Editor's note: This chapter is the normative companion to the preceding chapter on the Second Circuit's net-equity decision (see [second-circuit-net-equity-madoff]). That chapter explains how the "money in, money out" rule made the clawback machinery work; this one asks whether the machinery, so calibrated, can be morally justified.
In what sense, exactly, is an eighty-year-old widow who withdrew quarterly distributions from her Bernard L. Madoff Investment Securities LLC ("BLMIS") account between 1992 and 2007 a wrongdoer? She believed she was drawing returns generated by a split-strike conversion strategy — buying a basket of large-cap equities, selling out-of-the-money index calls, and buying out-of-the-money index puts. She paid federal and state income tax on the gains. She gave a portion to her synagogue. She bought a smaller apartment when her husband died. She had no idea that the "returns" were principal contributed by later investors in a Ponzi scheme that had been running, by some accounts, since the 1970s.
This is the question Amy Sepinwall sets at the center of Righting Others' Wrongs: A Critical Look at Clawbacks in Madoff-Type Ponzi Schemes and Other Frauds, 78 Brook. L. Rev. 1 (2012). Sepinwall does not contest that Madoff defrauded thousands or that his victims deserve compensation. She contests a subtler claim embedded in the trustee's recovery strategy — that an innocent recipient of fictitious profits stands, for distributional purposes, in the same moral position as a wrongdoer. Her answer is that she does not, and that the doctrine, as administered by Irving H. Picard, the SIPA trustee, papers over the gap with a fiction of unjust enrichment that cannot bear the normative weight placed on it.
Defining the players: net winners and net losers
Because this is the chapter in which the terms first do load-bearing work in the book, it is worth fixing them precisely. A net winner, in the BLMIS liquidation, is a customer whose cumulative cash withdrawals exceeded cumulative cash deposits at the time of the firm's collapse on December 11, 2008. A net loser is one whose cumulative deposits exceeded withdrawals. The labels are bookkeeping facts; they say nothing about culpability, sophistication, or knowledge of the fraud. A widow who took small monthly distributions for thirty years is a net winner. A pension fund that placed a large allocation in 2006 is a net loser. On the trustee's theory, the first owes the second.
Three clawback mechanisms, often conflated
Students reading the BLMIS adversary-proceeding dockets will see the trustee deploy three different recovery mechanisms, and the moral analysis depends on keeping them straight. First, SIPA itself, at 15 U.S.C. § 78fff-2(c)(3), authorizes the trustee to recover "customer property" — including transfers a debtor made within the statutory look-back period — to fund the pro rata distribution to net-equity claimants. Second, the trustee inherits the bankruptcy estate's fraudulent-transfer powers under 11 U.S.C. § 548, reaching transfers made with "actual intent to hinder, delay, or defraud" within two years of the petition, with a narrow good-faith, value-for-value safe harbor under § 548(c). Third, under 11 U.S.C. § 544(b), the trustee may step into the shoes of any actual unsecured creditor and assert that creditor's state-law fraudulent-conveyance claim — most consequentially, in this case, under New York's then-existing Uniform Fraudulent Conveyance Act, which extended the reach to six years. Picard used all three. Each rests on a slightly different normative premise; Sepinwall's critique presses hardest on the second and third, where the legal characterization of an innocent withdrawal as a "fraudulent" transfer does the most moral work.
The asymmetry the doctrine ignores
The heart of Sepinwall's argument is what she frames as a moral asymmetry between innocent winners and innocent losers. Both relied on Madoff's fraud. Both received fictitious account statements. The only difference between them is when they happened to ask for their money. A retiree who began drawing down in 1995 is a net winner by 2008; a younger investor who put money in during 2006 is a net loser. On the trustee's theory, the first owes the second. But neither did anything wrong, and neither was in any meaningful sense enriched at the other's expense — the enrichment ran, at every step, through Madoff.
