Proposal to establish a new Ponzi scheme-specific arm of New Zealand’s statutory insolvency regime

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Thursday, June 14, 2018

Jennifer Tunna, Principal at Lowndes Law, discusses the Government’s discussion paper which proposes a new regime for unravelling Ponzi schemes. Submissions are due by July 6. 

Jennifer Tunna Crop

The Ministry for Business, Innovation & Employment (MBIE) has issued a discussion paper which proposes a new regime for unravelling Ponzi schemes. Submissions are sought by July 6. The paper proposes a new, Ponzi-scheme-specific arm to New Zealand’s statutory insolvency regime.

The rationale for the additional law is to better ensure that defrauded investors are treated equally where a Ponzi scheme is identified, something MBIE perceives has not always been possible when applying the provisions contained in the Companies Act 1993 and the Property Law Act 2007.

Ponzi schemes occur when early investors to a scheme are paid ‘dividends’ using funds introduced by later investors. As more investors are lured into the scheme by higher-than-market-rates of return, it becomes increasingly difficult to pay all investors because the amounts required to make those payments (together with the amount of the shortfall) increase exponentially.

MBIE’s view is that certain aspects of the existing insolvency regime, which were designed to balance the interests of competing trade creditors, operate unfairly in a Ponzi scheme scenario where fraud is at play.

The recent Supreme Court decision of McIntosh v Fisk is cited as an example of a single investor escaping with his principal investment intact because, out of good luck, he withdrew his investment before the scheme collapsed – other investors received much less or nothing.

The aim of the proposed legislation is to ensure that investors are treated as equally as possible without regard to:

  • the timing of the introduction into or withdrawal of funds from a scheme – where there is an intent to defraud, investors should not be treated differently when they are the victims of the same type of fraud;
  • the underlying structure of the investment – it should not matter which entity an investment attaches to, and the fraud should be unravelled as a whole; or
  • the rights of particular investors to bring claims in respect of specific assets, such as where some investors (but not others) are entitled to trace assets. MBIE’s preliminary view is that investors should not be allowed to trace assets – it is more important to treat investors equally than to permit tracing principles to distinguish investors arbitrarily.

MBIE proposes to add new liquidation provisions into the Financial Markets Conduct Act 2013 (FMCA). A broad range of people (including individual investors, with the leave of the Court) would be entitled to apply for a declaration that a scheme is a Ponzi scheme. A broad definition of Ponzi scheme is proposed to avoid arbitrary outcomes. Where the Court is satisfied there are serious questions to be answered, an insolvency practitioner would be appointed to investigate and report to the Court.

If the practitioner identifies a Ponzi scheme, a liquidator would be appointed and would determine the commencement date of the Ponzi scheme (MBIE notes that many schemes start out life legitimately and later become Ponzi schemes). The liquidator would recover whatever assets remain, as well as funds withdrawn and fictitious profits paid to investors (with a maximum clawback period).  The amounts recovered would be distributed to all investors net of the liquidators’ costs.

MBIE proposes that where an insolvency practitioner is appointed to investigate whether a Ponzi scheme exists, those costs would be treated as an expense of the resulting liquidation, or, where no Ponzi scheme is found, would be borne by the applicant. MBIE argues that the prospect of such costs will act as a deterrent to bringing an application without having sufficient evidence.

However, it seems likely that the prospect of incurring such costs (in addition to the legal costs of getting the matter before the Courts) will act as a deterrent to individual investors making any application full stop. In practice, a suspicious investor would be better to approach the Financial Markets Authority and invite it to bring an application.

Several alternatives to the new legislation were considered, including the establishment of a compensation fund for investors defrauded in a Ponzi scheme. MBIE concluded that such a fund could disrupt market forces and encourage imprudent lending, which seem to be valid concerns.

Despite being included in the FMCA, the new regime would continue to rely heavily on Part 16 of the Companies Act in respect of liquidators’ powers and duties, and in relation to the general process to be followed by the liquidator looking to claw back assets. However:

  • There would be several major departures from the defences available under the Companies Act. It would be irrelevant whether an investor had “given value” or altered his/her position in reliance of the payment being made. Instead, an investor who provides funds in good faith and without knowledge of the Ponzi scheme would be able to resist a clawback of funds where “significant financial hardship” would result. MBIE proposes that “hardship” be defined so as to impose a high bar to investors seeking to rely on it.
    The current proposal is that an investor would need to demonstrate that he/she cannot meet minimum living expenses, mortgage repayments on a family home or the cost of medical or palliative treatment for the investor or their dependants. In addition, a whistle blower defence is tentatively proposed, which would prevent a clawback from an (honest) investor who alerts the Courts or relevant authorities to the existence of a Ponzi scheme.
  • The clawback period for Ponzi schemes would be four years from the date the application was made for a scheme to be declared a Ponzi scheme (versus two years from the date an application is made for liquidation under the Companies Act). The longer period is essentially justified by MBIE on the basis that frauds can take longer to detect than trading difficulties. No further explanation is provided as to why a period of four years was chosen (other than to note that any given period will be arbitrary).

The discussion paper is a well-considered work in progress.  However, what appears at first glance to be a sensible addition to New Zealand’s insolvency regime quickly highlights a number of nuanced issues that will need to be considered carefully before new legislation can be implemented successfully.

Jennifer Tunna has broad experience within the finance sector, particularly in insolvency and restructuring. She has been centrally involved with many of the largest and most complex corporate collapses in recent times. Jennifer has over 12 years’ experience with leading firms in New Zealand and the United Kingdom.

She has significant experience in executing business and asset sales across a range of industry sectors, particularly in distressed situations. Jennifer also has experience in various aspects of contentious insolvency. Since 2013, she has been recognised as an ‘Associate to Watch’ by Chambers and Partners. Contact Jennifer at jennifer.tunna@lowndeslaw.com

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