Midnight in the Garden of Good Faith: Using Clawback Actions to Harvest the Equitable Roots of Bankrupt Ponzi Schemes

Abstract

This paper addresses an increasingly relevant issue in bankruptcy – does it make sense to protect “good faith” investors who have invested (some quite profitably) in a Ponzi scheme from clawback actions by the trustee? This article presents issues of economic equity (equitable payouts to individual creditors vs. equitable distribution among all creditors); bankruptcy policy (retaining antiquated notions of good faith in an ever-evolving financial playground); and judicial inconsistency (disparities in the treatment on Ponzi investors).

In the aftermath of the financial crisis, investors have attempted to pull their money back from the markets, collapsing hundreds of Ponzi schemes across the country. In response, some courts have narrowed the definition of “good faith,” moving it to an objective standard with rigorous requirements for due diligence. In other cases, courts strictly adhere to a liberal interpretation of good faith. This article proposes that we remove the defense of good faith from Ponzi scheme cases altogether. Courts have already begun to adopt a modern approach of “objective good faith,” divorcing it from its common usage as to protect only a small class of savvy investors dealing with highly sophisticated and persuasive Ponzi schemers. This article – in about 27,000 words – argues that extending such a small loophole is neither efficient nor fair.

Keywords: bankruptcy, Ponzi, clawback, good faith, law, financial crisis, markets, white collar crime, investment, fraud, due diligence

JEL Classification: G24, G33, K14, K20, K29, K39