Step 2: Determine whether evidence exists that a scheme promoter acted with intent to deceive.

The Securities and Exchange Commission defines a “Ponzi scheme” as follows:

A Ponzi scheme is an investment fraud that involves that payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity.[1]

The rationale that Courts have articulated to support a presumption of intent to hinder, delay, or defraud in an established Ponzi scheme was summarized by the Court in Merrill v. Abbott (In re Independent Clearing House Co., 77 B.R. 843, 860 (D. Utah 1987) as follows:

One can infer an intent to defraud future undertakers from the mere fact that a debtor was running a Ponzi scheme. Indeed, no other reasonable inference is possible. A Ponzi scheme cannot work forever. The investor pool is a limited resource and will eventually run dry. The perpetrator must know that the scheme will eventually collapse as a result of the inability to attract new investors. The perpetrator nevertheless makes payments to present investors, which by definition, are meant to attract new investors. He must know all along, from the very nature of his activities, that investors at the end of the line will lose their money. Knowledge to a substantial certainty constitutes intent in the eyes of the law, and a debtor's knowledge that future investors will not be paid is sufficient to establish his actual intent to defraud them.

Id.

The Ninth Circuit Court of Appeals in In re Agricultural Research & Tech. Group, Inc., 916 F.2d 528 (1990) defined a Ponzi scheme as an arrangement whereby an enterprise makes payments to investors from the proceeds of a later investment rather than from profits of the underlying business venture, as the investors expected. The fraud consists of transferring proceeds received from the new investors to previous investors, thereby giving other investors the impression that a legitimate profit making business opportunity exists, where in fact no such opportunity exists. Id. at **3, citing Cunningham v. Brown, 265 U.S. 1, 68 L. Ed. 873, 44 S. Ct. 424 (1924) (holding, in what has been referred to as the original Ponzi scheme case, that under circumstances involving multiple victims and commingled funds, tracing should not be utilized and that, instead, equity demands that all victims of the fraud be treated equally).

The Second Circuit Court of Appeals in Hirsch v. Arthur Andersen & Co., 72 F.3d 1085, n.3, described a Ponzi scheme as a scheme whereby a corporation operates and continues to operate at a loss. The corporation gives the appearance of being profitable by obtaining new investors and using those investments to pay for the high premiums promised to earlier investors. The effect of such a scheme is to put the corporation further and further into debt by incurring more and more liability and to give the corporation the false appearance of profitability in order to obtain new investors. Id. at *1088, citing In re Huff, 109 Bankr. 506, 512 (S.D. Fla. 1989). See also Drenis v. Haligiannis, 452 F. Supp. 2d 418, 422 (S.D.N.Y. 2006) (case involved a hedge fund Ponzi scheme, “ a species of fraud whereby an investment fund that is unprofitable uses money from new investors to pay “false profits to old investors in order to encourage further investment and sustain the scheme.”

The United States Tax Court has held that that taxpayers are allowed to deduct losses from investments that turn out to be a Ponzi scheme as a theft loss. Jensen v. Commissioner, T.C. Memo. 1993-393 (the taxpayers were entitled to a theft-loss deduction even though they had contact only with their insurance broker, who invested their money in a Ponzi scheme, and who was not alleged to have been part of the scheme), aff’d without published opinion, 72 F.3d 135 (9th Cir. 1995) Premji v. Commissioner, T.C. Memo. 1996-304, aff’d. 139 F.3d 912 (10th Cir. 1998).

 

[1] U.S. Securities and Exchange Commission, Ponzi Schemes – Frequently Asked Questions, http://www.sec.gov/answers.ponzi.htm.