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Fraud Case Receiver's Recovery of Ponzi Profits: An Update of Clawback Recovery Actions By Morgan, Nick & Puji, Nick* Though the names in the headlines change, the scenario is all too familiar to regulatory receivers and their counsel: The Securities and Exchange Commission or other regulatory agency brings expedited proceedings in federal court with allegations of massive fraud, requests for an asset freeze and the appointment of a receiver to take over an enterprise in some stage of disarray. Indeed, with the embarrassment of having overlooked the Madoff affair still smarting at the SEC, that agency will likely be bringing an increasing number of such actions, and there is no reason to believe that other agencies such as the FTC and CFTC won’t be following suit in the current climate. That raises the prospect for an increase in receiverships, and with that increase, a greater number of tough questions about clawbacks and related issues. Time for Payback? Then an investigative reporter publishes an article questioning the company’s bona fides. Investors scramble to pull out their money. Luckily, our investor retrieves her money before the enterprise collapses. On balance, she feels that she fared well, having recovered her initial investment back as well as collecting years of interest payments. But then a trustee demands that she return those profits and her principal. This scenario, which could have been taken from today’s headlines, is not entirely fictional; it derives from a U.S. Supreme Court case involving one of America’s most famous flim-flam artists: Charles Ponzi (Cunningham v. Brown, 265 U.S. 1, 13 (1924)).
More than 80 years later the law hasn’t changed much.In July 2008, the Ninth Circuit described the plight of Robert Kowell, an investor who received 20 percent returns every 90 days “risk free” from a business that purported to provide working capital to a latex glove manufacturer in Malaysia. Long after Kowell had spent his gains, he received a letter from a court-appointed receiver demanding that he return $69,546 in “profits” or face a lawsuit (Donell v. Kowell, 533 F.3d 762 (9th Cir. 2008)). Such “clawback” demands and related controversies have only increased as the number of SEC receiverships rises. Fraudulent Conveyances In addition, whether or not a bankruptcy proceeding is pending, in most states (including California) an SEC receiver may employ a version of the Uniform Fraudulent Transfer Act (UFTA). Actions under the UFTA (Cal. Civil Code §§ 3439–3439.12) against innocent investors generally are limited to recovery of fictitious profits (Donell, 533 F.3d at 770) [Ed. Note: California law allows up to a seven-year reach-back depending upon facts of the case.] As Judge Richard Posner explained in Scholes v. Lehmann (56 F.3d 750, 755 (7th Cir. 1995)), an investor fortunate enough to have received fictitious profits “should not be permitted to benefit from a fraud [at the expense of other investors] merely because he was not himself to blame for the fraud. All he is being asked to do is to return the net profits of his investment—the difference between what he put in at the beginning and what he had at the end.” (Scholes, 56 F.3d at 757–758.) Disgorgement Another common strategy is for receivers to recover funds by naming victim-investors as “relief defendants,” or “nominal defendants,” in an action. (See Janvey v. Adams, Alguire, et al., Nos. 09-10761, 09-10765 (5th Cir.) (ancillary actions to Stanford Int’l Bank, Ltd., No 3-09-0298-N (N.D. Tex.)).) A relief defendant is not accused of wrongdoing, but a federal court may order equitable relief against such an individual where that individual (1) has received ill-gotten funds, and (2) does not have a legitimate claim to those funds. (SEC v. Colello, 139 F.3d 674, 677 (9th Cir. 1998).) These proceedings may allow a receiver to claw-back both the profits and original principal invested by investors, quickly turning into true victims of the scheme those lucky enough to have received temporary profits. (See SEC v. George, 426 F.3d 786, 798-99 (6th Cir. 2005) (ordering winning investors to return profits and principal); Forte, Nos. 09-63, 09-64, 2009 WL 4809804, at *6 (acknowledging statutory and case law support for a receiver’s recovery of both profits and principal from investors).) As the Ninth Circuit has noted, “Ponzi schemes leave no true winners once the scheme collapses—even the winners were defrauded, because their returns were illusory.” (Donell, 553 F.3d at 779.) Although clawbacks from defrauded investors may seem harsh, the process is designed to achieve an equitable result in which no single investor shoulders a disproportionate share of the damage inflicted by the underlying fraud. In other words, each investor is made to feel the pain. Oftentimes, investors feel relieved or reassured once they begin
receiving interest payments on that investment in a foreign currency
exchange firm, yet two years down the road they may be forced to pay back,
not only the interest they “earned”, but their own principal investment.
Receivers and their counsel should be aware of the various strategies and
pitfalls that await their attempts to clawback such principal and profits. |