Recovering the Fruits of Ponzi Schemes: The Canadian Experience

A Ponzi scheme is a fraudulent arrangement where an entity makes payments to investors from monies obtained from later investors, not from profits of any underlying business venture. The scheme is a variation of robbing Peter to pay Paul. Charles Ponzi is regarded as the mastermind of the first such scheme. Ponzi made millions running a postage stamp speculation scheme, using funds from new investors to pay out early takers.

The proposed investment opportunity that forms a Ponzi scheme often seems too good to be true, and it is. While it may be comforting to think that only inexperienced, greedy and naïve individuals are at risk of being duped, research suggests that many factors contribute to the success of Ponzi schemes and even savvy investors can become victims.

The Aftermath of a Ponzi Scheme: Unraveling the Web

There are significant challenges to recovering assets in Ponzi scheme proceedings in Canada. Unsurprisingly, fraudsters typically do not keep diligent records of the source of funds, the trail of transactions, and the ultimate recipients of funds paid out. However, this does not mean that victims can never recover their losses.

Once the decision to investigate an alleged Ponzi scheme is made, professionals must be careful to preserve the chain of custody so that it is possible to subsequently identify how evidence was obtained, who handled it, what procedures were followed to protect the integrity of the evidence collected, why they were implemented and where evidence was stored. Successful investigations will seek to locate and analyze electronic and physical evidence, and should include interviews of the individuals involved in the scheme. The goal, ultimately, is to locate any assets of the fraudster that can be used to reimburse victims, or to identify other sources of recovery.

Asset-Recovery Options

In many instances, the exposure of a Ponzi scheme in Canada will lead to the appointment of a trustee in bankruptcy over the fraudster’s estate. A trustee in bankruptcy will thus often be the entity entrusted with proceeding to “claw back” as much of the fictitious profits paid to the net winners of the Ponzi scheme (i.e., the “lucky” investors who recovered principal investments plus “profits”) for the benefit of the less fortunate “net losers.” While these so called “clawback” proceedings have received significant judicial consideration in the U.S., there is little Canadian jurisprudence in this context.

The ability to claw back payments of fictitious profits made from the scheme will depend on the trustee’s ability to prove the fraud.[1] At a minimum, the following should be established to prove the fraud: (1) investors made deposits into the scheme; (2) the fraudster conducted little or no legitimate business operations as represented to investors; (3) the fraudster’s business produced little or no earnings; and (4) payments made to investors were made with monies received from new investors.

Ponzi frauds generally operate for years before collapsing. Once uncovered, the sources of funds have often dried up, and there is little money left for the defrauded investors to fight over. The key to maximum asset recovery is to “claw back” as much of the profits paid to the net winners for the benefit of the less fortunate, net losers. To do so, Canadian federal bankruptcy legislation, provincial preferences legislation, and common law remedies, such as unjust enrichment, may be relied upon.

Canadian Federal Bankruptcy Legislation

The Canadian federal Bankruptcy and Insolvency Act contains provisions enabling a trustee in bankruptcy to void transfers made by a debtor within prescribed “reach-back” periods. Under s. 95 of that Act, a transfer of property or a payment made by an insolvent person to a creditor, with the view of giving that creditor a preference over another creditor, is void against the trustee in bankruptcy if the payment is made within three months of the bankruptcy (for arm’s-length transfers) or within one year of the bankruptcy (for non-arm’s-length transfers).

Section 96 may also be of assistance. A trustee may declare a transfer void where (a) the impugned transfer occurred within one year of the date of the bankruptcy (for arm’s-length transfers); (b) the debtor was insolvent when the transfer was made or was rendered insolvent by it; and (c) the debtor intended to defraud, defeat or delay a creditor by making the transfer. Where the transfer was to a non-arm’s-length party, the occurrence of the transfer within one year before the bankruptcy is sufficient to void the transfer. The reach-back period extends to five years prior to the bankruptcy for transfers to non-arm’s-length parties where the debtor was also insolvent or rendered insolvent by the transfer and intended to defraud its creditors as a result of the transfer.

Provincial Preferences Legislation

Provincial creditors’ relief legislation may also assist in clawback proceedings. The advantage of this legislation is that applicants may challenge transactions made with the intent of giving a preference regardless of when these transactions occurred, subject to provincial limitation periods. Four general elements must be established: (1) a transfer of property was made; (2) by an insolvent person; (3) to a creditor; (4) with the intent of giving that creditor a preference.

Provincial preferences legislation was the basis of successful clawback in Re Titan Investments Ltd. Partnership.[2] In that case, the Canadian court adopted the American principle that Ponzi schemes, due to their fraudulent nature, are inherently insolvent from their inception. With respect to whether the requisite intention to give a creditor a preference was met, the court construed the fraudster’s refusal to pay certain investors despite their requests, while continuing payments to others, as evidence of fraudulent intent.

However, a potential limitation to the applicability of Re Titan Investments is the fact that many courts have identified an additional requirement of fraudulent intent on the part of the transferee, despite the fact that provincial legislation only refers to the intention of the debtor.

Unjust Enrichment

In addition to statutory remedies, recovery of profits from net winners in Canada may be sought on the basis of unjust enrichment. The claimant must establish (1) an enrichment of the defendant, (2) a corresponding deprivation of the plaintiff and (3) the absence of a juristic reason for the enrichment. One Canadian decision[3] addressed unjust enrichment in Ponzi clawback proceedings, suggesting that Canadian courts are likely to be receptive to such a claim in appropriate circumstances.

A flexible approach based on equitable principles will likely govern Canadian courts’ analyses in clawback proceedings in the aftermath of exposed Ponzi schemes. While recovery may seem doubtful, there are avenues for recovery to assist victims left holding the bag once the fraud is exposed.