US Finance WorldCredit Cards, Bank Rates, Insurance, Loans, Debts and Mortgages News

A Ponzi scheme uses money from later investors to pay unrealistically high returns to earlier investors. Accordingly, earlier participants are more likely to have received a financial benefit than later investors. When a Ponzi scheme unravels, a key question is how to fairly distribute any recoveries to the victims. Should earlier investors be required to return the amounts they withdrew? Should the recovered funds be distributed in proportion to the amounts invested (net of any withdrawals) or in proportion to the amounts reported on the last account statements? 

Similar issues were argued before Judge Burton R. Lifland on February 2, 2010, in connection with the proposed allocation of funds recovered from Bernie Madoff (Securities Investor Protection Corp. v. Bernard L. Madoff Investment Securities LLC, 08-01789, U.S. Bankruptcy Court, Southern District of New York (Manhattan)).

The attorney for the trustee, Irving H. Picard, argues that the payments to victims should be proportional to the amounts they paid to Madoff less any withdrawals.

The attorneys for some of the victims, however, argue that the payments to victims should be proportional to the amounts reported on the last account statements provided to them by Madoff.

Both sides offered differing interpretations of the same legal precedents in support of their proposed allocation of the payments to victims.

The Securities Investor Protection Act of 1970 at 15 USC 78fff-2(c)(1)(B) requires the payments to be in proportion to each customer’s “net equities.” Net equity is defined at 15 USC 78lll(11) as “the sum which would have been owed by the debtor to such customer if the debtor had liquidated, by sale or purchase on the filing date, all securities positions of such customer (other than customer name securities reclaimed by such customer)” less any debt owed by the customer to the debtor.

Victims who withdrew more funds than they invested in a Ponzi scheme, so-called “net winners,” would prefer payments to be based on the fictitious account statements. Net winners would get nothing under the trustee’s approach, and might even have to return some of the money they withdrew. Some of the earlier investors in a Ponzi scheme who didn’t withdraw any funds also prefer that the payments be based on the account statements because this will increase the amount of their potential payments. These investors may also argue that they paid taxes on the fictitious earnings.

The IRS issued Revenue Ruling 2009-9 on March 17, 2009, concerning the claiming of theft losses from Ponzi schemes in which the lead promoter has been indicted. It allows theft-loss deductions on up to 95% of the total investment, including any fictitious earnings on which they paid income tax, less any withdrawals or recoveries. Losses exceeding income are treated as a net operating loss and may be carried back 3, 4 or 5 years and carried forward 20 years.

The allocation method will also affect which victims would be eligible for a $500,000 cash advance from the SIPC.

The two arguments concerning the allocation of payments to victims can be viewed as representing net present value calculations, but with different discount rates. The trustee’s approach seems to involve a 0% discount rate, while the account statements approach would assume a discount rate based on Madoff’s fictitious returns. One could also argue for other intermediate discount rates. For example, perhaps the discount rate should be based on the Consumer Price Index so that the investments and withdrawals represent constant dollars instead of the trustee’s current dollars approach. After all, money invested earlier has a greater value than money invested later due to inflation. Another approach would consider the amount of money the investors could have earned had they invested in US Treasuries (i.e., a discount rate based on the risk-free rate of return) or in a broad-based stock market index.

Basing the victim compensation on amounts invested net of any withdrawals seems fairer than basing the compensation on the fictitious statements, since the net winners have already benefited from the Ponzi scheme. Why should earlier investors receive a greater share of the recovery than later investors? If the court bases the allocation formula on the fictitious statements, it is in effect becoming a party to the fraud after the fact.

It is unclear which of the possible allocation methods is legally valid. What is clear, however, is that either method will result in many unhappy investors, who are certain to appeal the judge’s ruling.

What do you think?

More Resources:

Mark Kantrowitz is a nationally-recognized expert on student financial aid, student loans, scholarships and paying for college. He is the publisher of FinAid.org, the leading free web site for student aid information, advice and tools, and FastWeb.com, the most popular free scholarship matching web site.

Similar Posts:

• Withdraw From Your IRA — Penalty-Free (The Tax Guy)
• Weisel Accused of Fraud
• Fixed Mortgage And its Types
• Simple steps to a more secure retirement
• Escrow Accounts Explained