While a certain level of restitution is desirable, Ponzi scheme avoidance law must allow winning investors to keep an amount of profit equal to the time value of their initial investments and certain opportunity costs. Far from a windfall to these investors, such a solution updates Ponzi scheme jurisprudence away from outdated modes of legal and economic thought surrounding the concept of value, and toward true damage awards that treat winning and losing investors alike. Fortunately, the juris­prudential framework for this solution already exists. With the magnitude of the Madoff scandal now highlighting the inequities of traditional law, courts must take the reins in redefining the value defense for winning investors, and remove the unreasonably sharp nails from trustees’ clawback paws.