Cunningham v. Brown

Background

Six lawsuits were brought by the trustee in bankruptcy for Charles Ponzi to recover sums paid to several people within four months before the bankruptcy petition. Ponzi had run a fraudulent scheme promising $150 for every $100 loaned and often paid notes early to encourage more investors. The defendants paid him between July 20 and July 24 and their deposits were held at the Hanover Trust Company. After a public investigation on July 26 and a widely circulated report on August 2, depositors rushed to get paid. Ponzi withdrew large sums and a bankruptcy petition followed in early August. Lower courts concluded these defendants had rescinded for fraud and were entitled to return of their money.

Reasoning

The Court considered whether those payments were true rescissions that restored ownership, or unlawful preferences under § 60b of the Bankruptcy Act. The Court held the defendants did not knowingly rescind for fraud; they simply used Ponzi’s repeated public promise to repay early. Even if rescission were claimed, the defendants could not trace their specific money into the bank account because Ponzi had withdrawn the traceable funds before their checks were paid. Without traceable funds, they became ordinary creditors, and payments to them within the statutory four-month period are avoidable as unlawful preferences. The Court distinguished rules that protect identifiable funds and reversed the lower courts’ judgments.

Real world impact

The decision allows the bankruptcy trustee to recover recent payments to some investors and treats rushed withdrawals during the run as unlawful preferences. People who raced to withdraw funds may lose priority and become ordinary creditors. Minors who received payments without identifiable funds are not protected from this result.