July 2012 Ponzi Scheme Roundup

Posted by Kathy Bazoian Phelps

July saw news in over 2 dozen Ponzi cases and court decisions in many others. Here are the highlights from the past month – who was arrested, convicted, sentenced, etc., followed by a summary of the more significant legal decisions and pleadings filed in pending cases. This isn’t everything that happened in the world of Ponzi schemes, but it is enough to give you a flavor of the level of activity in just this one month period of time.

PONZI SCHEME CASES

James W. “Bill” Bailey’s Ponzi scheme case saw 42 property owners, who had their property seized by the government in a related forfeiture action, challenge the forfeiture. The property owners contend that a new plea agreement rendered the preliminary forfeiture order invalid and that there is no nexus between their properties and the criminal conduct of Bailey, who is accused of running a $13 million Ponzi scheme in North Carolina.

Steven Bingaman, 55, pleaded guilty to 23 counts relating to his Ponzi scheme. He falsely told his victims that their money would be put in escrow or safely invested, but spent the money instead on his homes, a Las Vegas bookie, and other expenses.

Full Tilt Poker CEO Raymond Bitar, 40, was arrested over an alleged Ponzi scheme where Bitar falsely claimed to Internet poker customers that their money would be safe and would not be mixed with company funds. Bitar pleaded not guilty, was held and then later released on $2.5 million bail. The scheme allegedly involved $430 million received from players.

Robin Brass, 55, was sentenced to 8 years in prison for her scheme which stole $1.9 million from investors.

John Clement, 66, from Southern California, surrendered to serve his 2 year prison term for running a $5 million Ponzi scheme called Edgefund Capital, LLC that he ran out of his house. Edgefund was supposedly a hedge fund that took money from 22 investors.

Brendan Coughlin, 46, and Henry Harrison, 47, were charged in the $485 million Ponzi scheme of Dallas-based Provident Royalties LLC founded by Joseph Blimline that defrauded more than 7,700 oil and gas investors.

John W. Cranney of Belmont, California, was accused of running a Ponzi scheme that defrauded at least 36 elderly victims of $10.4 million, promising them high returns of 6% or more on supposedly safe investments for retirement, which were invested in unregistered securities and that he called promissory notes. He used investors’ money to, among other things, fund his company, Shaklee Corp., that recruits sales people to sell health and personal care products.

Ramon Desage, 61, was arrested on charges of wire fraud and for allegedly soliciting about $75 million from at least 4 investors to fund his lavish lifestyle and payoff gambling debts. Desage, a Las Vegas businessman with a dual Lebanon citizenship, used his company, Cadeau Express, to solicit funds from investors with promises of high returns.

Gordon A. Driver, who lives in Las Vegas and has ties in Southern California, operated a Ponzi scheme using his companies, Axcess Automation, LLC and Axcess Fund Management LLC, that stole $14.3 million from more than 100 people in the U.S. and Canada. Driver was ordered to pay $9.6 million in restitution plus a $31.8 million civil penalty.

Jedidah Duarosan of Hawaii plead guilty to operating a Ponzi scheme that took $882,000 from 6 families, promising them risk-free returns of 5% per month supposedly funded by investments in oil, gold, and real estate.

Archie Larue Evans, 41, of South Carolina, was charged of various crimes for his Ponzi scheme operations of Gold & Silver, LLC, which invested in futures markets through a company named Open E Cry. The alleged scheme, which promised investors a high rate of return, resulted in losses in excess of $2.5 million.

Mark Feathers, 48, and his Los Altos company, Small Business Capital Corp. (known as SB Capital), had their assets frozen by the SEC for operating a Ponzi-like scheme that raised $42 million from more than 400 investors by claiming to invest in mortgages that could provide a 7.5% annual return. SB Capital underwrote loans to commercial properties.

Alan G. Flesher, 64, Wayne D. Flesher, 62, and Nancy Carol Khalial, 64, of Oxnard, California, pleaded guilty to 17 counts in connection with a Ponzi scheme they were running through companies called Unlimited Cash Inc. (UCI) and Douglas Network Enterprises Inc. (DNE). The defendants told victims that UCI would sell ATMs and “Ad Toppers”—computer monitors capable of displaying video advertisements—and DNE would place the devices in commercial locations that would generate income. The defendants took in approximately $41 million over a four-year period from approximately 700 investors, but did not place most of the ATMs and Ad Toppers sold to investors. The loss amount to victims is approximately $27 million.

Celia Gallardo, 42, of San Fernando, California, was arrested and accused of operating a real estate Ponzi scheme that bilked dozens of investors out of over $1 million using her companies Gold Feather Realty and Gold Credit Investments. Gallardo told investors that she would purchase condominiums located in other states that would yield extraordinary short-term returns of as much as 100% in thirty days. Gallardo told investors that their money was safe and she issued them promissory notes evidencing their investment and promised returns.

