Tax Rascal

“Fraudulent Conveyance” Aligns the Ponzi with the Ponz-ee

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“Fraudulent Conveyance” Aligns the Ponzi with the Ponz-ee

In the wake of the Madoff scandal, some people have discussed how “fraudulent conveyance” could be a major issue. The doctrine of fraudulent conveyance basically holds that after a fraud, someone who benefited should give up some (or all) of their benefits to those who were wronged, even if they had no idea what was going on. It’s a usful doctrine in a lot of cases — if Madoff, for example, had given his sons tens of millions of dollars but left others high and dry, it wouldn’t be a great plan to let them keep the money.

But what people don’t often mention is the big problem with fraudulent conveyance: it encourages people to look the other way when they suspect that they’ve accidentally invested in a Ponzi scheme.

Imagine a Madoff investor who realizes that Bernie has been lying, and is billions of dollars short of what he said he’d earned. The investor has two basic ‘exit strategies’: to hope that Madoff makes back the money he said he had, or to pull out money now. But pulling out money makes it harder for Madoff to make it back! If Bernie has $5 billion, and says he has $10 billion, then he needs to double his money to make it back; if investors pull out 25% of the money they think they have, it drops to $2.5 billion of actual money and $7.5 billion of fake money — so he’d have to triple the remaining investment. And if that investor’s withdrawal leads other investors to move out, it makes it even more likely that the fraud will collapse and the withdrawn money will be taken back by fraudulent conveyance and the associated legal fees.

Instead, their incentive is to help the schemer along: with the numbers from before, if Madoff can raise another $5 billion, the gain he needs will drop from 100% to 50% — still hard, but more doable. For investors who stick with their fraudster, there are higher odds of getting money, and lower odds of losing it, thanks to the doctrine of fraudulent conveyance.

At the same time, this result is basically an accounting fiction: it still means that the fraudster is lying about how much he has, and probably taking uneccesary risks to make the money back. As long as the investments people make don’t reflect the risks they want to take, that investing activity destroys wealth. Thanks to fraudulent conveyance, it’s entirely possible to put everyone involved in a Ponzi schem on the side of whoever has the most destructive morals.

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