Appeals Court Confirms Use of Net Investment Method to Calculate Claims in Ponzi Scheme

By: Andrew G. Lizotte

When a Ponzi scheme collapses, as they all eventually do, the court must develop a process for repayment of victims based upon the limited funds that may be available.  A critical component of this process is determining the amount of a victim’s claim that will share in any recovery.  The Second Circuit Court of Appeals recently issued a ruling in the Madoff Ponzi case that should finally resolve one aspect of the claims process in that case and which should inform claims allowance in other Ponzi cases.

In a typical insolvency proceeding, the amount of a creditor’s claim is often calculated based upon damages computed under a contract, that is, promises to pay made by the breaching party.   Ponzi schemes require a different perspective, however, because the scheme itself is illegal and the promised payouts could only occur from drawing new victims into the scheme, not from any legitimate profits.  In such instances, courts often compute claims based solely on amounts that a victim invested in the program, less any amounts recovered, and without regard to promised profits (the so-called “Net Equity” invested).  The Madoff court was required to go one step further, and determine how much of a claim a victim would receive for amounts transferred from another investment account.  Under the “Inter Account Method”, the Madoff trustee asserted that victims should only receive credit for the Net Equity in an account whose balance was transferred to them.  Hundreds of victims in Madoff objected to this approach, alleging that they should receive credit for the stated balance in an account whose balance was transferred to them.  The lower courts sided with the trustee and, last week, the highest court in the Second Circuit affirmed the decision of the lower courts.

This decision continues to re-enforce the principles that have developed surrounding the allowance of claims and distribution of funds in a collapsed Ponzi scheme – that is, principles of equity favor restitution to victims for amounts actually invested and lost, not honoring promises of profits that were illusory to being with.

The case is Sagor v. Picard (In re Bernard L. Madoff Inv. Sec., LLC), 2017 US. App. LEXIS 9842 (2^nd Cir. June 1, 2017).