Allen R. Jacobson who was named as part of an alleged $200 million Ponzi scheme was held in contempt for trying tried to hide assets from a court-appointed receiver. Jacobson failed to turn over $220,000 in tax refunds to the receiver appointed to take over Management Solutions Inc. Jacobson has since returned over $170,000 but had not yet paid over the remaining $50,000. Jacobson, his father and his company took in more than $200 million from about 225 investors for real estate investments, mostly in apartment buildings in various states. Jacobson and his had used their connection as members of LDS Church to solicit 225 investors through a complex web of entities under the umbrella of Management Solutions, Inc. The Jacobsons have entered into a settlement with the SEC although the terms of the settlement are not yet known.

David Lincoln Johnson, 73, of Southern California, was sentenced to 14 years in prison for being one of 3 perpetrators of a $16 million Ponzi scheme. Co-defendants Christiano Kawika Hashimoto, and Catherine Lipscomb, previously pleaded guilty to mail fraud and receiving sentences of 10 years and two years, respectively. Through their companies, Financial Solutions, and Gentech Fabrication, Inc., they defrauded investors, offering a fixed rate of interest ranging from 5% to 20%, payable on a monthly basis. Promissory notes supplied to investors also indicated that their investment was backed by a $100 million government bond.

Chetan Kapur, the sole managing principal of ThinkStrategy Capital Management LLC, a hedge-fund manager who allegedly invested with convicted Ponzi scheme operators Samuel Israel III and Arthur Nadel, was himself charged with fraud.

Thomas E. Kelly was sentenced to 4 years and 3 months plus 5 years supervised release. For 15 years, Kelly lured at least 19 investors to invest at least $1 million in his fictitious entity, Seneca Group.

Stephen J. Klos, 86, a former usher of a Mercer Island Church, pleaded guilty to 10 counts of securities fraud for running a Ponzi scheme that defrauded elderly victims. Klos and Robert Justice, paid later investors in the scheme with money from new clients, and kept money for themselves along the way. Between 10 and 23 victims were affected, and more than $3 million was stolen from church members and others. Klos had been barred from securities and financial dealings in 1992 for running another Ponzi scheme that raised more than $3.4 million. Justice pleaded guilty earlier this year to four counts of securities fraud and received a one-year sentence. Klos faces a sentencing range of 51 to 68 months when he is sentenced in December.

Jeffrey Lowrance, who once lived in Houston Texas, pleaded guilty to charges related to a $25 million Ponzi scheme that he operated by taking advantage of liberal laws in New Zealand. Lowrance set up a shell company, First Capital Savings & Loan, in New Zealand for $130, which he ran from Panama, and he defrauded over 400 victims by promising them up to 7% interest each month by investing in his foreign currency trading scheme. Lowrance kept the money for himself, and it is alleged that he used some of it to fund an unsuccessful religious newspaper called “USA Tomorrow.”

Peter Madoff, brother of Bernard Madoff, remains free on bail until his October 4th sentencing, after pleading guilty and agreeing to serve 10 years in prison. He also agreed to surrender all of his assets, and his Park Avenue co-op is on the market for $4 million. Proceeds from the sale will be turned over to the U.S. Marshals Service as part of his forfeiture agreement.

Brian Keith Miller, 46, admitted to soliciting about $1 million from clients of an investment firm from which he had been fired. Miller had worked as a financial adviser for Anderson and Strudwick, an investment firm, when he was fired over accusations that he misused clients' money. He continued to solicit money from other clients, who said he never told them he'd lost his job.

Ward Onsa, 60, of New Century Investment Management, LLC, was sentenced to 6 ½ years in prison for running a Ponzi scheme in which investors, primarily retirees, lost more than $3 million. Onsa told the New Century investors that their money would be used to purchase securities, futures contracts, and options designed to profit when the Dow Jones Industrial Average reached 10,748. Onsa’s trading theory was that the market would not go above this level. When the market surpassed the 10,748 level, the investments lost their value.

Terrance Osberger, 48, was indicted in connection with an alleged Ponzi scheme that he allegedly ran through Eagle Trades, Ltd., a “high-yield” investment program designed to entice investors with the promise of high returns. At least one investor was promised returns of 1,100 percent over the course of 190 days.

Wayne L. Palmer, 57, owner of National Note of Utah, LC, was the subject of a complaint filed by the SEC in connection with an investment program that took in more than $100 million from more than 600 investors over the past eight years. Palmer and the company are based in West Jordan, Utah. Palmer has solicited investors to purchase two to five-year promissory notes issued by National Note, which were to pay interest at a fixed annual rate of 12% with a minimum investment of $25,000.

