It’s a mad mad Madoff world:

New rules for insolvencies

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Article endnotes

On 10 December 2008 Bernard Madoff’s sons told authorities their father had just confessed to them that the asset management arm of his firm was a massive Ponzi scheme, and quoted him as saying it was “one big lie”. Five days later Irving Picard was appointed the trustee over Bernard L. Madoff Investment Securities, LLC.

A Ponzi scheme is a fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any real profit earned. This means that to the extent an investor receives more than what they paid into such a scheme, those profits were paid from other investors’ monies. A Ponzi scheme usually fails when new money coming into the scheme is insufficient to fund withdrawals.

For a liquidator appointed over a fund who was itself an investor in the world’s largest fraud, particularly one whose account statement with Madoff showed a balance of approximately $6.2 billion (albeit a fictitious balance), there is definitely a challenge in winding up that fund and seeking recoveries. It’s a whole new world of complex, cross-border issues for recovering and distributing assets within a Ponzi scheme scenario.

Impact on insolvencies
The objective of a liquidator is to maximise recoveries and to distribute the assets to creditors and investors as promptly and efficiently as possible. Within a Ponzi scheme scenario, recovering assets and determining who are its creditors is not as simple as it sounds.

“ … joint liquidator of the Fairfield Sentry funds … says he plans to use New York state law to go after $4 billion that investors redeemed out of the Fairfield Sentry funds in the six years prior to the Madoff collapse” 1

Starting with recovering assets, particularly where the losses are as significant as those incurred in Madoff, the usual remedies are insufficient to cover the deficit in the estate. The traditional wrongdoers against whom the liquidators would consider pursuing claims and recoveries will have limits on either the amount of assets or insurance they can contribute. Therefore, other avenues of recovery need to be considered.

The nature of a Ponzi scheme results in the “early” or “first in” investors taking out more assets than they originally invested. So one possible avenue to consider is pursuing the investor to repay the fictitious profits it earned on its investment. Thus an investor who redeemed from the fund may be asked to repay the profits it earned on its original investment.

Another possibility is to seek to recover not only the fictitious profit but the gross redemption paid. Under most insolvency legislation, a liquidator can pursue preference claims, which are claims for monies paid within a period of time (in the US it’s 90 days; in English common law jurisdictions it is typically six months) in circumstances where the entity is insolvent and the redeemer was paid in preference to other creditors. In some jurisdictions, this period is extended to one or two years if the redeemer is a connected party. In BVI, for instance, the definition of a connected party is a statutory one and includes any person who is a shareholder.

Claims for the full redemption may also be available when it can be shown that the redeemer intended to make the redemption and had knowledge of the fraud and received payment to the detriment of the other creditors. Thus, if a liquidator was able to demonstrate that a redeemer had knowledge of the Ponzi scheme or consciously disregarded facts which suggested this and withdrew his investment on that basis, the liquidator may be able to recover the full redemption for the benefit of the estate.

Issues may arise when the redeemer in question holds the investment in the fund and any redemption proceeds for another person. A custodian bank, for example, may be the shareholder of record and, on that basis, be the subject of a restitutionary claim for redemption proceeds. The true beneficiary, however, would be unknown to the liquidator and indeed may have received the benefit of the redemption in another jurisdiction, where any subsequent cause of action may have to be considered.

Clearly when investigating such claims, various options exist as to the jurisdiction(s) in which to pursue such claims. This is important for a number of reasons, not least of which is the look-back period to during which redemptions can be pursued, the level of sophistication of the legal system to address such complex claims and whether there are any assets in that jurisdiction. It can often be the case that the liquidator cannot pursue all redeemer claims in one jurisdiction, so multi-jurisdictional coordination is necessary to avoid duplicative costs and compromise to the overall strategy.

Creditors and investors:
“A federal bankruptcy judge ruled today that Bernie Madoff victims’ losses will be calculated by how much money they lost over the course of their investments, rather than what their balance was at the time the Ponzi scheme collapsed” 2

Not only is recovering assets different in a Ponzi scheme scenario, but the process of determining who is a creditor or investor can also prove to be complicated. In a scenario where investors are frequently subscribing and redeeming shares, particularly if one is a custodian bank for numerous clients, the shares that remain when the Ponzi scheme is revealed are a mixture of original subscription and profit. This can be shown in the following example. If an investor subscribes $100 comprising 100 shares for $1 and subsequently redeems $100 when the share price is $1.25, that investor will have 20 shares remaining in the fund, as follows:

  # shrspricesum
 20   #    #

In the above example the twenty shares remaining in the fund are all net profit.

In March 2010, the US bankruptcy judge overseeing the Madoff case ruled that investors who withdrew at least their initial investment from Madoff before the exposure of his massive fraud will recover nothing from Madoff’s estate. Such investors are now known as “net winners”. So-called net losers, whose withdrawals from Madoff’s fund never reached the amount of their initial investment, will be entitled to recover in the estate.

The above ruling is attractive as it in effect compensates the ‘victims’ of the fraud. But such a finding may face some challenges in the British common law jurisdictions, where courts may not determine investors based on a net winner/loser basis.

Another interesting issue is the position of custodian banks. While it may be that a custodian bank will be able to demonstrate that redemption funds flowed through to its clients (possibly establishing thereby a defence to a claim for unjust enrichment), that same bank will be the party that makes the claim in the estate as the shareholder of record. Thus on the one hand the custodian bank will argue it is not the debtor because it never received the benefit of the funds, while on the other hand it will claim as the investor of record in order to pass any recoveries to its own clients.


We are still in the early stages of resolving some of the issues and complications that are arising in the liquidations affected by such large scale Ponzi schemes and frauds, and it is likely that some of these issues will be tested in court. It will come as little surprise that the amounts involved will result in these issues being vigorously contested.

Options exist for attempting to address the net winner/loser issue. It is possible that net losers may be able to make creditor claims and attempt to adjust their position and ranking priority to the assets for distribution. Also it is possible that a scheme of arrangement could be implemented that addressed priority to assets and timing of distributions.

One of the subjects being discussed in insolvency circles is whether there need to be two sets of insolvency rules: one for standard insolvencies and another for Ponzi schemes. Whether investors feel that the current process is fair may ultimately have some impact on whether any proposals are progressed.


1 EXCLUSIVE: Some Fairfield Investors Knew About Madoff Ponzi and Profited – 17 August 2010
2 Madoff Judge Sides With Picard: Net Winners Are Losers – 1 March 2010

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Michael Klein
Michael Klein Editor Compass Media Ltd. PO Box 1365, Grand Cayman, KY1-1108, Cayman Islands T: 345-326-1720C: 345-815-0064 E: [email protected] Michael is a financial journalist and copywriter.  In the past he has been responsible for the Risk Management and Corporate Finance sections of a British monthly Corporate Treasury publication.  He has written various financial handbooks, notably on European Banking and Cash Management and the Debt Capital Markets.   In addition he has worked as a copywriter for banks and investment funds and served as corporate communications consultant to US and European blue chip companies.   Michael holds an MA in Political Science and International Law from the University of Bonn in Germany. 

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