Evaluating Ponzi Schemes
Advocate, Vol. 38, No. 2
By: Ara Jabagchourian
It is obvious that investors suffer when they enter into a Ponzi scheme. This article suggests how to find out where the money went and how to try to recover it.
From 2008 through 2010, it seemed that every time you opened a newspaper or turned on the televised news, you could not help but see another Ponzi scheme being brought to light. Madoff and Stanford have unfortunately become household names for their roles in some of the biggest financial-fraud schemes ever seen in the United States. In 2008, about 40 Ponzi schemes were exposed and shut down by regulators and law enforcements. In 2009, over 150 such fraudulent schemes were exposed as tens of thousands of investors lost more than $16.5 billion. In 2010, it is estimated that over 250 large Ponzi schemes are being investigated. Despite not being reported on as often by the media, Ponzi schemes keep sprouting up all over the country.
Undoubtedly, many attorneys whose focus has been on representing victims of financial-fraud matters have come face-to-face with victims of Ponzi scheme in the last two years. Outside of the initial considerations associated with the client from a civil litigation standpoint, one of the initial questions that springs into mind is, “Where did the money go?” The second question that most inevitably is asked is, “Who else was involved?” The answers to these questions are typically intertwined and require a clear understanding on how the scheme worked to be able to understand the number of participants and their qualitative role in it. This article sets out to provide a basic framework on how to go about assessing and if moving forward, providing potential avenues in prosecuting a Ponzi scheme case.
What is a Ponzi scheme?
The notion of a “Ponzi” scheme derives from the infamous 1920s swindler, Charles Ponzi. He executed an enterprise to obtain profits through arbitrage in international reply coupons. These coupons could be cashed in foreign countries. The difference in rates of the coupons between Italy and the United States exceeded 400 percent. So Charles Ponzi sent money to Italy and had his relatives begin to purchase international reply coupons and send them to him in the United States. When Ponzi attempted to cash in the coupons, he ran into bureaucratic red tape. However, this did not stop Ponzi from moving forward with his enterprise. Even though he was not getting the coupons cashed, Ponzi kept promoting the “investment” and its high returns. As his business began to take off, Ponzi hired agents and paid them commissions based on the amount of money they had brought in. Eventually the scheme collapsed and he pled guilty to a federal charge of mail fraud and was eventually convicted of larceny in his third state court trial.
A Ponzi scheme is defined as a fraudulent investment operation that pays its investors returns from their own money or money of others rather than through actual profits earned. These schemes stay afloat as long as new investors join the scheme. Where they fail is when the influx of new monies ceases. It is no coincidence that the recent rash of Ponzi schemes that came to light came around the time the economy took a huge hit.
The nature of the modern Ponzi scheme varies from case to case, but they all have common characteristics. The modern Ponzi scheme promises either high or constant returns, typically through promissory notes or through monthly or quarterly statements demonstrating inflated returns. These returns typically have no relation to the returns found in the open market, such as the S&P. Another thread that exists in these schemes is that they seem to target either a particular ethnic group or religious group and the scheme spreads like a wildfire through the network. The built-in trust of those in these groups exacerbates the problem as real scutiny of the scheme is diminished based on the referrals from close friends and relatives.
Tracing the assets from the orchestrator
From a civil-litigation standpoint, a big question an attorney faces from the initial client meeting is the existence and size of any remaining assets. The modern Ponzi scheme usually operates through a fictional entity, either a corporation or a limited-liability company. By the time the scheme is exposed, these entities are nothing more than hollow shells. More sophisticated schemes use many layers of companies which tend to function merely as alter egos of one another. All of these companies should also be explored for the existence of assets and if need be, the ability to pierce the corporate veil to satisfy the claims.
