You Can't Cheat an Honest Man (42 page)

Beginning in or about July 1990, “in an effort to lend additional credibility and respectability to its operations, Towers [Financial] hired Duff & Phelps to rate the Towers Bonds.” According to Shain, the relationship between Towers Financial and Duff & Phelps soon became “symbiotic.” Towers paid Duff & Phelps fees and Duff & Phelps helped Towers promote itself to the investment community.

Duff & Phelps had never directly solicited Shain or other individual investors. Instead, Shain argued, the firm had “solicited” the sale of Towers notes to the investors by communicating with brokers.

The court ruled that Shain’s theory that Duff & Phelps “solicited” investors through brokers was too convoluted to work. It wrote: “the district court decisions in this circuit consistently have held that persons are not liable...for solicitation unless they directly or personally solicit the buyer.”

In April 1995, Hoffenberg pleaded guilty to running an investment scam, fraudulently selling notes and bonds to investors and using some of the proceeds to pay interest owed earlier investors. A year later, he asked to withdraw his guilty plea because he had been suffering from mental illness. A federal judge ordered psychiatric tests.

In March 1997, Hoffenberg was sentenced to 20 years in prison. District Judge Robert Sweet also ordered him to pay $463 million in restitution and a fine of $1 million. “There has been tremendous suffering here,” Sweet told Hoffenberg. “You have not accepted responsibility for these securities frauds.”

Hoffenberg said he would appeal.

CHAPTER 22
Chapter 22: Fight Like Hell in Bankruptcy Court

All Ponzi schemes eventually collapse. After a scheme has ground to its inevitable conclusion, filing for bankruptcy protection—sometimes voluntarily, but usually court-ordered—is all that’s left.

In order to get anything out of the bankruptcy process, a burned Ponzi investor has to fight like hell at each of several stages. This will usually require lawyers, various kinds of professional fees and enough fellow burned investors or creditors to raise a collective voice.

Even though the effort is complex and expensive, it can be worth the effort. And you don’t have to be a lawyer to make the decision whether you should fight or—within some limits—how. You only need to know a few basic points about how Ponzi schemes work their way through bankruptcy proceedings.

To start, federal appeals court judge Richard Posner has written:

Corporate bankruptcy proceedings are not famous for expedition.... So, the last resort for the burned Ponzi investor is to look for some restitution in bankruptcy court. The law treats Ponzi investors a little better than shareholders of a legitimate company when it comes to court-ordered liquidation...but only a little better.

A more important distinction is the one between a Ponzi investor and a creditor of a Ponzi company. Sometimes there isn’much of one. In its 1924 decision
Cunningham v. Brown
—which involved Carlo Ponzi’s original scam—the U.S. Supreme Court wrote that a “defrauded lender becomes merely a creditor to the extent of his loss and a payment to him by the bankrupt within the prescribed period...is a preference.”

What’s more: the Bankruptcy Code allows a court to consider
any
transaction which occurs within the last 90 days before a filing inherently preferential—simply because of the time at which it took place. This protects “those investors who transfer monies to the scheme within the ninety day pre-petition period who receive nothing in return due to the collapse of the scheme, yet whose funds are used to pay earlier investors.”

Bankrupcty law discourages creditors “from racing to the courthouse to dismember the debtor during his slide into bankruptcy.” Instead, it tries to set a framework within which a debtor can “work his way out of a difficult financial situation through cooperation with...creditors.”

Burned investors often argue that these goals have “no rational application” in the context of a Ponzi scheme—since Congress could not have intended to protect such a debtor so as to enable it to perpetuate fraudulent activities. Courts don’t always agree. As one noted:

[Congress’s] intention to avoid a debtor’s dismemberment may rationally apply even to a Ponzi scheme when one considers that creditors of such a debtor may include non-investors. For example, if a Ponzi scheme uses telephone services and its telephone company remains unpaid, preventing investor creditors from rushing to dismantle the debtor as it slides into bankruptcy would serve to protect the [telephone company’s] interests....

