The most important lesson of the US$50 billion Bernie Madoff Ponzi Scheme is that even the world's most sophisticated investors—not to mention regulators—were asleep at the wheel. It underscores why you need to be skeptical of something that seems too good to be true, because it probably is.
But there's another, mostly overlooked, lesson as well. If you invested with Madoff, decided that the returns were too good to be true, and subsequently withdrew your money before his Ponzi Scheme was exposed, you might not to keep your money. Madoff's creditors might claw your profits—and even your original investment—back from you under an obscure legal doctrine called "fraudulent conveyance."
Fraudulent conveyance laws exist to prevent debtors from giving away their assets to others to avoid paying their creditors. Let's say that a member of your family operates a Ponzi Scheme. He then gives you US$100,000 without disclosing the fact the funds are the proceeds of a fraud. Under fraudulent conveyance laws in effect in all 50 states, that US$100,000 isn't rightfully yours, even though you knew nothing about the Ponzi Scheme. The victims of the fraud can thus sue you to reclaim the assets for an extended period—four to six years in most states.
The Bernie Madoff scenario is conceptually similar, albeit on a much larger scale. Using fraudulent conveyance laws, clients Madoff defrauded—or more likely, the bankruptcy trustees appointed by the court to pursue Madoff's assets—can sue clients "lucky" enough to cash out before the scam was discovered. Indeed, bankruptcy trustees are legally required to pursue every possible source of funding to recover assets on behalf of the fraud victims they represent. So even if you cash out years before a Ponzi Scheme is discovered, you might be required to pay back every dollar you "earned" from it, and even part of your original investment.
That's exactly what happened in a recent case involving Connecticut hedge-fund company Bayou Group LLC. Like Madoff, Bayou's co-founder Samuel Israel III turned out to be running a Ponzi Scheme disguised as a hedge fund. Investors in his fund lost around US$400 million. Earlier this year, a federal bankruptcy court ordered investors who had pulled their money out of Bayou years before it collapsed to give back their profits, and even a portion of their initial investments, to offset losses by other investors.
In any event, the lawsuits in the Madoff Affair have already begun. Many more will be filed in the weeks and months ahead. Investors who cashed out before the collapse that can't pay what a bankruptcy trustee claims is their "fair share" will be forced into bankruptcy. Let's hope they have a good asset protection plan in place—an offshore trust, offshore annuity, or other vehicle resistant to legal claims from a future unknown creditor.
Copyright © 2008 by Mark Nestmann
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