I must be behind the eight-ball at the moment – how else could I have missed Eoin’s post at Cearta.ie on restitutionary liability and Bernie Madoff’s failed investment schemes?
The Madoff case involves an alleged Ponzi scheme, or a scheme where early investors are actually being paid money received from later investors rather than true dividends. This particular scheme was apparently cleverer than most, as the returns averaged around 10%, as opposed to many Ponzi schemes, which collapse much more quickly because of the extraordinary returns they offer. In addition, Madoff apparently turned away investors regularly, giving the scheme an “exclusive” feel. Half of the money was channeled to Madoff’s fund via “feeder funds” which were set up by third party investment advisors.The investment advisors sold Madoff’s fund to clients as delivering a safe and consistent return. Some clients didn’t realise that their funds were invested with Madoff’s fund by their fund managers (known as a “funds of funds” arrangement). Although suspicions were raised about the scheme on a number of occasions, including a 2005 report to the US Securities and Exchange Commission (“SEC”) by trader Harry Markopolis which explicitly alleged the scheme was a Ponzi scheme, the SEC failed to uncover any evidence of this. Nor had it uncovered the fraud in previous investigations. The scheme unravelled when nervous investors requested the return of funds in the wake of the current financial crisis, and there was not enough money to pay them back. It now appears that investors may have lost US$50 billion.
Eoin notes that investors may have a claim for money had and received against Madoff. I’m presuming that the unjust factor would be failure of consideration (ie, failure of the purpose for which the money was paid). Some portion of losses by investors who invested directly with Madoff will also be paid for by the Securities Investor Protection Corp., but only up to the value of US$500,000, which is chicken feed when your loss runs to the billions.
In addition, there could also be claims of accessorial liability – possible knowing assistance on the part of agents and investment advisors who referred clients to Madoff, and knowing receipt claims against those agents who knew or suspected the scheme was illegal and received commission from Madoff.
Earlier investors may face legal action from later investors. First, US law has an action known as “fraudulent conveyance” which applies in bankruptcy proceedings. The doctrine has recently been extended to apply to earlier investors who removed their money from the fund if they knew or ought to have known that the transaction was fraudulent. The difficult question will be ascertaining whether the investors ought to have known that the fund was fraudulent. Furthermore, there could also be tracing claims against the earlier investors who thought they were receiving dividends but were in fact receiving funds from later investors.
I always wonder how the guys who run schemes like this can live with themselves. From my observations of other schemes which have collapsed like this, I suspect the investment business starts off as legitimate, but the perpetrator feels compelled to turn the scheme into a Ponzi scheme to hide losses when legitimate investments fail. The perpetrator has to continue sucking in investors once the Ponzi scheme has started, otherwise the whole thing collapses. And so it keeps on going. Perhaps the panicked perpetrator hopes that one day, he will get into a situation where he can become legitimate again. Perhaps it is just a further indication of the entrepreneurial personality, about which I have speculated earlier: those who take extreme risks can suceed in an extraordinary way, but it may also mean that they keep forging on when a prudent person would cut their losses and ‘fess up. As I’ve said before, I would love to know if there’s an evolutionary reason for this kind of attitude.
Well, we’ll just have to watch this space and see what happens with the various legal claims. Yet again, I suspect the only people who will emerge happily from this will be the lawyers (no wonder nobody loves us).
WSJ Law Blog raises the question of the liability of Madoff’s sons who worked at his firm and reported Madoff to authorities. There is no suggestion that the sons knew of Madoff’s activities, but the question is raised as to whether they should have known.