Gurudeo ‘Buddy’ Persaud was charged by the SEC with defrauding at least 14 investors of more than $1.1 million with promises of 6 to 8 percent returns. Persuad was investing money through his company, White Elephant, on the basis of lunar movements, mainly relying on an internet service that provided directional market forecasts based on lunar cycles and gravitational pull. His investment strategy was based on the idea that gravitational forces affect mass human behavior and the stock market, and that, when the moon exerts greater gravitational pull on the earth, people feel dejected and are more inclined to sell securities.

Aubrey Lee Price, a Georgia banker who disappeared after writing a suicide letter, was indicted for bank fraud. Price is accused of embezzling over $21 million from a bank in Georgia and for stealing more than $40 million from investors in a Ponzi scheme.

Richard F. Reynolds aka Richard F. Adkins, of Bozeman, Montana, was arrested after being charged with over 20 felonies, including allegations that he operated a pyramid or Ponzi scheme by soliciting investors for a purported foreign currency trading platform through Buffalo Extension and Buffalo Exchange, among other things, which were not registered with any state securities department or the SEC. Investors, many of whom were clerics and pastors, were promised quarterly returns of 100 percent. Reynolds took in $5.4 million from over 140 investors in 21 states and six countries. He has pleaded not guilty and is being held on $10 million bail.

Eric Schmickle, 37, of Cedarburg has admitted to stealing nearly $3 million from investors in a Ponzi scheme, whose victims included his father, brothers and attorneys who worked with his brother. Schmickle, through his businesses Q Wealth Management and Aquinas, traded commodity futures contracts through the Chicago Mercantile Exchange. It is alleged that Schmickle took in $4.2 million from 10 investors. Schmickle agreed to pay $2.9 million in restitution.

Allen Stanford, 62, who was convicted earlier this year of running a multi-billion dollar Ponzi scheme, has been moved to a high security federal prison in Central Florida to begin serving his 110-year sentence. He has been in custody since his arrest in June 2009, and was found guilty of defrauding more than 20,000 investors of $7 billion through the sale of bogus certificates of deposit at his Antigua-based Stanford International Bank. It is reported that according to the orientation handbook for the prison facility, the Coleman II facility, located 50 miles northwest of Orlando, it serves brunch on the weekend, has Bocce ball courts, a music centre and a game room.

Arthur Strasnick, 64, a Florida investment adviser, was sentenced to five years in prison followed by three years of supervised release and ordered to pay $1.9 million in restitution. As president of Backstreet Associates Inc. from 2003 to 2006, he ran a Ponzi scheme that promised investors a "guaranteed" rate of return of 12 percent to 20 percent annually.

Ron Wilson, 64, of South Carolina, and former Anderson County Council member, pleaded guilty in connection with his Ponzi scheme operations of Atlantic Bullion & Coin. He never actually purchased the metal as he promised his investors. More than 900 people invested more than $90 million.

PONZI SCHEME NEWS IN PENDING LEGAL CASES

The SEC lost its battle with SIPA in the Stanford Financial Ponzi case to have Stanford investors covered as “customers.” About 7,000 clients who purchased Stanford International Bank CDs will not be treated as customers and therefore will not receive the benefit of SIPC insurance. SEC v. SIPC, 2012 U.S. Dist. LEXIS 91496 (D.C. July 3, 2012).

California Attorney General Kamala Harris and Irving Picard, the liquidator of Bernard l. Madoff Investment Securities, LLC, have agreed to mediate a dispute regarding Harris’ lawsuit against the estate of Stanley Chais, a target of litigation commenced by Picard for $1 billion allegedly withdrawn from the Ponzi scheme. Harris is seeking $270 million from the Chais estate. Picard contends that only he can collect money for Madoff's Ponzi victims and that Harris’ lawsuit interferes with his exclusive right to recover money for Madoff victims, while Harris contends her suit can proceed because she's using her state policing power to protect consumers from fraud.

Irving Picard, the Madoff trustee, filed a motion asking for approval to make another distribution of recovered funds, ranging from $1.5 billion to $2.4 billion. The appeals period ran on July 16, 2012, on a ruling to deliver $5 billion of settlement funds from Picower to the Madoff estate, which has freed up those funds for distribution to investors. However, many investors have filed objections regarding their claim amounts, seeking claims for time-based damages of interest at 9% since the time when their funds were first invested. If no interest is allowed, Picard would be able to distribute $3.019 billion, or 41.826% of each customer’s allowed claim. However, if Picard is required to reserve 3% for Time-Based Damages, he can only distribute $2.427 billion, or 33.541% of each customer’s allowed claim. If he is required to reserve 9% for Time-Based Damages, he can only distribute $1.493 billion, or 20.563% of each customer’s allowed claim.

