Investment scheme collapses give rise to equitable and restitutionary claims

By Legal Eagle

I must be behind the eight-ball at the moment – how else could I have missed Eoin’s post at 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.


  1. Posted January 25, 2009 at 8:37 pm | Permalink

    LE said “I always wonder how the guys who run schemes like this can live with themselves.”

    Years (?decades?) ago there was a Leunig cartoon, with an obscenely rich guy being asked “How do you sleep at night”. The answer was something like “I sleep between satin sheets, on a king size mattress, in a four poster bed, in a mansion, with a woman whose beauty would make you weep”

  2. Posted January 25, 2009 at 8:49 pm | Permalink

    I can’t think of an evolutionary reason, but a behavioural position would suggest that people like Madoff (or just people in general?) keep doing things that pay off until they stop paying off, even if there is a high risk in the long-term that the behaviour will lead to bad consequences.

  3. Posted January 26, 2009 at 8:49 am | Permalink

    If you look at the history of Ponzi schemes (including Ponzi’s) most started off as fairly legitimate – paying returns out of profits or expected future returns. The person starts to look invincible and then starts to believe their own hype.

    Something then goes wrong with the original scheme and the principal turns to fraud when they start paying returns out of capital, rather than profits. This normally happens when the principal has made some big promises, puffed up with optimism and then experiences fear of failure.

    The principal gets caught in a bind – to quit means small losses and failure, to continue means that (at least for a while) you will look like a big success and an omniscient genius. The temptations are immense to delay the point of your own failure. After all, the market may turn and fix everything or the next investment could always pay everyone out – couldn’t it?

    Of course there are also the outright fraudsters that know from the start that they are in it for fraud and believe that they can get away at the end of it. Most do not start that way, though.

  4. Posted January 26, 2009 at 10:56 am | Permalink

    There was one in WA years ago when I was with the DPP here. Robin Greenburg was her name from memory. She established “Western Womens Finance” and proceeded to target women for funds – spending most on herself and some on returns to investors.
    That was why I was very careful to use non gender specific terms, although I would agree that the vast majority of fraudsters are male.

  5. Anthony
    Posted January 26, 2009 at 6:10 pm | Permalink

    “or a scheme where early investors are actually being paid money received from later investors rather than true dividends. ”

    But isn’t that just how the whole stockmarket bubble worked for the past decade? Whereby the capital gains of early investors were financed soley on the basis of later-entry investors? The bubble was a gigantic ponzi scheme, and the thing about ponzi schemes is that they’re not illegal.

  6. pedro
    Posted January 27, 2009 at 9:56 am | Permalink

    A stock bubble is not a ponzi scheme. There is no central guiding management diverting funds from the later investors to the earlier. On that view any capital gain from value growth is wrong.

  7. Anthony
    Posted January 27, 2009 at 5:42 pm | Permalink

    “There is no central guiding management diverting funds from the later investors to the earlier”

    OK, OK. So a stockmarket bubble functions LIKE a ponzi scheme.

  8. jc
    Posted January 27, 2009 at 9:47 pm | Permalink

    You reckon Madoff was a Ponzi scheme?

    You haven’t seen the so-called “legitimate” rip-offs created here in Australia that go right under our noses if they aren’t stopped.

    This one is a beaut.

    A fund manager of a set of infrastructure assets like UK water and gas pipes feeding into Australian metropolitan cities metropolitan cities. It’s pretty boring, but the assets are relatively “safe” and the firm isn’t too leveraged.

    Every coupla of months or so I do a Google search of the firm to see if it’s in the news, and I found a PDF doc lodged with the ASX.

    The doc stated that because the fund performed “well” to the ASX 200 the by-laws allowed the responsible entity to receive what was termed an “out performance fee” amounting to $18 million paid in stock thereby diluting the current unit holders by around 5% of the fund.

    Why was the out-performance fee paid? It was because the fund had fallen “only” 22% in the year while the ASX had tanked by 45%.

    Here are some other stats. The fund has made 4.1% since inception, which means initial unit holders would have been better off simply sticking their money in a cash fund over the same period or gone with government bonds that offered a higher risk free rate of return. Since it’s highs the fund is down 47% that was in May or June 2007!

    I bought into this fund only a little while ago so I’m not down a great deal of money. However I have been causing these dudes to get one hell of a headache over the past week.

    I contacted two business scribes who wrote up a piece almost the same day they were contacted. I have asked for a share register so as to contact the big holders that form over 50% of the company.

    I also spoke to the chairman and gave him a complete serve. His pathetic response was that the by-laws allowed for a relative out-performance fee and basically ignored my suggestion that he must be looking at the chart showing the unit’s historical price upside down.

    What amazes me is that 3 of the eight board members are independent directors who are there to protect the interests of the unit holders. Where were they?

    It’s quite clear that the intent of “out performance” was never meant to mean they would glom an “out performance fee” when the stock has basically tanked.

    The effects of the dilution are absolutely pernicious as it means there are big headwinds when the stock is doing well as the firm immediately puts on a bib, goes to dinner and rips off another 5% from the unit holders hind legs.

    What amazes me is how the independent directors didn’t resign from the board en masse if they couldn’t stop it, as a mass walk would certainly be reputationally irreparable.

    This is what is going on.

    Here are the two stories about this firm.

    Part of 3 called Reward for dismal results,28124,24954284-5013408,00.html


    I gave them some of the pertinent details.

  9. jc
    Posted January 27, 2009 at 9:48 pm | Permalink

    comment is being moderated?

  10. Posted January 27, 2009 at 10:31 pm | Permalink

    Sorry jc, had to fish you out of the spammer. It’s been a mite tetchy lately.

  11. pedro
    Posted January 28, 2009 at 10:45 am | Permalink

    Great story from JC, illustrating yet again how compulsory super is the basis for a huge wealth transfer from ordinary people to financial engineers. Thanks Mr Keating.

  12. jc
    Posted January 28, 2009 at 12:43 pm | Permalink


    Could this have a legit challenge in court? I’m of the impression that there is such a thing as shareholder oppression and that the clause was never intended to be abused in such a way.

  13. nudd
    Posted January 29, 2009 at 9:56 am | Permalink

    I thought in the UK, the Lipkin-Gorman-type money had and received claim would be more like a tracing claim and does not appear to require an unjust factor. So long as you can trace the money into its product, you are home free subject to the defence of change of position.

  14. jc
    Posted January 29, 2009 at 10:29 am | Permalink


    No, the directors are nowhere near the majority shareholders. However I see the oppression stemming from the board abusing the real intention of the bylaw to pay the responsible entity the fee.

    So they used their position to oppress the unit holders.

    My take is that a judge would really look down on the payment of an out performance when the fund’s results have been miserable and they used a legalistic interpretation of the by-law to get it through.

3 Trackbacks

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