Suppose you’ve got money invested in a fund. You take some out, but days later you change your mind and put it back. Then the fund collapses. It turns out to be a Ponzi scheme. Under the dominant method for calculating reimbursement, your losses are going to be a lot bigger than if you’d just left the money there all along.

And that’s OK, says a decision this week by the U.S. Court of Appeals for the Fourth Circuit.

I have some concerns.

The case arose from an effort to unwind what the Securities and Exchange Commission labeled a “brazen fraud” involving a $325 million fund that was supposedly buying and selling consumer debt. Instead, the proprietors stole some of the money “and used the remainder to pay purported dividends, or ‘distributions,’ to earlier investors.” The Ponzi scheme duly collapsed, and the fraudsters pled guilty.

A court-appointed receiver recommended that cheated investors should be repaid according to the “rising tide” method, in which everyone receives a certain minimum percentage of the value of their lost accounts—but money that was previously withdrawn is credited dollar-for-dollar against the reimbursement.

Seems simple enough. If you put in $10,000 and the rising tide figure is 30%, you get back $3,000. On the other hand, if you’d invested $10,000 and withdrew $2,000, you get back only $1,000.

But a group of investors objected, contending that their reimbursement should not be reduced if those withdrawals had soon been returned to the fund. Instead, they argued, reimbursement should be calculated based on the actual account balance at the time of the collapse.

The trial court rejected the claim, and the investors appealed. In an opinion by Judge DeAndrea Gist Benjamin, the Fourth Circuit let the ruling stand. The panel didn’t say that one approach is better than the other—only that the choice was within the discretion of the trial judge. Judge Benjamin also pointed out that no court has ever required that what’s become known as the “maximum balance” methodology be used.

But that doesn’t mean no court thinks it’s a good idea.

Maximum balance was first proposed by Judge Richard Posner, in a 2012 opinion for the U.S. Court of Appeals for the Seventh Circuit, concerning the Ponzi scheme run by William Huber and Hubadex. After approving a “rising tide” distribution for the calculation of investor losses on the facts presented, the court appended a caveat: “We are given pause, however, by the situation of an investor who having withdrawn some money from the Ponzi scheme then reinvests it.”

What did Posner have in mind? Suppose you invest $150,000 in XYZ fund and so does your friend, whom we’ll call Ben. Ben leaves his $150,000 intact; but you briefly withdraw $50,000, then return the money to the fund. XYZ turns out to be a Ponzi scheme. After it goes belly up, the receiver recovers enough of the missing cash to award each investor to one-third of the loss.

Ben gets $50,000, obviously. But what about you? Under the rising tide methodology, your total investment (not your “balance”) was $200,000—the original $150,000 plus the $50,000 you reinvested. Of this amount, you’re entitled to recover only $16,667, representing one-third of $200,000 ($66,667) minus the $50,000 you’ve already “received.”

Posner is understandably skeptical:

We can’t see why those two investors should be treated differently, as would be obvious if the withdrawal and reinvestment had occurred on successive days. In cases of withdrawal followed by reinvestment, the investor’s maximum balance in the Ponzi scheme ($150,000 in our example) should be treated as his investment; the withdrawals, having in effect been rescinded, should be ignored.

I’m skeptical too. But the courts aren’t. A few years after Judge Posner posed his hypothetical, a nearly identical case presented itself. In the litigation over the Ponzi scheme run by Mark Varacchi, a dispute arose between the receiver and an investor called Flatiron Partners LP. Rounding the dollar figures, Flatiron claimed that it had invested $5 million and received $1 million, or 20%, in distributions. According to the receiver, however, Flatiron had invested $7 million and received $3 million back, meaning that it had already recovered about 43% of its investment.

Why the difference in calculation? Because shortly after making an initial capital contribution of $2 million, Flatiron asked for, and received, that money back, only to return it to the fund a week later. According to Flatiron, the issue arose because of confusion over whether it was permitted to invest in the fund. When the confusion was cleared up, it put the money back. The receiver treated the episode as a withdrawal and a fresh investment, and a Connecticut federal court, in a 2021 opinion, agreed. That’s how rising tide works.

Defenders of rising tide point out that if the fund in question is a Ponzi scheme, the withdrawn cash isn’t the investor’s own stake—it’s cobbled together from the money of lots of other investors who are meanwhile being fed fake account balances. And it’s perfectly fair to give that point heavy weight if the investor keeps the money.

But even if the withdrawal was paid in other people’s money, it shouldn’t matter, as long as the investor put the money back. That’s what Flatiron did; that’s what the investors in the Fourth Circuit case did. They put the money back. To treat the returned cash as a new, separate investment is to punish a phantom.

Judge Benjamin didn’t dispute this point, but concluded that the maximum balance approach would place too great an administrative burden on the receiver. Other courts have agreed.

I’m not so sure. The receiver can simply choose not to penalize innocent investors who return the cash within a given period — two days, two weeks, what have you—and the problem is solved.

With Ponzi schemes said to be on the rise—especially in crypto—it’s important to get this right.

Stephen L. Carter is a Bloomberg Opinion columnist, a professor of law at Yale University and author of Invisible: The Story of the Black Woman Lawyer Who Took Down America’s Most Powerful Mobster.

This article was provided by Bloomberg News.