Posted by Kathy Bazoian Phelps
The quest of defrauded investors in Ponzi schemes to be made whole is ongoing. To recover their funds in the resulting bankruptcy and receivership cases of the Ponzi debtor, investors file proofs of claim to seek reimbursement of their unpaid principal investments and the promised but unpaid interest on their investments.
But all investors are not created equal, and the manner in which investor claims are allowed in a case can have a huge impact on the ultimate payout. Different categories of investors – “net winners” and “net losers” - may find themselves doing battle with each other in an effort to be repaid a larger portion of their claims.
Net winner investors may have invested money earlier in the scheme and actually received profits that exceed the amount they originally invested. However, those net winners still want to be paid the unpaid interest promised to them - the time-value of their money that was tied up in the Ponzi scheme, often for much longer than the net losers’ investments.
On the other hand, the net losers have either recouped nothing, or some amount less than that originally invested. Net losers also want to be paid the handsome profits that they were promised, in addition to their unreturned principal investment. Net losers, therefore, want the cash available for distribution to repay their principal before the net winners are paid anything.
Academics, courts, and others have considered different methodologies to balance the rights and claims of net winners and net losers. Some say neither net winners nor net losers should be allowed claims for unpaid interest because the entire enterprise was a fraud. Others conclude that net losers should be repaid the full amount of their principal investment before net winners are paid anything.
Another line of thinking on the subject has been gaining traction, however. What if investors are allowed some standardized amount of interest for the time period that their funds were invested in the fraudulent scheme? Essentially, all investors would be allowed an imputed interest amount for the time-value use of their funds. Investors who invested earlier in the scheme and, therefore, for a longer period of time, would be allowed a greater amount of interest than those who had invested more recently.
Pending before the Second Circuit is a case involving this exact issue in a challenge to a receiver’s distribution plan. In the Stephen Walsh, Paul Greenwood Ponzi scheme, the SEC appointed receiver, Robb Evans & Associates LLC, proposed a distribution plan to distribute the assets on a pro rata basis. Several investors objected to the distribution plan, but the district court approved the plan over the objections. One investor appealed because its proposed distribution plan (which differentiated between classes of investors based upon the type of investment the investor had purchases) was rejected. Another investor, the Kern County Employees’ Retirement Association, cross-appealed, seeking an adjustment to the pro rata plan to account for the time-value of money, stating:
KCERA’s cross-appeal asks this Court to adjust the pro rata distribution for inflation under the well-established economic principle that a dollar in 1995 has a different value than a dollar today. Such an adjustment is a commonplace Economics 101 calculation that results in the fairest distribution.
Kern County argued in its cross-appeal that it was unfair for an investor like itself, who had invested funds in the scheme for over a decade, to be treated the same as an investor who had only been invested for one year. Kern County argued, “Without this inflationary adjustment, short-term investors are favored at the expense of long-term investors when there is absolutely no need or justification for such a disparity.” Kern County’s appellate brief is attached here.
Of course, making an adjustment for the time-value of money will enhance the claims of earlier investors, who are more likely to be net winners that have already received back their principal investment, and thereby dilute the claims of later investors who are more likely to be net losers. Net losers, therefore, have a different sense of “the fairest outcome.”
In response, the receiver argued:
With respect to factual findings, the District Court correctly determined that KCERA’s inflation adjustment would not be fair to the investors. For example, as a result of KCERA’s proposed adjustment, some of the investors (including KCERA) would receive millions of dollars over and above their net investments (i.e., the investor's total contributions, minus total withdrawals, unadjusted for inflation or fictitious earnings) before other investors recovered their net investments. An inflation adjustment could also seriously jeopardize the Receiver's efforts to recover, or “claw back,” fictitious earnings that were paid to former investors in the Westridge Entities, further putting at risk the same current investors who would suffer most at the hands of KCERA’s proposed inflation adjustment.
The receiver’s brief is here.
Treatment of investor claims in Ponzi cases is definitely a balancing act where everyone feels that they have lost. Net losers have suffered actual losses and at a very minimum, should certainly be allowed claims for their unpaid principal. Whether investors should be allowed claims for the unpaid fictitious interest is a more complicated question. It seems that, on a basic level, both net winners and net losers should either be allowed or disallowed interest, but that the same basic rule should be applied to both categories of investors.
The good news is that courts are starting to look more closely at these nuanced issues. The bad news is that there are a lot of lingering and unanswered questions.
Should net winners have to wait to be paid interest until net losers are repaid principal in full? And should net winnings be “clawed back” from net winners for purposes of redistribution to all investors after net losers have been repaid principal?
If interest is allowed for investors, should both net winners and net losers be paid at the same rate, and should that rate be the fictitious promised rate, the prime rate, some other imputed rate? And for what period of time?
Should a net loser’s actual damages of its unpaid principal be treated differently than a net winners damages from the loss of use of its money for a long period of time? Are those two types of losses the same, or should they be treated differently?
The argument for imputed interest to compensate for the time-value of money is gaining ground, although no prior decisions appear to have seriously considered it. We will await the Second Circuit’s decision on Kern County’s cross-appeal to see whether there will finally be some court setting some guidelines to establish an equitable solution to a very inequitable situation.
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