You Can't Cheat an Honest Man - James Walsh [145]
Burned investors often argue that these goals have “no rational application” in the context of a Ponzi scheme—since Congress could not have intended to protect such a debtor so as to enable it to perpetuate fraudulent activities. Courts don’t always agree. As one noted:
[Congress’s] intention to avoid a debtor’s dismemberment may rationally apply even to a Ponzi scheme when one considers that creditors of such a debtor may include non-investors. For example, if a Ponzi scheme uses telephone services and its telephone company remains unpaid, preventing investor creditors from rushing to dismantle the debtor as it slides into bankruptcy would serve to protect the [telephone company’s] interests....
Avoiding preferences in a Ponzi scheme serves the primary purpose— to equalize distribution to creditors and, to a lesser extent, to discourage a race to the bankrupt company’s assets. Invariably, this directs a lot of responsibility to one person.
The Trustee Determines a lot
One of the critical aspects of a bankruptcy proceeding is the naming of a trustee. This person serves as a combination of CEO and defense counsel during the liquidation. While the trustee is not directly responsible for protecting burned investors (technically, the responsibility is to the bankrupt corporate entity), he or she is instrumental in setting the tone for the proceedings.
In fact, if a trustee is found to be asserting claims belonging to creditors rather than the debtor, the court—which ultimately supervises the proceedings—can overturn any activity.
Very often, burned Ponzi investors will argue that any claims asserted in a bankruptcy case “really” belong to them. This argument usually stems from the mistaken assumption that the investors are the ones who will receive the money anyway, so they should be able to pursue the wrongdoers themselves.
That’s not how bankruptcy—or a bankruptcy trustee—works. It’s not a debt collection device. Indeed, the trustee’s job is to investigate the debtor’s financial affairs, liquidate assets, pursue the debtor’s causes of action, and acquire assets through avoiding powers in order to make a distribution to creditors. Whether a trustee considers a burned investor an ally or adversary depends on the burned investor’s standing in a case. And this standing isn’t always clear.
There are some lessons to be learned from existing cases regarding how a trustee in bankruptcy should plead a claim against a third party participant in a Ponzi scheme. A trustee will usually be careful not to plead for a recovery based on any injury to investors or creditors, even though fraud against investors may be a part of the background allegations.
In alleging background facts, trustees often explain how investors have been defrauded. These background facts, however, should not be confused with the actual claims. A trustee will usually be careful not to plead damages as an amount equal to the funds invested in the debtor’s Ponzi scheme (the investor’s biggest concern); instead, the trustee will measure damages based on funds improperly paid out.
There is a difference between a creditor’s interest in claims held by the corporation against a third party, which are enforced by the trustee, and the direct claims of the creditor against the third party. Only the creditor can enforce a direct claim; and this has to take place in civil court, not bankruptcy court.
But a reciever or trustee can protect a Ponzi company’s interest, which indirectly helps burned investors get at least some of their money back. As Judge Posner has noted:
We cannot see any legal objection and we particularly cannot see any practical objection. The conceivable alternatives to these suits for getting the money back into the pockets of its rightful owners are a series of individual suits by the investors, which, even if successful, would multiply