Avoiding preferences in a Ponzi scheme serves the primary purpose— to equalize distribution to creditors and, to a lesser extent, to discourage a race to the bankrupt company’s assets. Invariably, this directs a lot of responsibility to one person.

The Trustee Determines a lot

One of the critical aspects of a bankruptcy proceeding is the naming of a trustee. This person serves as a combination of CEO and defense counsel during the liquidation. While the trustee is not directly responsible for protecting burned investors (technically, the responsibility is to the bankrupt corporate entity), he or she is instrumental in setting the tone for the proceedings.

In fact, if a trustee is found to be asserting claims belonging to creditors rather than the debtor, the court—which ultimately supervises the proceedings—can overturn any activity.

Very often, burned Ponzi investors will argue that any claims asserted in a bankruptcy case “really” belong to them. This argument usually stems from the mistaken assumption that the investors are the ones who will receive the money anyway, so they should be able to pursue the wrongdoers themselves.

That’s not how bankruptcy—or a bankruptcy trustee—works. It’s not a debt collection device. Indeed, the trustee’s job is to investigate the debtor’s financial affairs, liquidate assets, pursue the debtor’s causes of action, and acquire assets through avoiding powers in order to make a distribution to creditors. Whether a trustee considers a burned investor an ally or adversary depends on the burned investor’s standing in a case. And this standing isn’t always clear.

There are some lessons to be learned from existing cases regarding how a trustee in bankruptcy should plead a claim against a third party participant in a Ponzi scheme. A trustee will usually be careful not to plead for a recovery based on any injury to investors or creditors, even though fraud against investors may be a part of the background allegations.

In alleging background facts, trustees often explain how investors have been defrauded. These background facts, however, should not be confused with the actual claims. A trustee will usually be careful not to plead damages as an amount equal to the funds invested in the debtor’s Ponzi scheme (the investor’s biggest concern); instead, the trustee will measure damages based on funds improperly paid out.

There is a difference between a creditor’s interest in claims held by the corporation against a third party, which are enforced by the trustee, and the direct claims of the creditor against the third party. Only the creditor can enforce a direct claim; and this has to take place in civil court, not bankruptcy court.

But a reciever or trustee can protect a Ponzi company’s interest, which indirectly helps burned investors get at least some of their money back. As Judge Posner has noted:

We cannot see any legal objection and we particularly cannot see any practical objection. The conceivable alternatives to these suits for getting the money back into the pockets of its rightful owners are a series of individual suits by the investors, which, even if successful, would multiply litigation; a class action by the investors—and class actions are clumsy devices; or, most plausibly, an adversary action, in bankruptcy, brought by the trustee in bankruptcy of the corporations if they were forced into bankruptcy.

For a burned investor, the last of these three methods is almost always the fastest...and the most cost-effective.

The Trustee Lays Claim

If—as a burned Ponzi investor—you can convince a bankruptcy trustee to file a lawsuit (what Posner called “an adversary action”) on behalf of everyone, the work has only begun.

By definition, the property of a bankrupt estate is a scarce commodity. The reason companies declare bankruptcy—voluntary or forced—is that their assets are no longer sufficient to repay creditors fully. These creditors, eager to assert their entitlement to whatever assets
do
remain, will often lay claim to the property by filing claims outside of bankruptcy court.

As the administrator of the bankrupt estate, the trustee is charged with marshalling all available assets of the estate, reducing these assets to money, and distributing this money to the estate’s creditors, in a manner that ensures each similarly situated creditor of the bankrupt debtor an equitable share.
Therefore, the trustee—like the creditor—is concerned with laying claim to any property that could conceivably belong to the estate. This “any property” usually includes lawsuits against the perps who tanked the company in the first place. The trustee’s concern isn’t only for money, though; it’s also for order. As one federal court noted, the trustee wants:

to avoid numerous lawsuits by individual creditors racing to the courthouse to deplete the available resources of the estate and thereby thwart the equitable goals of the bankruptcy laws.