The orchestrator himself is also a source of recovery as liability attaches to all aiders and abettors. Typically, the orchestrator and his close family members have lived a lavish lifestyle, including ownership of luxury homes, amassed a treasure trove of jewelry and a fleet of high-dollar vehicles. These assets can be inferred to have been derived directly from the scheme as it is highly unlikely that a legitimate business enterprise was used to acquire these items.
Bank and investment accounts are also other avenues of tracing where the assets have gone. I have found that bank statements help lead to some of the assets, which are no longer in the bank accounts themselves. Seek to obtain bank records going back at least two years from the time the scheme broke, and you may see wire transfers to other accounts. You may also see large cash withdrawals which themselves raise several questions. In order to recover for your clients, you will most likely have to undertake an extensive effort to track the liquid assets, probably with the help of a foensic accountant.
The schemer’s accoutant is another fountain of information. The accountant can have information not only related to assets related to the entity operating the scheme, but also personal assets related to the schemer himself. You may find insurance policies for jewelry, information related to individual bank accounts, safe deposit boxes, etc. from the accountant.
These are all avenues on where to look to see if it will be worth the client’s and your time to pursue a civil action against those that are directly liable. However, as discussed below, you should also look to see if there are other avenues of recovery from third parties who may have been functioning as aiders and abettors to the Ponzi scheme.
Given the highly-unlikely prospect that the orchestrator of the scheme will have enough in assets, liquid or otherwise, to compensate all the victims of the scheme, one is forced to determine if others were involved as aiders and abettors. Applying secondary-liability theories in Ponzi scheme cases is a very effective tool in at least moving down the path of getting full recovery for your clients. As the former Supreme Court Justice and Chairman of the Securities and Exchange Commission wrote about secondary liability in fraudulent financial enterprises:
But just as a fine natural football player needs coaching in the wiles of the sport, so, too, it takes a corporation lawyer with a heart for the game to organize a great stock swindle or income tax dodge and drill the financiers in all the precise details of their play. Otherwise, in their natural enthusiasm to rush in and grab everything that happens not to be nailed down and gaurded with shotguns they would soon be caught offside and penalized, and some of the noted financiers who are now immortalized as all-time all-American larcenists never would have risen beyond the level of petty thief or short-change man.
(William O. Douglas, Directors Who Do Not Direct, 47 Harv.L.Rev. 1305, 1329 (1934) (quoting Westbrook Pegler, N.Y.World Telegram, Jan. 24, 1923, at 19).
As Justice Douglas noted, no fraudulent scheme of significance is done alone.
Both federal and California state cases have dealt with many scenarios where secondary actors have faced potential liability associated to financial fraud. The United States Supreme Court held that investors may not sue a third party under section 10 of the Securities Exchange Act for those who aided and abetted in misreprsentation made by the defendant when the third party did not make the representation itself, but can be sued as an aider and abettor under state fraud laws. (Stoneridge Investment Partners, LLC v. Scientific Atlanta, Inc. (2008) 552 U.S. 148.)
In Stoneridge Investment Partners, a cable provider orchestrated wash sales with its supplier of cable boxes to help inflate its quarterly reports to meet Wall Street expectations. The lead plaintiffs sued the cable box supplier under section 10, alleging that these wash sales were executed to skirt around auditors so that the financial reports could be made public. The Supreme Court held that in a criminal action, the Securities and Exchange Commission could prosecute the third-party supplier, but there is no such private right of action under section 10. If your case faces potential violations of the Securities Exchange Act and you have evidence of aiding and abetting, allege common law fraud.
A California case sought to hold financial institutions liable for an alleged money-laundering scheme perpetuated by a purported investment house. (Casey v. U.S. Bank Nat’l Assoc. (2005) 127 Cal.App.4th 1138, 1144-45.) In order to allege aiding and abetting in a tort, the plaintiff must allege either: that the actor knows that the other’s conduct constitutes a breach of duty and gives substantial assistance or encouragement to the other to so act; or gives substantial assistance to the other in accomplishing a tortious result and the actor’s own conduct, seperately considered, constitues a breach of duty to the third person. (Id. at 1144, citing Saunders v. Superior Court (1994) 27 Cal.App.4th 832, 846.) The Casey court stated that a bank’s “ordinary business transactions” can satisfy the substantial assistance element of an aiding and abetting claim if the bank actually knew the transactions were assisting the customer in committing a specific tort. (Id. at 1145.) Proving knowledge is the key to establishing liability against financial institutions that have aided or encouraged the fraudulent scheme.
