More on Law, Madoff, Fairness and Interest Rates

Last year, I blogged about a US bankruptcy court ruling which said that the net claim that a Madoff investor could make in court was for the total of all amounts invested less all amounts withdrawn. Somebody who invested $10 million in 1988 and withdrew $10 million in 2007 would be deemed to have got back his investment and would have no claims in the bankruptcy court. This ruling completely ignores the time value of money.

Grant Christensen, has written a detailed paper explaining the legal position regarding allocating losses in securities frauds, particularly Ponzi schemes like Madoff. Apparently, the bankruptcy courts “have a great deal of leeway when it comes to ratifying different methods to determine loss and allocate assets.” While the net investment method used by the court in the Madoff case is the most popular method, it is not the only method that is legally sustainable. The rescission and restitution method subtracts only the withdrawal of principal and does not subtract any interest or dividend that was withdrawn. Apparently, “appellate courts have expressed a clear preference for the rescission and restitution method over the net investment approach.”

Quite frankly, I have not been able to understand the mechanics of the various methods discussed in the Christensen paper. The economic difference, if any, between the rescission and restitution method (from civil law) and the loss to the losing victim method (based on criminal law) is not explained at all. The paper focuses on the legal foundations for various methods. I do know that some of the readers of my blog are lawyers and if they can throw light on this in the comments, that would be most helpful.

From what I have been able to understand, the alternative methods are based on accounting definitions of interest and principal. These would then be based on the promised rate of return which would be unrealistically high. Finance theory would suggest that the rate of return on a risk free asset (or a low risk asset) might be more appropriate. Alternatively, the average return earned by the Ponzi operator on the actual invested assets could be considered. For a successful Ponzi scheme, the cash inflows from new investors would exceed the cash outflows to withdrawing investors. This surplus cash would hopefully earn some return and this realized rate of return could be used as the discount rate.

Posted at 3:51 pm IST on Mon, 22 Aug 2011         permanent link

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