The Second Circuit upheld an arbitration award against Goldman Sachs in the amount of $20,580,514.52 for handling of funds in the Bayou Group, LLC Ponzi case. Goldman Sachs Execution & Clearing, L.P., fka Spear, Leeds & Kellogg, L.P. v. Official Unsec. Cred. Comm. of Bayou Group, LLC, 2012 U.S. App. LEXIS 13531 (2d Cir. July 3, 2012)

An $11 million class settlement was approved on a preliminary basis regarding claims arising from the Ponzi case of LandAmerica Financial Group, Inc. The claims against Commonwealth Land Title Co. and others were that they defrauded nearly 400 investors by helping LandAmerica Financial Group Inc. orchestrate a Ponzi scheme that cost the investors $191 million.

Bank of America agreed to pay $5.9 million to settle allegations that it ignored warning signs in the Nevin Shapiro investment fraud, a Florida Ponzi scheme. The bank is seeking a court order banning any future lawsuits against it related to Shapiro.

Two investors, Joshua M. Berman and Richard Born failed in their attempts to recover $1.25 million and $10.5 million respectively, from fund manager J. Ezra Merkin for money lost in Bernard Madoff's Ponzi scheme. An arbitration panel denied Berman’s claim and allowed only $1 million plus interest to Born. In the meantime, Merkin agreed to pay $410 million to settle a lawsuit brought by New York state that accused Merkin of secretly steering client money to Madoff. Berman and Born could still recover losses from the Attorney General’s settlement or from Irving Picard, the Madoff trustee, despite the arbitration. Merkin also agreed to pay an additional $110 million to investors.

A Minnesota Court of Appeals ruled that 19 banks that were victims of Corey Noel Johnston’s $135 million Ponzi scheme will divide the remaining funds based on their net investment and leave out the interest owed. Johnston and his company, First United Funding, had sold “loan participations” to banks, having the banks participate in loans for commercial real estate deals that already had been sold to other banks. After the scheme unraveled, the victim banks disagreed on how distributions of any recovered assets should be calculated. A district court ruling said that recovered assets would be distributed based on each bank's net investment. Some of the banks that had invested with First United for a longer period of time argued they would have received more money from the receiver if the payouts were based on principal and interest. The appellate court noted that calculations by the court-appointed receiver in the case show that 10 banks would get more money back using the interest-included method, and nine would get more back with the net-investment method.

A U.S. District Court in Dallas ruled that Allen Stanford’s U.S. court-appointed receiver may keep control of the process to collect and distribute Stanford’s assets to victims, overruling efforts by the Antiguan liquidators to administer those assets. The court said that it was "manifestly clear" that the United States was the "nerve center" of Stanford's estimated $7 billion fraud, which centered on bogus certificates of deposit.

The Ponzi Perpetrator’s Art Dealer? The Endless Scope of Clawback Claims

Posted by Kathy Bazoian Phelps

Sheila Gowan, the trustee of Dreier, LLP (“DLLP”), has filed a fraudulent transfer action against Marc Dreier’s personal art advisor. Gowan asserts that Marc Dreier caused DLLP to make a series of transfers to the defendant totaling $1,940,915.00 for Mark Dreier’s personal obligations and that DLLP received no consideration for these transfers. The Trustee asserts that Dreier retained the defendant to advise him on his art purchases for his personal collection and that DLLP was not a party to any agreement with the defendant.

The Trustee’s complaint asserts a claim for avoidance and recovery of the payment as constructive fraudulent transfers under 11 U.S.C. § 548(a)(1)(b) and § 550 on the theory that DLLP did not receive any value from the defendant’s services in exchange for the money DLLP paid to the defendant. The complaint also objects to the defendant's proof of claim under § 502(d), which requires the court to disallow a claim filed by a party from whom property is recoverable under §§548 or 550.

It will be interesting to see what defenses the defendant asserts to this claim. Undoubtedly, the Trustee will have little difficulty in proving her case-in-chief. Presumably, the Trustee has the DLLP checks payable to and negotiated by the defendant, so the Trustee’s case will be complete when she establishes either: (1) that DLLP was insolvent at the time of the transfers; (2) that the transfers left DLLP with unreasonably small capital; or (3) that DLLP intended to incur or believed that it would incur debts beyond its ability to pay as such debts matured.

The defendant may assert a good faith value defense under § 548(c), but even that will be challenging for her. While she may have acted in good faith and without knowledge or notice of Dreier’s fraud, that is not enough. The defense will only help her to the extent that her services provided value to DLLP, and that may be tough for her to prove since the services rendered by the defendant were allegedly for the benefit of Dreier individually and not for DLLP.

This case highlights the difference between preferences and fraudulent transfers from the perspective of the transferee. The Trustee does not allege that the defendant did anything wrong or out of the ordinary course of the defendant's business. Unfortunately for the defendant, however, there is no ordinary course defense for fraudulent transfer claims as there is in a preference action. See 11 U.S.C. § 547(c)(2).

