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Innocent Investor Overcomes Objections and Profits from a Ponzi Scheme: Lewis v. Taylor
Posted on Categories Business & Employment, Court DecisionsTags , ,

By Paul J. Dubow

In considering whether an innocent investor in a Ponzi scheme gives “reasonably equivalent value” when receiving “profits” from a Ponzi fund, a court must consider the time value of the funds that the investor deposited into the fund.

Lewis vs. Taylor, No. 13-0239 (Colo. App., 2/9/17).

Ponzi Schemes, Profits and a Reversal of Fortune

Defendant invested $3 million in a hedge fund that proved to be a Ponzi scheme. He ultimately withdrew the full amount of his investment plus $487,000 in presumed profits, but did so in good faith, because he was not then aware that he was dealing with an operator of a Ponzi scheme. Plaintiff, the fund’s receiver, brought suit under a Colorado statute that is identical to the Uniform Fraudulent Transfers Act (UFTA) to recover the “profit” that defendant received. Plaintiff’s motion for summary judgment was granted and defendant appealed.

The Court reverses and remands. In doing so, it rejects the holding in Donell v. Kowell, 533 F.3d 762 (9th Cir. 2008) that innocent investors in a Ponzi scheme must disgorge any profits that they received from their investment. UFTA provides that a transfer (payout) by a debtor (the fund) is fraudulent (and voidable) as to creditors (here, the investors who lost money) where the transfer is made with the actual intent to hinder, delay, or defraud the creditors. But UFTA also provides that the transfer is not voidable “against a person who took in good faith and for a reasonably equivalent value.”

An Inconsistent Rationale?

In Donell, the Ninth Circuit held that an innocent investor who withdraws funds in good faith can keep the principal but must disgorge any profits. It reasoned that a payment of “profits” by a Ponzi scheme operator is not a return on investment in a business venture but a payment that depletes the assets of the scheme operator for the purpose of creating the appearance of a profitable business venture. The Colorado Court finds an inconsistency in this rationale, because the return of principal also depletes the fund’s assets. Indeed, this would also apply to any landlords of or vendors to the scheme operator who legitimately profited from the services that they rendered to the fund.

The Ninth Circuit attempted to mitigate this flaw in its analysis by explaining that the return of an innocent investor’s principal is given for reasonably equivalent value because such transfers “are settlements against the defrauded investor's restitution claim.” This rationale is fraught with contradiction. When one considers the value of a defrauded investor’s restitution claim, then one must also consider the amount of prejudgment interest to which the defrauded investor would be entitled.  But if that were the case, then the value of the settlement would be greater than the principal investment.

The Plain Language of the Statute

Putting these practical issues aside, the Court concludes that it is improper in the first place, when determining what constitutes reasonably equivalent value under UFTA, to consider a purely hypothetical restitution claim that an innocent investor might have brought and succeeded on had the investor not recovered the principal. The plain language of the statute is what is determinative. The statute addresses the propriety of a transfer, not the propriety of the transferor’s overall business. Accordingly, any evaluation of what constitutes reasonably equivalent value in this case must address what was actually exchanged, not how the hedge fund fraudulently used whatever it received in the exchange. This evaluation cannot ignore the fact that there is value in the use of money for a period of time.

The Court therefore concludes that the trial court erred by not accounting for the time value of defendant's principal investment when determining whether he gave reasonably equivalent value for transfers he received from the fund. Because there were several transfers to defendant, the Court remands the matter to determine whether defendant gave reasonably equivalent value each time that a transfer occurred.

(P. Dubow: One could argue that there is also a flaw in the Colorado court’s reasoning. Under its rationale, an investor in a Ponzi scheme who is fortunate enough to withdraw the entire principal can recover interest, but this will deplete the fund, causing an investor who does not withdraw principal to recover no interest and only part of the principal. The Ninth Circuit approach seems to be fairer.)

(SLC Ref. No. 2017-20-05)

NOTICE: The court decision synopsis published above represents an abbreviated description of the actual decision and is re-printed here for its educational value. The author's effort is to report concisely the substance of the decision or a selected portion of the decision; commentary or analysis is generally reserved for the italicized section at the bottom of the summary. Subscribers to SAC's Online Litigation Alert (SOLA), from which this synopsis is excerpted, have immediate access to the full decision, in addition to the synopsis.

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