To accomplish these goals, the trustee is given statutory power to sue and be sued as a representative of the estate.

In practical terms, it means that money paid to Ponzi investors is the property of the scheme. The Bankruptcy Code allows “fraudulent transfers made in furtherance of a Ponzi scheme” to be reversed. Specifically, it allows the trustee to avoid a payment made within one year of filing, if the scheme “made such transfer...with the intent to defraud any entity to which the debtor was...indebted.” And all Ponzi payments are made with that intent.

A Ponzi scheme is considered—by definition—to involve fraudulent intent. In the wake of a Ponzi scheme collapse, a bankruptcy court can order the reversal of any transaction that occurred within one year before the bankruptcy filing. This one-year limit is known as the “reachback period.” The court can order any investor who took money out of the scheme within the reachback period to give it back.

Another Way to Overturn Ponzi Payments

The trustee can also void transfers on somewhat different grounds. If the debtor “received less than reasonably equivalent value” in exchange for a transfer of the debtor’s property, the trustee may avoid the transfer if several additional elements are established.

“Value” is defined for purposes of the Code as “property, or satisfaction or securing of a present or antecedent debt of the debtor.” Bankruptcy courts have concluded that a defrauded investor in a Ponzi scheme gives “value” to the debtor in the form of a dollar-for-dollar reduction in other investors’ restitution claims against the scheme.

On this subject, the federal appeals court in the Ponzi scheme case
In re Independent Clearing House Co.
ruled:

[T]o the extent the debtors’ payments to a defendant [investor] merely repaid his principal undertaking, the payments satisfied an antecedent “debt” of the debtors, and the debtors received “value” in exchange for the transfers. Moreover, to the extent a transfer merely repaid a defendant’s undertaking, the debtor received not only a “reasonably equivalent value” but the exact same value—dollar for dollar. We therefore hold that such transfers are not avoidable....

In theory, the trustee is not allowed to reverse transfers made for reasonably equivalent value because creditors are not hurt by such transfers. If the scheme no longer has the thing transferred, either it has something equivalent—which creditors take to satisfy their claims— or its liabilities have been proportionately reduced.

But a trustee has some leeway in reversing payments to Ponzi investors. If all the scheme receives in return for an investment is the use of an investor’s money to continue itself, there is nothing added to the estate for creditors to share. In fact, by helping the scheme perpetuate itself, the investors exacerbate the harm to creditors by increasing the amount of claims. As one federal court observed:

If the use of the [investors’] money was of value to the debtors, it was only because it allowed them to defraud more people of more money. Judged from any but the subjective viewpoint of the perpetrators of the scheme, the “value” of using others’ money for such a purpose is negative.

There’s an exception to this so-called
value rule
: a lender who accepted scheme assets as security can still collect the money it loaned.

Ponzi investors being forced to give back distributions will often argue against the one-year limit by claiming that the United States Constitution mandates people who are similarly situated receive like treatment under the law (this argument cites the theoretically complex Fourteenth Amendment).

The theory behind this argument is that a statute may single out a class of people for distinctive treatment only if that classification bears a rational relationship to the purpose of the statute. The argument implies that all investors in a Ponzi scheme are predominantly creditors of the same class and should be treated equally.

However, this argument usually relies on non-bankruptcy cases. As one court said, succinctly, “These cases are unhelpful.” The chief judge ruling in
In re Independent Clearing House Co.
offered a more specific analysis:

All investors in a Ponzi scheme are creditors of the same class, so in theory all should be treated equally.... The equitable solution would be either to apply the statute to all transfers to investors in a Ponzi scheme— without regard to when the transfers were made—or to apply the statute to none of the transfers. Yet this court is no more free to rewrite the statute to bring the early undertakers into its net than it is to ignore the statute to treat later undertakers equally. Courts must apply the statute as written.