A fraudulent transfer claim has a different objective than a preference claim, where the ordinary course of business makes a difference. The purpose of the ordinary course exception in preference actions is “to leave undisturbed normal financial relations, because it does not detract from the general policy of the preference section to discourage unusual action by either the debtor or [its] creditors during the debtor's slide into bankruptcy.” Lawson v. Ford Motor Co. (In re Roblin Indus., Inc.) 78 F.30 (2d Cir. 1996).

In constructive fraudulent transfer actions such as the Trustee’s claims against the defendant, however, the purpose and perspective is different. Fraudulent transfer law considers liability from the perspective of the financial condition of the debtor to ensure that the debtor hasn’t given away its property with no return value being provided in exchange. Whether the transaction is ordinary or unusual, therefore, not an issue.

The defendant may be out of luck in this case, even though all she did was accept payment for the services she provided. In the fraudulent transfer context, however, defendants are stuck with the option of demonstrating both good faith and value, and if the money came from an entity different from the entity that received the value, the value element of the defense cannot likely be established.

Gowan’s suit was filed in the United States Bankruptcy Court for the Southern District of New York. (Adversary Proceeding No. 12-01717)

A complete discussion of fraudulent transfer claims, preference claims, and the defenses to them may be found in The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes (LexisNexis 2012).

Hedge Fund Liability for Inadequate Due Diligence

Posted by Kathy Bazoian Phelps

Due diligence is not just for the buyer, auditor, or investor anymore. It is for everyone, including the hedge fund investing in sub-hedge funds. One court recently found a hedge fund liable for failing to conduct adequate due diligence and then misrepresenting to its investors the amount of due diligence that it actually conducted. Schwarz v. ThinkStrategy Capital Management LLC, 2012 U.S. Dist. LEXIS 79453 (S.D.N.Y. May 31, 2012)

Investors in a hedge fund, ThinkStrategy Capital Management LLC, sued ThinkStrategy and its sole member/managing director, Chetan Kapur, for misrepresenting the amount of due diligence they conducted in the other hedge funds in which they were investing (the “sub-hedge funds”). The plaintiff investors brought claims under New York state law for fraud, negligent misrepresentation, and breach of fiduciary duty against ThinkStrategy and its director.

Many of the sub-hedge funds into which the defendants poured the investors’ funds were fraudulent, causing the investors to suffer losses. The investors alleged that had the “sparse due diligence practices been truthfully disclosed to them, they would never have invested” with the defendants. Additionally, the investors alleged that the defendants concealed problems from them after they had invested which, if disclosed, would have caused the investors to immediately redeem their investments.

The court found for plaintiffs and awarded them $3,068,483, which was the total amount of plaintiffs' investment, net of redemptions that the investors had received.

So what did ThinkStrategy do wrong that led to liability? In summary, the court found that “ThinkStrategy's due diligence was cursory and that this diligence entailed virtually no independent verification of representations made to it by prospective sub-funds.” The decision runs through all kinds of misrepresentations that were made about the due diligence that was done, and the court found that the due diligence conducted by ThinkStrategy did not conform to industry standards. The court found that the four central misrepresentations were that the defendants: “(1) conducted background and reference checks on prospective sub-fund managers; (2) performed in-person interviews of sub-fund managers; (3) invested only in audited sub-funds; and (4) invested only in sub-funds with reputable service providers.”

The testimony revealed that “industry-standard due diligence on these funds would have revealed various red flags and irregularities that would have precluded a rational manager from investing client funds in them.”

The problem here was that ThinkStrategy represented that it was doing substantial due diligence. In reality, it wasn’t. And, as it turns out, seven of the twenty funds that ThinkStrategy invested in were fraudulent.

The court found that the defendants were liable for common law fraud.

The evidence established that Kapur made knowingly false representations to plaintiffs about a variety of subjects. . . The Court also readily finds that these statements were made for the purpose of inducing plaintiffs to rely, by investing in the TS Fund, and that plaintiffs did justifiably rely on those statements. The Court also finds that these false representations caused injury to plaintiffs: The Court fully credits plaintiffs' testimony that, but for these representations, they would not have invested in the TS Fund.

The court also found that the defendants were liable for negligent misrepresentation.

The defendants undeniably had a duty, as a result of their fiduciary role towards the [investors], to give them correct information. Defendants made false representations to the [investors], as set out at length above. The information in question (as to ThinkStrategy's due diligence practices generally, and also as to whether the TS Fund had invested in Bayou) was known by defendants to be desired by the [investors] for a serious purpose. The [investors] intended to rely and act upon the information supplied by the defendants. And, the [investors] reasonably relied on the false and incomplete information supplied by the defendants to their detriment.

The court additionally found that the defendants were liable for breach of fiduciary duty.

