March 23, 2011
Ponzi schemes have grabbed headlines over the past few years. In 2008, Bernard Madoff’s investment firm collapsed, revealing a $50 billion Ponzi scheme — reportedly the largest of all time. In 2009, Allen Stanford and his associates were charged with running a $7 billion scheme, and Kenneth Starr was discovered running a $30 million scheme whose list of victims read like a Hollywood Who’s Who.
Multibillion-dollar losses and celebrity names sell newspapers, but Ponzi schemes affect scores of ordinary investors as well. According to the Associated Press, 150 Ponzi schemes collapsed in 2009 alone, resulting in more than $16 billion in losses to tens of thousands of investors. These victims face the challenge of calculating their losses for recovery claims as well as tax purposes.
On the rise?
Ponzi scheme investigations currently account for approximately 21% of the Securities and Exchange Commission’s (SEC’s) enforcement workload — up from 17% in 2008 and 9% in 2005. The Commodity Futures Trading Commission alone filed 31 Ponzi-related civil actions last year.
These numbers don’t necessarily point to a rising prevalence of Ponzi schemes. By definition, Ponzi schemes involve fictitious investments whose “returns” are paid out using funds received from subsequent investors or from the operators’ pockets. (See the sidebar, “Anatomy of the Ponzi scheme.”) As the economy has struggled, such frauds have collapsed with increasing frequency based on simple math: The pool of new investors has shrunk while many current participants have withdrawn their money.
There’s another reason Ponzi schemes may appear to be on the rise: Recent high-profile cases have caused the SEC and other authorities to more closely scrutinize investment funds that report abnormally high or consistently positive returns.
The challenge of recovering losses
By the time a Ponzi scheme is discovered, the fund’s assets usually represent only a fraction of the balances shown on investors’ phony account statements. Typically, investors’ claims must be sorted out in bankruptcy court. Funds also may be available from the Securities Investor Protection Corporation (SIPC) to help alleviate investor losses. But the combination of SIPC protection, fund assets and the Ponzi scheme operators’ personal wealth rarely covers all of the claims.
With thousands or tens of thousands of victims clamoring for a limited pool of dollars, the calculation of an investor’s loss is critical to maximizing his or her recovery. In many cases, forensic accounting techniques are needed to trace a victim’s investment activities and place a value on losses. Accurate calculations are also needed to support tax deductions for theft losses.
The fairness of cash in/cash out
In a litigation context, the method used to calculate losses depends on the approach the court takes in valuing victims’ “net equity” in the fund. In the Madoff case, the U.S. Bankruptcy Court ruled in March that net equity should be measured on a “cash-in/cash-out” basis. This means that investors whose net withdrawals equaled or exceeded their principal investments have no claim. The U.S. Court of Appeals for the Second Circuit recently accepted a direct appeal of the net equity issue, but has yet to make a decision.
Critics of the cash-in/cash-out approach argue that it unfairly favors newer investors and robs previous investors of the profits they legitimately expected to enjoy based on Madoff’s account statements. It also raises the possibility that the bankruptcy trustee will attempt to recover, or “claw back,” money from victims who withdrew more than they invested.
Proponents counter that it’s inappropriate to base recovery on fictitious, fraudulently inflated account statements. They also contend that to do so would be unfair to recent investors, whose investments essentially funded long-term investors’ withdrawals.
SEC weighs in
The SEC offers yet another approach. Although it supports the cash-in/cash out method, the Commission believes that net equity calculations should be adjusted for the time value of money. Suppose, for example, that a victim invested $1 million in 1995 and withdrew $1.2 million in 2010. Under the Bankruptcy Court’s approach, the investor’s claim would be rejected because withdrawals exceeded principal investments. The SEC contends that withdrawals should be measured in 1995 dollars, which would likely change the result.
Complicating matters is the fact that, while many Ponzi schemes are fraudulent from inception, some start out as legitimate investments with the operators only later turning to fraud. In those cases, victims who can identify the fraud’s “start date” may be able to claim legitimate profits they earned before the Ponzi scheme began.
The Second Circuit’s net equity decision and other rulings are likely to have a major impact on the way Ponzi scheme losses are calculated. Regardless of those decisions, forensic accountants play a crucial role in valuing victims’ claims and helping them to recover losses.
SIDEBAR: Anatomy of the Ponzi scheme
Ponzi schemes are old forms of fraud that prey on investors’ evergreen desire to earn high returns with minimal risk. Perpetrators generally place investor money in risky investments such as derivatives — that is, if they don’t spend it on themselves.
To keep the scheme going, they continually lure new investors with the promise of high or consistent returns. Eventually, however, the scheme collapses because investors demand their money and the assets underlying their investments either don’t exist or are grossly overvalued.
Issue 3 - Spring 2011