Should All Ponzi Scheme Investors Be Treated Equal?

Posted by Kathy Bazoian Phelps

   Everyone loses in a Ponzi scheme. The question is – who loses how much? There is certainly no right that "All investors shall be treated equally." The Second Circuit has just spoken on this issue in a decision that is likely to be often cited in the battles among trustees or receivers and different constituencies of investors.

   The Second Circuit affirmed a distribution plan that treated all of the investors the same in CFTC v. Walsh, 2013 U.S. App. LEXIS 6801 (2d Cir. April 3, 2013). Disputes among different groups of defrauded investors arose in the nearly $1 billion Ponzi scheme case of Westridge Capital Management Inc., which was run by Stephen Walsh and Paul Greenwood.

   The receiver, Robb Evans & Associates, had about $815 million to distribute on about $959 million of investors’ claims pursuant to his proposed plan of distribution filed in April 2011. That plan sought to treat all investors equally, providing a pro rata distribution of available funds based on a net investment claim calculation. In this calculation, each claim is the net of the dollars out less the dollars in, and each investor would receive approximately 85% of its net investment.

   There were essentially two objections to the distribution plan:

   1. One group of investors objected to the pro rata plan because it didn’t distinguish between investors who had selected riskier investments compared to those who had chosen safer investments. They argued that it would be unfair and inequitable to treat those who took greater risk the same as those who sought to avoid risk.

   2. Another group of investors objected to the plan because it did not provide a "constant dollar" adjustment for inflation to compensate longer-term investors. This objection was also made by some investors when the trustee proposed a second distribution in the Madoff case last year, as reviewed in this blog’s July 2012 Ponzi Scheme Roundup. They called the adjustment "time based damages." These Madoff investors requested time-based damages of interest at 9% from the time their funds were first invested. The issue has not yet been resolved by the bankruptcy court in the Madoff case, but last August the court ordered Picard to maintain a reserve for the time-based damages issue of at least 3% of the proposed distribution pending a final determination.

   The lower court in the Westridge case had approved the receiver’s plan over both of these objections, finding that the groups of investors were "similarly situated" and that "a net pro rata distribution is equitable." The court also rejected the constant dollar method, finding that it favored "a more limited number of investors."

   Now, two years after the distribution plan was first proposed, the Second Circuit has spoken on these issues. On the issue of treating different groups of investors differently, the court rejected the concept of an enhanced distribution to investors due to their increased risk, affirming the use of a pro rata distribution in a Ponzi scheme case. The court noted that an imbalance that would result, causing a reduction in the distributions to some investors while permitting other investors to receive back more money than they had invested. The court stated, "It was well within the district court's discretion to conclude that, as a matter of equity, some of the similarly situated victims should not profit at the expense of the other victims." Id. at *51.

   The Second Circuit also readily held that the district court’s rejection of an inflation adjusted distribution was not an abuse of discretion, finding no "authority that supports the proposition that an inflation adjustment is required as a matter of law when there is to be a distribution of assets to a group of similarly situated victims and those assets are insufficient to make all of the victims whole." Id. at *52.

   Leaving the door open for a possible different outcome in cases with funds in excess of a 100% payout on net investment claims, the court stated, "In the event that the Receiver does recover sufficient funds to provide all of the fraud victims with more than their respective net investments, the district court will be free to consider whether to approve an inflation adjustment if the Receiver proposes one, or to consider whether to require such an adjustment if it is not proposed." Id. at *54.

   Now that the Second Circuit has spoken on the issue, the question is whether that will be the end of the tug of war. Some advocates of different priority schemes for different categories of investors and of a constant dollar method for calculating claims believe that such priorities and adjustments should be statutory. Is it time for an amendment to the Bankruptcy Code, statutory receivership provisions, or state statutes on the subject? Or does fiddling with priorities and interest on claims unduly complicate the analysis and create other problems?