The plaintiffs had entrusted their savings to ThinkStrategy and Kapur, and defendants had a duty not only to handle plaintiffs' money with due care but also to make sure that any representations made to plaintiffs with regard to ThinkStrategy's investment of their funds were followed through on . . . . Here, that duty was breached when defendants failed to follow through on various false and misleading representations to plaintiffs, chronicled above, and when defendants failed to correct those representations. For the same reasons as discussed above, defendants' false statements and representations caused damages to plaintiffs, by inducing them to invest money with ThinkStrategy which was later lost, and by leading them not to exercise their right to redeem their investments. The Court therefore finds for plaintiffs on their claim for breach of fiduciary duty.

The court went further to find that the managing director of ThinkStrategy was individually liable for these torts.

When a corporate officer commissions a tort through misfeasance or malfeasance (as opposed to a mere failure to act), that officer may be held individually liable "regardless of whether the officer acted on behalf of the corporation in the course of official duties and regardless of whether the corporate veil is pierced."

The court rejected the defendants’ defense that the Offering Memorandum contained disclaimers that put investors on notice not to rely on statements or representations made, along with the defense that plaintiffs did not demonstrate loss causation as part of the breach of fiduciary duty claim.

The only good news for the defendants was that the court declined to impose punitive damages, noting that:

[A]lthough the evidence revealed dismaying misconduct by Kapur, amply justifying liability for fraud, negligent misrepresentation, and breach of fiduciary duty, it did not, in the Court's view, meet the higher bar of moral culpability required under New York law for the imposition of punitive damages. There was no evidence presented, for example, that Kapur absconded with plaintiffs' money. On the contrary, the evidence suggests that he, too, was decimated by the collapse of the sub-funds, and there is no evidence that Kapur knew of their wrongful machinations, as opposed to his being a gullible, negligent, and inept investor. Thus, although the Court easily finds that defendants engaged in tortious, callous, and unprofessional behavior, plaintiffs have not proven that defendants' conduct reaches the level of gross, willful, or wanton fraud necessary to justify imposition of punitive damages.

A thorough discussion of claims for fraud, negligent misrepresentation, and breach of fiduciary duty may be found in The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes (LexisNexis 2012) by Kathy Bazoian Phelps and Hon. Steven Rhodes.

Is the “Ponzi Scheme Presumption” Expanding into New Territory?

Posted by Kathy Bazoian Phelps

Most courts endorse and affirm the use of the “Ponzi scheme presumption” against recipients of transfers from the Ponzi debtor. These courts hold that, in an actual fraudulent transfer case, the transferor’s fraudulent intent is presumed if the trustee establishes that the transferor was perpetrating a Ponzi scheme and that the transfer was made within the scope of the scheme. See, e.g., Wing v. Dockstader, 2012 U.S. App. LEXIS 11390 (10th Cir. June 6, 2012); Perkins v. Haines, 661 F.3d 623 (11th Cir. 2011); Donell v. Kowell, 533 F.3d 762 (9th Cir. 2008); SEC v. Res. Dev. Int’l, LLC, 487 F.3d 295, 301 (5th Cir. 2007).

The rationale for the broad brush application of a presumption of actual intent in a Ponzi scheme is that “transfers made in the course of a Ponzi scheme could have been made for no purpose other than to hinder, delay or defraud creditors.” Bear, Stearns Sec. Corp. v. Gredd (In re Manhattan Inv. Fund, Ltd.), 397 B.R. 1, 8 (S.D.N.Y. 2007). Such a presumption can be a powerful tool in a Ponzi scheme case, as it eliminates the need to prove actual intent to hinder, delay or defraud by the more customary “badges of fraud” analysis that uses circumstantial evidence.

Some courts have questioned the broad scope of the Ponzi scheme presumption. As one court put it, “The Ponzi scheme presumption must have some limitations, lest it swallow every transfer made by a debtor, whether or not such transfer has anything to do with the debtor’s Ponzi scheme.” Kapila v. Phillips Buick- Pontiac-GMC Truck, Inc. (In re ATM Financial Services, LLC), Bankr. LEXIS 2394, at *17-18 (Bankr. M.D. Fla. June 24, 2011). The ATM Financial court found that the presumption applies only to transfers made in furtherance of the Ponzi scheme.

A recent case, however, moves in the opposition direction and has expanded the application of the Ponzi scheme presumption in a significant way. In Stoebner v. Ritchie Capital Management, L.L.C. (In re Polaroid Corp.), 2012 Bankr. LEXIS 1926 (Bankr. D. Minn. April 30, 2012), the court applied the presumption of intent to defraud to a transferor who was not even directly involved in a Ponzi scheme.

The decision arose out of the Petters Ponzi scheme group of cases. Petters had granted a security interest to the defendants in his capacity as chairman of Polaroid, and the trustee sought to avoid that transfer as an actual fraudulent transfer. Polaroid was not, however, directly involved in Petters’ Ponzi scheme. Rather, Petters ran his scheme through Petters Company, Inc., and other entities. Nevertheless, the court held that the presumption did apply to the transfer made by Polaroid. The court reasoned:

[Petters’] intent is attributed to the Polaroid Corporation as transferor, because he controlled that artificial entity. And the point of the Trustee's theory is that Tom Petters also controlled the whole structure centering around PCI, through which the Ponzi scheme had been transacted to the detriment of its final victims.

