Agreeing with the Second Circuit’s Madoff decisions, the First Circuit held that only a trustee can sue so-called net winners in a Ponzi scheme, regardless of how cleverly the perpetrator structured the fraud.
The TelexFree Ponzi Scheme
Carefully designed to look like a legitimate business, TelexFree was a combination of a Ponzi scheme and a pyramid scheme. Reduced to its essentials, new participants paid previous investors. Those paid more than they invested were called net winners, and those who took out less were referred to as net losers, the same nomenclature used in the Madoff cases.
To generate recoveries for distribution to all net losers, the TelexFree trustee brought fraudulent transfer and preference suits against net winners under Sections 547 and 548. The fraudulent transfer suits were based on the idea that money paid to net winners was actually stolen from net losers.
Some victims of the scheme got together and started their own unjust-enrichment suit against net winners. In effect, they were hoping to make recoveries from net winners before the trustee did. In bankruptcy court, the trustee mounted an adversary proceeding to stop the individual creditors from suing.
Eventually, the district court adopted the bankruptcy court’s findings and entered an injunction against further prosecution of the individual creditors’ suit. The creditors appealed to the First Circuit, raising the question of whether the individual creditors’ claims were derivative of the trustee’s claims and whether the trustee had the exclusive right to sue net winners.
The First and Second Circuits Agree
In her opinion, First Circuit Judge Sandra L. Lynch upheld the district court and reached the same result as the Second Circuit’s Madoff opinions. See Picard v. Fairfield Greenwich Ltd., 762 F.3d 199 (2d Cir. 2014); and Marshall v. Picard (In re Bernard L. Madoff Inv. Sec. LLC), 740 F.3d 81 (2d Cir. 2014).
The individual creditors argued that the trustee did not have standing to sue net winners, on the theory that the avoidance actions were not estate property. Judge Lynch nixed the theory, holding that the trustee’s claims were property of the estate.
Unlike Bernie Madoff’s scheme, new investors in TelexFree would sometimes pay old investors, not the company itself. The creditors argued that the trustee could not sue to recover payments that went to old investors, only payments to the company.
Judge Lynch disagreed. Significantly, she compressed and recharacterized the scheme, saying that payments to old investors were “functionally the same” as payments to the company. Like the Second Circuit, she said that “fraud comes in many forms.”
Next, the creditors contended that the trustee could not sue, because the contracts with the company were fraudulent and void ab initio. Again, Judge Lynch disagreed. She said that the transactions were voidable “at most,” not void.
The creditors took the position that the doctrine of in pari delicto barred the trustee’s suits. Judge Lynch ruled otherwise, saying in pari delicto “does not defeat [the trustee’s] standing to bring avoidance actions.”
Finally, Judge Lynch held that the claims brought by the creditors were derivative of the trustee’s claims and thus were barred by the automatic stay in Section 362(a).
Judge Lynch already had held that the claims were estate property. She noted that the creditors’ suit was not based on wrongdoing by individual net winners. Rather, she said, the creditors sought “to prove [their] unjust enrichment case through the overall fraudulent scheme . . . . That is what the trustee seeks to do.”
Holding that the creditors’ suit was derivative of claims belonging to the trustee, Judge Lynch went on to say that the creditors pursuing the unjust-enrichment suit “were harmed in the same way as the rest of the TelexFree Net Loser creditors were harmed: they purchased worthless membership plans in a fraudulent Ponzi/pyramid scheme.”
Evidently, Judge Lynch didn’t think it was a close case. She awarded costs to the trustee.
Agreeing with the Second Circuit’s Madoff decisions, the First Circuit held that only a trustee can sue so-called net winners in a Ponzi scheme, regardless of how cleverly the perpetrator structured the fraud.
The TelexFree Ponzi Scheme
Carefully designed to look like a legitimate business, TelexFree was a combination of a Ponzi scheme and a pyramid scheme. Reduced to its essentials, new participants paid previous investors. Those paid more than they invested were called net winners, and those who took out less were referred to as net losers, the same nomenclature used in the Madoff cases.
To generate recoveries for distribution to all net losers, the TelexFree trustee brought fraudulent transfer and preference suits against net winners under Sections 547 and 548. The fraudulent transfer suits were based on the idea that money paid to net winners was actually stolen from net losers.
Some victims of the scheme got together and started their own unjust-enrichment suit against net winners. In effect, they were hoping to make recoveries from net winners before the trustee did. In bankruptcy court, the trustee mounted an adversary proceeding to stop the individual creditors from suing.
Eventually, the district court adopted the bankruptcy court’s findings and entered an injunction against further prosecution of the individual creditors’ suit. The creditors appealed to the First Circuit, raising the question of whether the individual creditors’ claims were derivative of the trustee’s claims and whether the trustee had the exclusive right to sue net winners.