Lasting legacy of litigation

The financial mess wrought by former real estate executive Doug Vaughan, who has admitted to scamming $75 million from 600 investors in a long-running Ponzi scheme, appears headed toward being an extended legal mess as well.

If the bankruptcy liquidation of Bernie Madoff’s securities brokerage is any indication, clawbacks being pursued as part of the bankruptcy liquidation of Vaughan’s flagship real estate brokerage, Vaughan Company Realtors, will take years of litigation.

As of the end of December, formal clawback lawsuits had been filed in U.S. Bankruptcy Court in Albuquerque against 21 investors and associates of Vaughan to force them to return a payment or payments made before Vaughan’s company filed its bankruptcy petition on Feb. 22, 2010.

More lawsuits are expected over the next six weeks as the deadline for clawbacks approaches on the two-year anniversary of the petition filing. Additional clawback actions have been and still are being settled out of court.

In both the Bernard L. Madoff Investment Securities and Vaughan Company Realtors cases, the clawbacks are being pursued by court-appointed trustees in charge of liquidating the bankruptcy estates of the two companies. Money recovered will be used to pay legal costs and compensate victims.

Madoff, who is now serving a 150-year sentence in federal prison, perpetrated the largest Ponzi scheme in history with 4,900 victims owed $68 billion. His decades-old scheme collapsed in December 2008, with hundreds of clawbacks filed over the next two years.

The “mini Madoff”

Vaughan, who faces 10 to 12 years in prison, has been described as a “mini Madoff.” Although the money he scammed from investors amounts to only about 1 percent of Madoff’s haul, Vaughan’s swindle is the biggest Ponzi scheme in New Mexico history.

Clawbacks are considered inevitable in bankruptcy liquidations involving fraud. They are commonly pursued through both the bankruptcy code and state securities law. In the Madoff Securities case, because it was a registered securities brokerage, federal securities law also comes into play.

The intent of the laws to protect investors or creditors is clear, notes a 1989 court decision, “but the specifics of precise resolution of individual situations are clouded by provisions … which range far from the clarity of blue sky one might expect in this area of law.”

In other words, it’s game on.

While clawback lawsuits filed by trustees tend to read the same in any given case, the counter claims filed by defendants can raise all sorts of legal technicalities to fight them. With so many legal technicalities to sort through, judge’s decisions can fall on any side of an issue.

In the bankruptcy liquidation of Madoff Securities, for example, two judges in New York City reached polar opposite decisions on whether “safe harbor” provisions of the Bankruptcy Code apply to investors in a Ponzi scheme. The provisions restrict a trustee’s power to claw back payments made to an investor in a securities contract.

Conflicting decisions

In a clawback action filed in U.S. District Court, a judge ruled the safe harbor provisions applied. In a clawback filed in Bankruptcy Court, another judge ruled the provisions did not apply.

The conflicting decisions point to the challenge of determining the legal liability of investors in a Ponzi scheme.

Looking at a Ponzi scheme as a two-sided transaction — Madoff and Vaughan on one side, for example, the investors or victims on the other — then clearly half of the transaction is a fraud.

Every one of Madoff’s and Vaughan’s payments in these transactions were made, in legal jargon, “with the intent to hinder, delay and defraud creditors.” They used money from new investors to pay off their financial obligations to earlier investors, which is the essence of a Ponzi scheme.

Clawbacks are a way to determine complicity in the fraud on the investor side of the transaction.

The burden of proof for a trustee to prove complicity in fraud can be fairly liberal in a bankruptcy liquidation, nothing close to what’s required in a criminal case. Allegations of circumstantial evidence can be enough to justify a clawback.

‘Red flags’

In both the Madoff Securities and Vaughan Company Realtors cases, clawbacks raise the issue that a given investor should have seen “red flags” indicating fraudulent activity. The red flag can be as simple as accepting unrealistically high interest rates on a steady basis when the economy is crashing.

Clawbacks in the Madoff case have advanced the theory of “willful blindness,” basically an investor turning a blind eye to evidence of a scam, that has found some lukewarm support in the courts.

A common topic of discussion in judicial rulings on clawbacks is “badges of fraud,” which are a set of criteria used to determine whether a payment or payments to an investor were “constructively fraudulent.”

The badges of fraud can vary from state to state — New York has eight, New Mexico has 11 — but typically apply to the timing and circumstances of a payment or payments. One badge is generally not enough to justify a clawback. In the Madoff Securities case, three badges have been sufficient.

The most vulnerable targets of clawbacks are insiders, especially those who received commissions or referral fees for steering investors into the Ponzi scheme. The trustee in the Madoff Securities case has clawed back billions of dollars from “feeder funds” whose managers profited from Madoff’s scheme.

Another vulnerable target is investors who had net equity in the Ponzi scheme and thus profited from their participation in it. Net equity means their original investment had been paid off over time and that every payment after that point was a fraudulent transfer.

Other potential targets can be sophisticated investors — an investment advisor or, in Vaughan’s case, a real estate professional, for example — who should have recognized the red flags, or investors who got preferential treatment by continuing to get their payments while most others had been cut off.