* * *

The Trustee’s expanded conception of the presumption is premised on common control within a larger structure. When this is the governing consideration, the automatic inference of fraudulent intent is made when the person in common control effects the transfer by the entity extrinsic to the Ponzi scheme, but in order to further the scheme as it has been maintained through the central entity.

Id. at *48-50 (emphasis in original and footnote omitted).

Simply stated, because Petters orchestrated the challenged transfer to further the Ponzi scheme, the Ponzi scheme presumption applied, even though the entity that made the transfer was not otherwise involved in the fraud. “The proof lies in a motivation: a manifest wish by the controlling person to prolong the imposture of the Ponzi scheme (thus ‘furthering’ it), by effecting the transfer by the controlled, related company.” Id. at * 51-52.

The court recognized that the creditors that were prejudiced by Polaroid’s grant of the security interest were not creditors or victims of the Ponzi scheme.  Still, it observed, “that does not mean the basic willingness to prejudice others’ rights is absent.”

In justifying its expanded use of the Ponzi scheme presumption, and noting that, “There is nothing untoward about using the presumption in this way,” the court in dicta attempted to leave a back door open to challenge the expanded use of the presumption. It stated, “The resulting inference, satisfying the intent requirement of the statute, can always be rebutted by hard proof of contrary intent, i.e., a credible motivation to make the transfer that is grounded in good economic reason, as to the transferor-entity.” Id. at *52 (citing Kelly v. Armstrong, 206 F.3d 794, 799, 801 (8th Cir. 2000)).

The problem with this invitation to challenge the expanded use of the Ponzi scheme presumption in dicta is that the cited case, Kelly v. Armstrong, is not a Ponzi case, and every other court addressing the Ponzi scheme presumption has held that it establishes actual fraudulent intent as a matter of law. See, e.g., Johnson v. Neilson (In re Slatkin), 525 F.3d 805, 814 (9th Cir. 2008); Hayes v. Palm Seedlings Partners-A (In re Agric. Research & Tech. Grp., Inc.), 916 F.2d 528, 534 (9th Cir. 1990); Gredd v. Bear, Stearns Sec. Corp. (In re Manhattan Inv. Fund, Ltd.), 359 B.R. 510, 517-18 (S.D.N.Y. 2007), aff’d in part and rev’d in part on other grounds sub nom. Bear, Sterns Sec. Corp. v. Gredd, 397 B.R. 1 (S.D.N.Y. 2007); Terry v. June, 432 F. Supp. 2d 635, 639 (W.D. Va. 2006); Picard v. Madoff (In re Bernard L. Madoff Inv. Sec. LLC), 2011 Bankr. LEXIS 3578, at *15 (Bankr. S.D.N.Y. Sept. 22, 2011); Bauman v. Bliese (In re McCarn’s Allstate Fin., Inc.), 326 B.R. 843, 850 (Bankr. M.D. Fla. 2005).

Despite that misstep, however, it seems likely that the court’s conclusion that the trustee can use the Ponzi scheme presumption in seeking to avoid Polaroid’s grant of a security interest to the defendants due to Petters’ intent to further his Ponzi scheme will withstand scrutiny on appeal. 

NY Times Column Criticizing Madoff Trustee Flawed on Many Levels

Posted by Kathy Bazoian Phelps

A recent New York Times article by Andrew Ross Sorkin severely and unfairly criticizes Irving Picard, the trustee for the Bernard L. Madoff Ponzi scheme. It states, “Mr. Picard has had much more success collecting money for himself and a dozen law firms and consultants than any victim of Mr. Madoff’s crime.” A copy of the article is attached here.

These remarks appear to be intended to inflame the public. Irving Picard is the neutral fiduciary charged with collecting funds for investors. He is not Bernie Madoff. Picard did not run a Ponzi scheme. The New York Times article makes sweeping, conclusory statements about Picard and his professionals, sensationalizing the compensation paid to them, without considering the facts, the law, or the process of unwinding a Ponzi scheme of this size and scope. I have no affiliation with Picard or his firm, although he did endorse a book that I co-authored, The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes (LexisNexis 2012). I do, however, have a strong familiarity with Ponzi cases and the work required to unravel them. As a rebuttal to the New York Times’ attempt to unfairly prejudice the public against the team charged with undoing Madoff’s epic fraud, I present the following insights into Ponzi schemes and the Madoff Ponzi scheme in particular.

First, the article states that Picard and his professionals have been paid $554 million and that the victims have only “actually received” $330 million. As written, this is quite misleading. Picard has actually recovered $9.1 billion. This is not a small number. The reason he hasn’t paid that to victims is that those funds are tied up in connection with pending appeals.

