Kathy Bazoian Phelps
Senior Counsel in Ponzi Scheme Litigation
and Bankruptcy Matters

Kathy is a senior business trial attorney with more than 30 years experience prosecuting and defending claims for high net worth clients involved in Ponzi scheme matters and in bankruptcy proceedings. Kathy’s practice includes recovering assets for clients in complex fraud cases under standard fee and alternative fee arrangements. She also handles SEC and CFTC whistleblower claims. Kathy also serves as a mediator in bankruptcy matters, in complex business disputes, and in matters requiring detailed knowledge about fraud or Ponzi schemes.

Kathy’s Clients in Ponzi Scheme Cases and Bankruptcy Matters
Equity Receivers
Bankruptcy Trustees
High Net Worth Investors
Debtors in Bankruptcy
Secured and Unsecured Creditors

Tuesday, May 29, 2012

The Power of Substantive Consolidation in Ponzi Cases

Posted by Kathy Bazoian Phelps
A trustee in bankruptcy may seek the substantive consolidation of a nondebtor entity or individual with the debtor to bring into the estate the assets of the nondebtor that may have been concealed from the debtor’s creditors.
For example, in In re Bonham, 229 F.3d 750 (9th Cir. 2000), the Ninth Circuit granted the trustee’s substantive consolidation request and the assets of the nondebtor entity became property of the estate.  Similarly, in In re S & G Financial Services of South Florida, 451 B.R. 573 (Bankr. S.D. Fla. 2011), the court ordered substantive consolidation when sought by the trustee to make assets of a nondebtor entity available for the creditors of the debtor.
Recently, however, the bankruptcy court in the Louis Pearlman Ponzi case declined to grant substantive consolidation of a nondebtor entity.  In re Pearlman, 462 B.R. 849 (Bankr. M.D. Fla. 2012).  In that case, the request to substantively consolidate the nondebtor entities with the debtors was made not by the trustee, but rather by the defendants in fraudulent transfer actions that the trustee had filed.  Granting substantive consolidation would have effectively terminated the trustee’s fraudulent transfer claims because, upon consolidation, the consolidated estate would be deemed to have received equivalent value for its transfer through the payment of its debt.  See First Nat’l Bank of El Dorado v. Giller (In re Giller), 962 F.2d 796, 799 (8th Cir. 1992).
The Pearlman court discussed the split of authority on whether substantive consolidation of nondebtor authorities is appropriate, but then declined to permit substantive consolidation of nondebtor entities in that case.  The court commented, “Bankruptcy courts cannot and should not simply drag unwilling entities that never chose to file bankruptcy into a bankruptcy forum simply because it is expedient and will help one party or another.”
In earlier rulings, the Pearlman bankruptcy court had held that although it was appropriate to substantively consolidate debtor entities, it was inappropriate to limit the consolidation by preserving fraudulent transfer claims as among the consolidated entities.  In re Pearlman, 450 B.R. 219 (Bankr. M.D. Fla. 2011); Kapila v. Integra Bank, N.A. (In re Pearlman), 2011 Bankr. LEXIS 1740 (Bankr. M.D. Fla. Apr. 26, 2011).
In this recent Pearlman decision, however, the court was unwilling to extend substantive consolidation  relief to nondebtor entities and therefore did not eliminate the fraudulent transfer claims against the moving parties.
Substantive consolidation is a remedy used offensively by trustees to bring in assets of other entities for administration and also defensively by fraudulent transferee defendants to try to avoid liability by substantively consolidating away and thereby eliminating the claims against them.
Issues relating to substantive consolidation and the impact of consolidation on fraudulent transfers in Ponzi scheme cases are discussed in The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes.

Thursday, May 24, 2012

Committee Alleges That the Auditor in the Stanford Financial Ponzi Scheme Did More Than Issue False Financial Statements

Posted by Kathy Bazoian Phelps
We have certainly seen many auditor liability cases recently where the auditor, either in reliance on data from the Ponzi insiders or in cahoots with the insiders, issued false financial statements on which the investors relied.  While not quite a dime a dozen, there have been many such cases lately where the results of the audit have created liability.
A new complaint that the Official Committee of Unsecured Creditors in the Stanford Financial Ponzi scheme case filed last week makes those types of allegations. But it goes well beyond that in seeking to hold the auditor, BDO USA and related BDO entities, liable for what may be millions, if not billions, of dollars.
Because Allen Stanford’s Ponzi scheme was largely centered in Antigua, he wanted to weaken that country’s banking laws.  He established a Task Force of nine individuals, three of whom were BDO partners.  The Committee complaint alleges, “A key initiative for the Stanford Task Force — fully known to BDO USA — was to amend Antigua’s Money Laundering (Prevention) Act to ensure that “fraud” and “false accounting” did not fall under the Act’s prescribed list of violations.” 
The complaint further alleges, “BDO USA was charged with some of the most important responsibilities to complete this initiative, including reviewing and advising on Antigua’s banking laws, and making recommendations to Antigua’s regulatory authorities, including procedures for supervising and examining international banks.”

