A Ponzi scheme is a criminal activity where someone involved with buying and selling investments collects money in exchange for promising an enormous return. The Ponzi criminal then pays the first people who invested in the scheme with the money that the last people invested. The scheme is criminal and fraudulent because there’s really no investment, simply an investment pyramid which favors the earliest investors.

In the bankruptcy world, typically a trustee will recognize that the debtor was involved in a Ponzi scheme and file lawsuits trying to recover the large returns that were paid to the early investors. The early investors are on notice that there’s a fraudulent scheme because the returns they’re getting are just too good to be true. If the investors can prove that they really had no idea that they were the beneficiaries of a fraudulent scheme, they will be able to keep the money that they collected. The person who’s running the Ponzi scheme usually gets a long prison term because the losses suffered by the later participants in the Ponzi scheme are substantial.

Courts believe that it’s fair for the earlier investors to pay back what they received from the fraudulent scheme because the later investors are damaged. The later investors are not going to get anything back, whereas the earlier investors typically get their money back and make a profit; it’s an attempt by the courts to impose fairness on what would otherwise be a grossly unfair and fraudulent activity.