The professional fees paid to date are 6.1% of the recoveries. Picard himself has been paid $5.1 million, which is 0.06% of recoveries. This is for 3½ years of work. Is this really so outrageous? It’s a good thing he didn’t hire contingency counsel at the going rate of 40%. Those fees would have been a whopping $3.64 billion!

Second, let’s consider the size of the estate that Picard is administering. As noted, it is $9.1 billion in recoveries so far, with claims of about $17.3 billion in principal investments. Incredibly, the New York Times criticizes Picard for attempting to recover more than the lost principal, stating: “In the last several years, Mr. Picard has brought more than 1,000 cases seeking more than $100 billion on behalf of victims, despite acknowledging that only about $17.3 billion had actually been invested by customers.” Yes, Picard is trying to recover funds in excess of the investors’ principal investments. But clearly this is so that he can distribute recoveries to investors due to their lost expected profits, which could be as much as $65 billion.

Wouldn’t Madoff’s victim sharply criticize Picard if he decided to shut down recovery efforts when he had just enough to pay the investors’ principal claims, but not their lost profits? The investors lost the use of their money by investing with Madoff. Shouldn’t Picard at least try to get them some interest if there are recoveries available under law for that purpose? Is Picard to leave money on the table by not pursuing additional recoveries for defrauded investors just because it is costing a small fraction of those amounts to try to collect those amounts?

Third, the New York Times article adopts, without question or analysis, the lower court decisions dismissing some of Picard’s claims. But those decisions are presently on appeal. The issues on appeal are issues being raised by other trustees and receivers across the nation in other Ponzi cases, and many of them have been brought with great success. So let’s wait to see the outcome of these appeals before we judge Picard’s strategy.

Picard may or may not prevail in these appeals. Still, can we really condemn him for trying to recover money from financial institutions and others who he alleges knew or should have known about Madoff’s fraud and about the billions of dollars of fraudulent funds that passed in and out of their accounts? If Picard’s claims are dismissed on standing or in pari delicto grounds, he would be merely one of many frustrated trustees denied the opportunity to recover money for defrauded investors on arguably unfair technicalities, even in the face of clear liability.

Perhaps it is not Picard whom we should be criticizing, but rather the system that allows wrongdoers to escape liability while defrauded investors are left with potentially shattered lives. The issues of standing and in pari delicto are complex issues, and they have been applied very unevenly by courts across the country. Let’s not disparage Picard for trying to recover money for investors. Let’s instead examine and reconsider the statutory and case law that mandates these often inequitable results for defrauded investors.

Fourth, let’s put the Madoff case in perspective in relation to the rest of the world. A study prepared by the International Monetary Fund for 2011 shows that 130 of the ranked 182 countries in the world have a Gross Domestic Product greater than $9.1 billion. That means that Picard now manages funds in an amount greater than the GDP of about 30% of the world’s countries. If we look at the total potential size of this estate of $65 billion, then Picard is working in the territory of the top 64 countries in the world. So why all the criticism over Picard’s $850 hourly rate? CEOs of much smaller corporations are paid well over $5.1 million for just one year’s worth of work, and Picard has been working at this for well over 3 years now.

Finally, the full scope of the services that Picard and his professionals have provided is, frankly, overwhelming. Picard’s Sixth Interim Report filed last November reveals much about what Picard has been doing. A small window into the size of the Madoff case is found in a few interesting numbers from that report, as of September 30, 2011:
     -Picard received and reviewed 16,518 customer claims.
     -Picard and his professionals fielded more than 7,500 hotline calls from claimants and their representatives.
     -Picard filed 2,310 objections to claims.
     -In lieu of litigation and its expenses, Picard reached agreements with approximately 440 customers, recovering over $1.7 billion.
     -There is international investigation and litigation in over a dozen countries.

A copy of Picard’s report is attached here.  And this is just a snapshot of what Picard did during one reporting period.  This does not include the massive number of settlements and lawsuits that Picard and his professionals have handled successfully to date in achieving recoveries for Madoff’s victims.

The article concludes with this seemingly uneducated speculative remark:

Nobody is asking Mr. Picard or his legal team to do all this work pro bono.  But given the amount of money at stake and the epic size of the crime, one would hope that he would have pursued a more effective legal strategy that would have made a lot more money for the victims than the lawyers.

The reader is left asking the following questions:

          What is the concept for a “more effective legal strategy”?

          Will that “more effective legal strategy” recover funds for investors?

          Will that “more effective legal strategy” cost any money to implement?

Let’s remember that Picard is not the bad guy here.  He is the court-supervised fiduciary managing an estate the size of a small country with an army of necessary professionals to assist him navigate his way through the morass that Madoff left behind.

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.

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.

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.

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.

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.

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.