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Decision in Ponzi Scheme Case Highlights the Importance of Filing Timely Proofs of Claim

Court decisions about failed Ponzi schemes often make good reading. The fact patterns always involve actual fraud. The illicit schemes give rise to insightful discussions on various legal concepts.

In the typical Ponzi scheme, the wrongdoer pays supposed “investment returns” to early investors from monies obtained from later investors, rather than from real business revenue. At some point, the fake funding runs out and the scheme is exposed. As one judge recently wrote, “the iron laws of mathematics” cause these schemes to collapse. In re Maui Indus. Loan & Fin. Co., 2017 Bankr. LEXIS 2553 (Bankr. D. Hawaii, Sept. 7, 2017).[i]

In that case, the Ponzi scheme ran for 23 years before it collapsed. The schemer was arrested and prosecuted. The company filed for bankruptcy and liquidated. A bankruptcy trustee was appointed, pursued litigation, and recovered about $8 million.

Creditors filed claims totaling about $10.6 million. Of this, $8.1 million was filed before the court-approved deadline or bar date. And of that amount, $5.8 was for principal while $2.3 million was for investment returns. Other claims totaling $2.6 million were filed after the bar date, and also for both principal and investment returns.

The trustee asked the court for instructions on a key issue: whether timely filed claims for lost profits should be paid before or after untimely filed claims for principal. Judge Robert J. Faris looked to the distribution priorities set forth in Bankruptcy Code section 726. That section provides for payment of:

  • allowed administrative priority claims;

  • allowed unsecured claims that are timely filed;

  • late-filed claims when creditors lack notice or actual knowledge of the bar date;

  • late-filed claims when creditors have knowledge of the bar date[ii]; and

  • allowed claims for penalties, fines, or forfeitures, or for multiple, exemplary, or punitive damages.

The trustee suggested that the court might see fit to permit payment of both the timely and untimely claims for principal before payment of any claim for lost investment returns. He argued that claims for lost returns in a Ponzi scheme are unenforceable.

Judge Faris disagreed. He said that untimely claims for lost investment returns are not unenforceable. They were submitted to the court in proofs of claim and “‘deemed allowed’ unless and until a party in interest objects to them, and no one has done so.” In re Maui Indus. Loan & Fin. Co. 2017 Bankr. LEXIS 2553, at *7.

In addition, Judge Faris considered if Bankruptcy Code section 105(a) gave him authority to permit payment of untimely filed claims for principal before timely filed claims for lost investment returns. Section 105(a) allows courts to issue any order, process, or judgment necessary to carry out the provisions of the Bankruptcy Code. But Judge Faris concluded that Bankruptcy Code section 105(a) couldn’t be used to “override the explicit mandates of other sections of the Bankruptcy Code.” 2017 Bankr. LEXIS 2553, at *8. He noted that “[s]ection 726 specifically lays out the order in which claims are paid. The bankruptcy court has no power to overturn the Congressional ordering of distribution rights.” Id.

The priorities in section 726 meant that both principal and investment returns set forth in timely filed claims would be paid before principal and investment returns sought in untimely claims. So while creditors that filed untimely claims could pursue payment to the extent the claims were allowed, that right would yield a distribution only if the bankruptcy estate had more than enough funds to pay all timely filed claims, even the portion for lost profits. Given that the trustee recovered $8 million, and the timely filed claims totaled about $8.1 million, creditors that filed late claims likely would not receive a distribution.

[i] The term Ponzi scheme is named after Charles Ponzi, a businessman in Boston who became infamous for using the device in the 1920’s to defraud investors.

[ii] Creditors that have knowledge of a bar date and yet file late claims must demonstrate why their failure to file on time should be excused. Pioneer Inv. Servs. Co. v. Brunswick Assocs. Ltd. P'ship, 507 U.S. 380 (1993) (setting forth the Supreme Court’s standard of excusable neglect).