It also alleges, “BDO USA’s service on the Task Force completely undermined its independence from Stanford Financial Group, and as a result, BDO USA blatantly violated Generally Accepted Auditing Standards (“GAAS”) by issuing unqualified audit opinions on its Stanford Clients’ annual financial statements during the years that BDO USA served on the Stanford Task Force.” 

The BDO audit engagement partner also allegedly concealed material information from the audit engagement team, e.g., that the SEC was investigating Stanford Financial for securities fraud.

Therefore, in addition to the “numerous audit failures,” which would support standard negligence claims, the Committee’s complaint also includes claims for relief based on several aiding and abetting theories, as well as conspiracy, and seeks both actual and punitive damages.  The complaint also requests a jury trial. 

We will continue to monitor the progress of this case.  A copy of the Committee’s complaint is attached here.

Negligence, aiding and abetting, conspiracy, and auditor liability issues are discussed in detail in The Ponzi Book: A Legal Resource for Unraveling Schemes.

Tuesday, May 22, 2012

Second Circuit Upholds Dismissal of Claims Against Auditor in Madoff Ponzi Scheme

Posted by Kathy Bazoian Phelps

The Second Circuit has upheld the district court’s decision in Stephenson v. PricewaterhouseCoopers LLC, 768 F. Supp. 2d 562 (S.D.N.Y. 2011), dismissing an investor’s claims for professional malpractice and fraud against the auditor of a Madoff feeder fund, Greenwich Sentry. Stephenson v. PricewaterhouseCoopers LLC. 2012 U.S. App. LEXIS 10017(2d Cir. May 18, 2012).

On the malpractice claim, the Second Circuit agreed with the district court’s conclusion that:

Stephenson has standing to bring a claim that PWC’s negligence induced him to invest in Greenwich Sentry (the “inducement” claim), but that he lacks standing to assert a claim based on his decision to remain invested in Greenwich Sentry through December 2008 (the “holding” claim). Stephenson's inducement claim arose from his alleged reliance, as an individual investor, on PWC’s unqualified audits of Greenwich Sentry.

The court further affirmed the district court’s dismissal of the malpractice claim, noting:

Although Stephenson has standing to assert his inducement claim directly, the complaint fails to demonstrate that PWC owed him a duty as a potential investor in the fund. To prevail on a negligence claim under New York law against an accountant with which the plaintiff has no contractual relationship, the plaintiff must show that (1) the accountant was aware “that the financial reports were to be used for a particular purpose”; (2) “in the furtherance of which a known party . . . was intended to rely”; and (3) some conduct on the part of the accountant linking it to the party which “evinces the accountant['s] understanding of the party[’s] . . . reliance” (the “Credit Alliance test”).

The plaintiff could not establish the “known party” prong of the Credit Alliance test, so the malpractice claim was dismissed.

In dismissing the fraud claim against the auditor, the district court had observed:

But an unseen red flag cannot be heeded. Hence courts in this Circuit have consistently dismissed fraud claims against auditors-including against auditors of BMIS feeder funds-that have not sufficiently alleged that an auditor knew of red flags.

Stephenson v. PricewaterhouseCoopers LLP, 768 F. Supp. 2d 562, 571 (S.D.N.Y. 2011).

The Second Circuit affirmed the dismissal of the fraud claim, holding:

[W]e conclude that the district court properly dismissed the SAC for failure to allege that PWC's conduct was so reckless as to raise a “strong inference” that it intended to deceive Stephenson. The district court properly found that: (1) despite the fact that PWC's audit did not comply with generally accepted accounting standards, it was not so poor as to raise an inference of an intent to defraud; (2) PWC lacked awareness of almost all of the red flags alleged by Stephenson; and (3) an intent to defraud could not be inferred from those flags of which PWC was necessarily aware. See, e.g., Novak, 216 F.3d at 309 (“[T]he failure . . . to interpret extraordinarily positive performance . . . as a sign of problems and thus to investigate further does not amount to recklessness.”); Chill, 101 F.3d at 270 (“The fact that [the defendant] did not automatically equate record profits with misconduct cannot be said to be reckless.”). Thus, we affirm the district court's dismissal of the SAC for failure adequately to plead scienter.

Claims for professional malpractice and fraud against auditors and other types of defendants are discussed in detail in The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes.

