Righting Others' Wrongs:
Critical Look at Clawbacks in Madoff-Type Ponzi Schemes and Other Frauds
Amy J. Sepinwall
In a typical Ponzi scheme, early investors earn "profits" not through any legitimate investmentactivity on the part of the Ponzi scheme operator; instead the operator simply transfers money that laterinvestors deposit to the earlier investors who seek redemptions. As such, when the scheme goes bust, as itmust, the Ponzi scheme operator will not have enough money to cover all of the investors' deposits, letalone the earnings on those deposits that the investors thought they were owed. Should the scheme'swinners — i.e., those who withdrew more money than they deposited — be compelled to return theirfictitious profits to help defray the losses to the scheme's losers? Should they be required to do so even ifthey did not know, and had no reason to know, that theirs was not a legitimate investment?Caselaw permits clawbacks from innocent winners in a Ponzi scheme, and there has been adramatic rise in the number of such cases over the last decade. But, as courts have noted, the clawbacksuits rest upon two bodies of law — securities and bankruptcy — that are on a "collision course." The twowere never intended to interact and their interaction has produced confusion, unpredictability andunfairness. More troubling still, there has been no sustained inquiry into the foundational normativequestion —
whether innocent winning investors
be made to help defray the losses of the losinginvestors in the first place. This Article addresses that question, and it argues that clawback suits targetingblameless winners lack a compelling legal and equitable basis.More specifically, the Article examines the relevant statutory framework as well as otherrestitutionary doctrines, and it finds that none of these can adequately justify attempts to have those whoinnocently profit from a fraud help restitute the fraud's victims. Nor, the Article argues, can the clawbacksuits be justified by appeal to basic concepts of fairness: It is true that mere luck differentiates theinnocent winners of a fraud from its equally innocent losers, but it is also true that mere luck differentiatesthe innocent winners of a legitimate investment from the equally innocent winners of a fraud. All threesets of investors are in a morally equivalent position. It is unfair, then, to require only those who benefitedinnocently from a fraud to defray the losses to the fraud's victims. Instead, the Article concludes, all ofthose who benefit from playing the market — whether through legitimate or fraudulent investment vehicles— should share responsibility for restituting the losses in which financial fraud results. The Article endsby proposing a mechanism for implementing the expansive restitutionary obligations that the Articleseeks to defend.
Assistant Professor, Department of Legal Studies and Business Ethics, Wharton, University of Pennsylvania. B.A., McGillUniversity, 1997; M.A., McGill University, 1999; J.D., Yale Law School, 2004; Ph.D., Philosophy, Georgetown University,2010. For helpful comments and suggestions, I am grateful to Dan Cahoy, David Grey, Peter Henning, David Luban, AndySiegel, Alan Strudler, and Bill Tyson, as well as audiences at Wharton and the 2011 Law and Society Annual Meeting. Thispaper was selected for the 2012 Huber Hurst Research Seminar in Business Law, Legal Studies and Ethics and benefited greatlyfrom feedback received there. Hilary Greenwald and Joyce Shin provided excellent research assistance. All errors that remain aremy own.