District Judge Criticizes SEC, CFTC Policy on Recovery of Principal from Ponzi Scheme "Winners"

Paul S. Diamond, a U.S. district judge for the Eastern District of Pennsylvania, "reluctantly" approved a receiver's settlement with two "winning" investors in a multi-million dollar Ponzi scheme. The agreement called for the investors to return their false profits to the receivership estate, but allowed them to retain the amount of principal returned to them before the scheme collapsed (SEC v. Forte).

The receiver initially planned to seek recovery of the entire transfer, including the principal, under Pennsylvania state law. According to Judge Diamond, the state fraudulent transfer statute could allow for recovery of the principal if the investor had sufficient knowledge to place him on inquiry notice of the voidability of the transfer.

However, both the SEC and the CFTC advised the receiver that they would object to any attempt to recover the principal amounts, and would strenuously litigate the issue. As described by the judge, the agencies effectively limited the receiver’s recovery of principal to those winning investors who shared the defendant's "criminal intent." He concluded that because "the winning investors’ returned principal is actually the losing investors’ money, those losing investors could well view the position of the SEC and the CFTC as extraordinarily unfair."

Judge Diamond also criticized the SEC's position, as set forth in a recent amicus brief in a similar case. The Commission wrote that "the receiver’s claims to recover principal lack statutory and case law support, and it would be inequitable to require the innocent investors in these cases to repay these amounts." The district judge rejected the SEC's legal reasoning, and emphasized that the receiver in this case would only seek recovery of principal from those investors who did not meet the good faith standard of the state fraudulent transfer law.

The judge stated that "in other circumstances, I would be inclined to disapprove the proposed consent decrees." However, in response to advice from the attorney for the receiver that the costs of litigating against the SEC, the CFTC and the investors could well exceed the principal that could be recovered, Judge Diamond "reluctantly" approved the orders.

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