Sepinwall presses this point through the corrective-justice framework most law students will know from torts. Corrective justice requires a normative connection between the party paying and the party receiving — typically, that the payor wronged the payee. In the BLMIS clawbacks, that connection is missing. The net winner did not defraud the net loser. The doctrine, Sepinwall argues, supplies a fictional unjust-enrichment story to bridge the gap, but the bridge does not hold: the winner reasonably believed the withdrawn funds were her own, ordered her life around them, and incurred reliance costs — taxes paid, gifts made, irrevocable life decisions — that the doctrine treats as outside the analysis.
One natural rejoinder is that net winners should have known something was wrong. The empirical literature on what investors could plausibly have read from BLMIS's marketing materials and reported performance is taken up elsewhere in this volume (see [stolowy-trustworthy-investment-opportunity]); for present purposes, it is enough to note that the very cues that ought to have alarmed a sophisticated due-diligence team were the same cues that reassured the affinity-fraud retail base. A rule that treats the latter as constructive co-conspirators of the former is not obviously doing justice.
What unjust enrichment can and cannot do
A serious portion of Sepinwall's article works through the standard justifications and finds each wanting. The unjust-enrichment story founders, she argues, on the change-of-position defense recognized in Restatement (Third) of Restitution and Unjust Enrichment § 65 (2011): a recipient who, in good faith, has so changed her position that requiring restitution would be inequitable is entitled to a defense. Fraudulent-transfer law, by contrast, has historically given good-faith transferees only the narrow value-for-value safe harbor of § 548(c) — a doctrinal mismatch Sepinwall, supra, at 30-35, considers unprincipled.
The pro rata fairness story fares no better in her telling. Pro rata distribution makes sense among creditors of a common debtor; it does not, on its own, generate an affirmative duty on prior recipients to disgorge in order to enlarge the common pool. To convert prior, settled withdrawals into a source of recovery, doctrine must first deem them voidable — and that is the move Sepinwall says lacks adequate moral grounding when the recipient is innocent.
A proposal, and what it leaves open
Sepinwall does not call for abolition. Her refinement is roughly this: clawbacks should be calibrated to the recipient's culpability. Those who knew or had constructive notice of the fraud — feeder funds with red-flag exposure, sophisticated insiders, parties who took unusual steps to claw back funds late in the scheme — remain fully exposed. Innocent recipients should be entitled to a robust good-faith defense, with reliance and change of position treated as substantive limits on recovery rather than equitable afterthoughts. Recovery against the innocent, where allowed at all, should be capped to avoid net hardship transfers.
For the student reader, several questions remain open. Does SIPA's net-equity regime, as construed by the Second Circuit, foreclose a culpability-graded approach as a matter of statute, leaving reform to Congress? Should § 548 be amended to import the Restatement's change-of-position defense in Ponzi cases specifically? And if the loss truly cannot be made to fall on Madoff, is there a public-fisc argument — that the SIPC fund itself, rather than other innocent victims, should absorb the residue?
Doctrinal takeaway
For the law student, the chapter illuminates the seam between bankruptcy avoidance doctrine and the equitable principles it claims to instantiate. The operative rules are 11 U.S.C. § 548(a) (avoidance of intentionally and constructively fraudulent transfers), § 548(c) (the value-for-value, good-faith safe harbor), § 544(b) (the trustee's borrowed state-law fraudulent-conveyance claim), and SIPA's customer-property recovery authority at 15 U.S.C. § 78fff-2(c)(3). The policy lever Sepinwall identifies is the scope of the good-faith defense: whether to read § 548(c) narrowly (value-for-value only, as current doctrine does) or to graft on a change-of-position defense modeled on Restatement (Third) of Restitution § 65. The deeper question — whether equitable recovery from innocent recipients to fund pro rata distribution to other innocent victims is a feature of a humane insolvency regime or a bug that should be patched — is left open, and is exactly the kind of question the rest of this book equips the reader to answer.