Ponzi Clawbacks

by Nicolas Morgan

The story is sadly familiar: The Securities and Exchange Commission swoops into federal court with allegations of massive fraud, requests an asset freeze, and appoints a receiver to take over the target enterprise.

Indeed, between January and April of this year SEC lawyers sought 27 emergency restraining orders and asset freezes (up from 7 for the same period in 2008). Nine of those new cases were in the Los Angeles area. Rosalind Tyson, director for the SEC's regional office in Los Angeles, told the Los Angeles Times, "These are four of the most exciting months of my career at the SEC, and I've been here 26 years."

Exciting, yes, but also punishing for investors caught up in the legal fallout who have been asked to return money they thought was profit.

Payback Time
Imagine this scenario: Your client invests money with a company purporting to arbitrage international postal coupons. Over a period of several years, your client receives interest payments like clockwork at the promised rate of return.

Then an investigative reporter publishes an article questioning the company's bona fides. Investors scramble to pull out their money. Luckily, your client retrieves hers before the enterprise collapses. On balance, your client feels that she fared well, having received her investment back as well as years of interest payments. But then a trustee demands that she return those profits and her principal. (This scenario 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. 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 have only increased as the number of SEC receiverships rises.

Fraudulent Conveyances
SEC receivers have a number of tools at their disposal for reclaiming money repaid to investors by a fraudulent enterprise. If the business is in bankruptcy, fraudulent-conveyance claims may be brought under the Bankruptcy Code. (See In re Bayou Group, LLC, 362 B.R. 624, 632 (Bankr. S.D.N.Y. 2007).) Indeed, the trustee may require investors to return fictitious profits and principal unless they can prove they gave value or acted in good faith in receiving the transfer.

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). 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
Finally, an SEC receiver has the power to simply move for disgorgement against third parties holding assets transferred to them by defendants in the underlying SEC enforcement action (SEC v. Wencke, 783 F.2d 829 (9th Cir. 1986)). Disgorgement proceedings are summary in nature and arise from the courts' equitable powers under federal securities laws to prevent dissipation of assets and recovery of diverted assets.

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.

A savvy person can avoid these issues entirely by thoroughly kicking the tires on an investment proposal before turning over any money in the first place.

Nicolas Morgan is a partner at DLA Piper in Los Angeles, where he practices complex securities litigation.

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