Federal Court Affirms the Ability of a Bankruptcy Trustee to Claw Back Fictitious Profits from Investors in LPs or LLCs Operated As Ponzi Schemes

On October 27, 2011, the Federal Court of Appeals for the Eleventh Circuit issued an opinion upholding clawback protections for members of limited liability companies and partners of limited partnerships who are victims of a Ponzi scheme.  This decision reaffirmed the general rule that, in the case of a Ponzi scheme, the return of an investor’s principal cannot be avoided where the investor can prove that he took that money in good faith.  See “Two Recent Federal Court Decisions Clarify the Differing Treatment under SIPA of Returned Principal and Fictitious Profits,” Hedge Fund Law Report, Vol. 4, No. 34 (Sep. 29, 2011).  Procedurally, the decision affirmed the lower court’s ruling and resolved an issue of first impression in the Eleventh Circuit.  This article explains the factual background of the decision and the court’s legal analysis, and references relevant HFLR articles.  Much of what we publish is intended to help hedge fund investors avoid Ponzi schemes and similar bad investment calls.  See, e.g., “What Should Hedge Fund Investors Be Looking for in the Course of Operational Due Diligence and How Can They Find It?,” Hedge Fund Law Report, Vol. 4, No. 36 (Oct. 13, 2011).  However, despite best efforts, even savvy investors sometimes wind up in Ponzi schemes.  See “Recent Bayou Judgments Highlight a Direct Conflict between Bankruptcy Law and Hedge Fund Due Diligence Best Practices,” Hedge Fund Law Report, Vol. 4, No. 25 (Jul. 27, 2011).  This article is intended to help clarify the rights and obligations of such investors.

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