Monday, May 21, 2012

Is Help On the Way for Investors Defrauded in Ponzi Schemes?

Posted by Kathy Bazoian Phelps

The quest of defrauded investors in Ponzi schemes to be made whole is ongoing. To recover their funds in the resulting bankruptcy and receivership cases of the Ponzi debtor, investors file proofs of claim to seek reimbursement of their unpaid principal investments and the promised but unpaid interest on their investments.

But all investors are not created equal, and the manner in which investor claims are allowed in a case can have a huge impact on the ultimate payout. Different categories of investors – “net winners” and “net losers” - may find themselves doing battle with each other in an effort to be repaid a larger portion of their claims.

Net winner investors may have invested money earlier in the scheme and actually received profits that exceed the amount they originally invested. However, those net winners still want to be paid the unpaid interest promised to them - the time-value of their money that was tied up in the Ponzi scheme, often for much longer than the net losers’ investments.

On the other hand, the net losers have either recouped nothing, or some amount less than that originally invested. Net losers also want to be paid the handsome profits that they were promised, in addition to their unreturned principal investment. Net losers, therefore, want the cash available for distribution to repay their principal before the net winners are paid anything.

Academics, courts, and others have considered different methodologies to balance the rights and claims of net winners and net losers. Some say neither net winners nor net losers should be allowed claims for unpaid interest because the entire enterprise was a fraud. Others conclude that net losers should be repaid the full amount of their principal investment before net winners are paid anything.

Another line of thinking on the subject has been gaining traction, however. What if investors are allowed some standardized amount of interest for the time period that their funds were invested in the fraudulent scheme? Essentially, all investors would be allowed an imputed interest amount for the time-value use of their funds. Investors who invested earlier in the scheme and, therefore, for a longer period of time, would be allowed a greater amount of interest than those who had invested more recently.

Pending before the Second Circuit is a case involving this exact issue in a challenge to a receiver’s distribution plan. In the Stephen Walsh, Paul Greenwood Ponzi scheme, the SEC appointed receiver, Robb Evans & Associates LLC, proposed a distribution plan to distribute the assets on a pro rata basis. Several investors objected to the distribution plan, but the district court approved the plan over the objections. One investor appealed because its proposed distribution plan (which differentiated between classes of investors based upon the type of investment the investor had purchases) was rejected. Another investor, the Kern County Employees’ Retirement Association, cross-appealed, seeking an adjustment to the pro rata plan to account for the time-value of money, stating:

KCERA’s cross-appeal asks this Court to adjust the pro rata distribution for inflation under the well-established economic principle that a dollar in 1995 has a different value than a dollar today. Such an adjustment is a commonplace Economics 101 calculation that results in the fairest distribution.

Kern County argued in its cross-appeal that it was unfair for an investor like itself, who had invested funds in the scheme for over a decade, to be treated the same as an investor who had only been invested for one year. Kern County argued, “Without this inflationary adjustment, short-term investors are favored at the expense of long-term investors when there is absolutely no need or justification for such a disparity.”  Kern County’s appellate brief is attached here.

Of course, making an adjustment for the time-value of money will enhance the claims of earlier investors, who are more likely to be net winners that have already received back their principal investment, and thereby dilute the claims of later investors who are more likely to be net losers. Net losers, therefore, have a different sense of “the fairest outcome.”

In response, the receiver argued:

With respect to factual findings, the District Court correctly determined that KCERA’s inflation adjustment would not be fair to the investors. For example, as a result of KCERA’s proposed adjustment, some of the investors (including KCERA) would receive millions of dollars over and above their net investments (i.e., the investor's total contributions, minus total withdrawals, unadjusted for inflation or fictitious earnings) before other investors recovered their net investments. An inflation adjustment could also seriously jeopardize the Receiver's efforts to recover, or “claw back,” fictitious earnings that were paid to former investors in the Westridge Entities, further putting at risk the same current investors who would suffer most at the hands of KCERA’s proposed inflation adjustment.

The receiver’s brief is here.

Treatment of investor claims in Ponzi cases is definitely a balancing act where everyone feels that they have lost. Net losers have suffered actual losses and at a very minimum, should certainly be allowed claims for their unpaid principal. Whether investors should be allowed claims for the unpaid fictitious interest is a more complicated question. It seems that, on a basic level, both net winners and net losers should either be allowed or disallowed interest, but that the same basic rule should be applied to both categories of investors.

The good news is that courts are starting to look more closely at these nuanced issues. The bad news is that there are a lot of lingering and unanswered questions.

Should net winners have to wait to be paid interest until net losers are repaid principal in full? And should net winnings be “clawed back” from net winners for purposes of redistribution to all investors after net losers have been repaid principal?

