Imagine you invest in the stock market and with a little luck, you pick stock funds that go up in value. Thereafter, you are wise enough to cash out your profits before the value of the fund declines. Imagine many years later, you receive a letter from the Securities & Exchange Commission ("SEC") or a Trustee, asking you to return all profits from the investment. For those unlucky Winning Investors from the Bernard Madoff Investment Securities ("MadoffSecurities"), this unfortunate circumstance may be a reality.
A. Introduction to The Madoff Ponzi Scheme
The public has been exposed to Ponzi schemes by former NASDAQ chairman named Bernard Madoff ("Madoff"). Madoff perpetrated the largest investment fraud ever committed by one individual, with an estimated $64.8 billion over 4,800 investors. After a decade of fraudulent transfers, Madoff was arrested in December 2008 and sentenced to over 150 years in prison after pleading guilty to 11 felonies in March 2009. The Trustee for Madoff Securities, Irving Picard, has uncovered $1.5 billion while $20 billion remains unaccounted.
As a matter of history, Madoff Securities was founded in 1960. Madoff has admitted that he stopped trading in the mid-1990s and that all subsequent returns were fabricated. For nearly twenty years, Madoff offered his investors short term returns with high and consistent profits.
Ponzi schemes are fraudulent operations because the returns are paid from money obtained through later investors, rather than any actual profits earned. Due to this structure, Ponzi schemes require an increasing flow of new money. Ponzi Schemes ultimately collapse because new investors eventually run out and no actual profits exist.
At the end of a Ponzi scheme, investors can be grouped into two separate categories: "Winning Investors" and "Losing Investors." The Wining Investors are those who received a positive return on their investment; meaning they took more money out than they put in. The Losing Investors are those who received a negative return on their investment; meaning they paid more into the scheme than they received.
The number of Winning Investors in Madoff Securities has been estimated to be 2,568 and net losers at 2,335. The number of net winners and net losers will be an issue of contentions by various parties. When assessing the amount to be collected from the Winning Investors, the Trustee will calculate recovery from the inception of the fund with no consideration for a commercially reasonable rate of return.
While Ponzi schemes on a scale as large as Madoff's are rare, Ponzi schemes in general are more common than one might think. In California, there have been several circumstances, including Reed Slatkin in Santa Barbara, California, and Richard P. Lewis, Jr. from Financial Advisory Consultants in Lake Forest. Both of these local Ponzi schemes resulted in hundreds of millions of dollars lost by investors.
B. Laws Governing Fraudulent Conveyances
In a Ponzi scheme, returns beyond one's initial investment can be considered a fraudulent transfer under the Uniform Fraudulent Transfer Act ("UFTA"). In California, the UFTA is codified under California Civil Code §§ 3439 through 3439.12 and applies to fraudulent transfers.
A transfer is fraudulent if the debtor makes a transfer with the actual intent to hinder, delay or defraud any creditor, and without receiving a reasonably equivalent value in exchange for the transfer. In a Ponzi scheme, net profits beyond one's initial investment are considered a fraudulent transfer (i.e., there was no exchange of reasonably equivalent value). To recover the assets fraudulently transferred by the investment company, the Trustee will ask for the return of all profits. The Winning Investors are placed in a position where they must return all of the money they earned through the investment. The Trustee will not make any consideration for a reasonable rate of return, or for money spent years prior.
When a Ponzi scheme ultimately collapses, a Trustee is appointed to recover the assets fraudulently transferred by the investment company and to return said assets to the Losing Investors. Irving Picard was appointed as Trustee in the Madoff Securities matter, and recently published an intent to file lawsuits against 1,000 WinningInvestors.
Currently, some Winning Investors are arguing they are Losing Investors and requesting the court share in assets returned to Picard as Trustee. Many of these Winning Investors have justifiably relied on this investment for security and spent their profits on admirable causes, gifts and philanthropic activities.
D. Defenses Available to Winning Investors
Winning Investors should consider whether one or more of the following defenses apply:
1. A transfer is not a fraudulent conveyance if the Winning Investor is a subsequent transferee who took the proceeds in good faith ("good faith transferee");
2. A transfer is not a fraudulent conveyance if the Winning Investor is a good faith transferee who paid a reasonable equivalent value for his or her returns; or
3. A transfer is not a fraudulent conveyance if it is beyond the statute of limitations.
Good faith transferees are entitled to keep their earnings and investment. A problem with this theory, however, is the determination of whether one has paid a "reasonably equivalent value" so as to qualify as a good faith transferee. In a Ponzi scheme, any net profits to a Winning Investor are not defined a good faith transfer because the profits are fictitious.
What if one receives the Madoff investment by inheritance? Since the investor paid nothing for the investment, does this mean that all of the withdrawals must be returned? The Trustee would argue that any transfer to this new inheritance could not be a good faith transfer as they did not offer a reasonably equivalent value for the transfer.
Other precarious examples include a car dealership that received a deposit by Madoff for a specialty sports car. Did the car dealership offer a reasonably equivalent value for this deposit? What if someone purchases Madoff's home for a discount? Would that be considered a fraudulent conveyance? These examples demonstrate how the lines become unclear.
The Trustee should consider other factors of a Winning Investor, such as: (1) age; (2) ability to pay without hardship; (3) solvency; and (4) health and dependencies. The Trustee will have to balance the Net Winners' ability to pay with the Net Losers' interest of recovery.
What is most unique in this Ponzi scheme is that Madoff Securities was insured up to $500,000 per investment by The Securities Investor Protection Corporation ("SIPC"). In other Ponzi schemes there were no such insurance.
Winning Investors should also consider the statute of limitations imposed. Some Trustees seek transfers almost four years back. In this case, the Trustee appears to be asking for monies back from the inception of a Winning Investor's account. We doubt the UFTA or the laws of New York allow for such a lengthy recovery. If venued in California, if the transfer occurred four years prior to the lawsuit, it would be subject to dispute whether the fraudulent conveyance is extinguished not allowing the Trustee to obtain the return profits from the Winning Investor.
Everyone loses in a Ponzi scheme. The Trustee will recover only a small percentage of the Losing Investors' initial investment, and the Winning Investors will be forced to return profits. The Trustee will have limitless resources, especially in the Madoff Securities matter with the involvement of SIPC. However, the Trustee must limit recovery within the law. Winning Investors should carefully review all their defense options before admitting liability and sharing financial information.
SIPC v. Bernard Madoff Securities, LLC, No. 08-1789 (Bankr. S.D. N.Y. 2009)
 Securities and Exchange Commission v. James P. Lewis, Jr., et al, Case No. CV03-9354 ABC (2004).
 In Re: Slatkin 525 F. 3d 805 (9th Cir. 2008)
 Donnell v. Kowell 533 F.3d 762 (9th Cir. 2008)