If interest is allowed for investors, should both net winners and net losers be paid at the same rate, and should that rate be the fictitious promised rate, the prime rate, some other imputed rate? And for what period of time?

Should a net loser’s actual damages of its unpaid principal be treated differently than a net winners damages from the loss of use of its money for a long period of time? Are those two types of losses the same, or should they be treated differently?

The argument for imputed interest to compensate for the time-value of money is gaining ground, although no prior decisions appear to have seriously considered it. We will await the Second Circuit’s decision on Kern County’s cross-appeal to see whether there will finally be some court setting some guidelines to establish an equitable solution to a very inequitable situation.

There are, of course, many other moving parts in the dialogue of claims allowance and claims distribution in Ponzi cases. An entire chapter of The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes addresses these issues.

Wednesday, May 9, 2012

Podcast on the Latest Legal Issues in Ponzi Scheme Litigation

Posted by Kathy Bazoian Phelps

Readers are invited to listen to a podcast that I recently did for the LexisNexis Bankruptcy Community on the latest legal issues in Ponzi scheme litigation. It is available here.

In this podcast, I review some recent developments and decisions in the Madoff, Rothstein, and Petters cases, including a discussion about who has been held liable, who has settled and who has escaped liability.

Tuesday, May 1, 2012

Government Forfeiture Beats Creditor Claim in Petters Ponzi Scheme

Posted by Kathy Bazoian Phelps

When a Ponzi scheme breaks, the government rushes to forfeit the assets that constitute or are derived from proceeds traceable to the crime. At the same time, creditors, thinking that they had properly secured their claims, try to grab those very same assets for themselves. 

A recent decision out of the Petters Ponzi scheme case highlights this battle, which has been raging in most of the pending Ponzi cases such as Bernard Madoff, Scott Rothstein, Marc Dreier and others. In United States v. Petters, 2012 U.S. LEXIS 57645 (Apr. 24, 2012), Crown Bank filed three petitions under 21 U.S.C. § 853(n) asserting interests in three assets that had been forfeited by the government.

As to the first asset, which was the Wisconsin Lodge, Crown had loaned money to Petters in 2008, and had taken back a security interest to secure the loan.  Crown alleged that Petters executed and delivered a Security Agreement that provided “a 100% Membership Interest in Tam O’Shanter Lodge, LLC,” which LLC is “the sole owner of the [Wisconsin] Lodge.” From Crown’s perspective, it sounded good – a 100% interest in the company that owned 100% of the asset.  From the government’s perspective, it wasn’t good enough.  As a threshold matter, to have standing to even make a claim, section 853(n) requires that the claimant have a “legal interest” in the forfeited property.  The government argued, and the court agreed, that Crown had an interest in the LLC, and not in the forfeited property itself.  “The Verified Petition alleges only that Crown held an interest in the LLC, which is simply one level too far removed from the forfeited property to have an assertable legal interest here.”  Id. at *7.  

1 for the Government, 0 for Crown.

As to the other two assets, the Keystone and Plymouth properties, things were looking up for Crown part way through the court’s opinion.  Crown clearly had a “legal interest” in these two assets, but the court noted that that “is only half the battle.”  Crown also needed to demonstrate either “priority of ownership at the time of the offense . . . or that [it] subsequently acquired the property . . . as a bona fide purchaser for value.” 21 U.S.C. § 853(n)(6)(A)-(B).  Crown made no attempt to demonstrate priority of ownership (since a third party cannot successfully assert priority if the property is proceeds of a criminal offense).  Rather, Crown asserted that it was a bona fide purchaser for value, which, under Minnesota law, is "one who gives consideration in good faith without actual, implied, or constructive notice of inconsistent outstanding rights of others."  The court observed that “under Minnesota law, acquiring an interest in property as security for an antecedent debt is a bona fide purchase for value.”  This was Crown’s situation, so one would have expected a ruling in favor of Crown on these last two assets. 

Instead, however, the court focused on a footnote in the Government’s brief, which stated that Crown "knew, or should have known, that the Keystone and Plymouth [P]roperties were subject to forfeiture."  Id. at *14-15.  This was enough for the court to put on the brakes and set the matter for further briefing on what Crown knew about the Petters’ fraud.  We will have to wait to see the ultimate outcome of this battle.

The Government’s forfeiture rights are powerful and are being exercised with increasing frequency.  An entire chapter of The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes by Kathy Bazoian Phelps and Hon. Steven Rhodes is dedicated to discussion of the Government’s forfeiture powers. The discussion includes criminal and civil forfeiture proceedings, third party rights to assert claims in those same assets, the struggles between the Government and trustee and receivers seeking to administer the same assets, and efforts at cooperation and coordination in these types of proceedings.