Shareholders can also be held liable in their conduct of aiding and abetting with the board of directors’ breach of fudiciary duties. (Hechman v. Almanson (1985) 168 Cal.App.3d 119, 127.) In Heckmann, the court upheld a preliminary injunction against a shareholder who sold the Disney Corporation stock valued 50 percent over market value so that the Board of Directors could maintain control of the company rather than face a hostile takeover, and by doing so, substantially increased the debt load of the company. The court held that this was sufficient to sustain a claim against both the directors and the shareholder.
Attorneys involved in a scheme are also not immune from liability. (Panoutsopoulos v. Chambliss (2007) 157 Cal.App.4th 297.) “An attorney may be held liable for conspiring with his or her client to commit actual fraud…” (Id. at 306.) However, pursuant to California Civil Code section 1714.10, a party must seek leave of the court where they seek to sue an attorney for civil conspiracy with his or her client. There are two exceptions to the requirement of having to seek leave of court set out in the statute: the attorney has an independent legal duty to the plaintiff; or the attorney’s acts go beyond the performance of a professional duty to serve the client and involve a conspiracy to violate a legal duty in furtherance of the attorney’s financial gain. Although no liability was found to have been properly alleged in Panoutsopoulos, the case sets out the various ways attorneys can be held liable under conspiracy claims.
These four cases provide some guidance in evaluating potential secondary targets in a Ponzi scheme. Although there may be some reluctance, looking to attorneys who participated in the scheme at any level should be carefully analyzed. Attorneys can be brought in to the suit if they have done something associated with the scheme. My office has come across counsel who have done what appears to be less than arm’s-length transactions with the schemer that they represent, which diluted the pool of assets. We have also seen counsel who represented the fraudulent entity that perpetrated the fraud, send letters out to the defrauded investors claiming that they are seeking on their behalf to recover the funds of the defrauded investors, while defending a lawsuit brought by some of the defrauded investors.
As for evaluating financial instisutions as potential targets, you would need to establish the groundwork to build an inference of knowledge by the bank of the scheme. It is highly unlikely that you will be able to get direct evidence of knowledge against a financial institution (unless you have an internal whistel blower). Therefore, you will want to attempt to get the institution’s policies and practices on how it is supposed to go about handling particular transactions that are in question. If you demonstrate consistent and prolonged failures to follow the bank’s own policies in the case of the Ponzi-scheme client, you are on your way to erecting an inference of knowledge.
Do not overlook agents who were involved in the promotion of the scheme. Just as in Charles Ponzi’s time, agents are encouraged to spread the word through commissions or kickbacks. My office has come across several schemes where the victim’s own accountant has referred them to the scheme and has received a “referral fee.” These feeders should also be assessed to see if they knew or should have known of the fraudulent enterprise. In fact, a higher fiduciary standard may be applicable to them, depending on the context of the relationship.
A serious look must be made of related business to the schemer. As many past cases have shown, these companies tend to be the alter ego of the orchestrator. The law of alter ego allows a party to pierce the corporate veil and pursue the shareholders of the corporation based on the manner in which they have dealt with the corporation. (Associated Vendors, Inc. v. Oakland Meat Co. (1962) 210 Cal.App.2d 825). The analysis of alter ego is one of equity. Factors that lend to alter ego liability include the commingling of corporate funds, failure to observe corporate formalities including maintaining minutes, and failure to contribute sufficient capital. (Id.; Mid-Century Ins. Co. v. Gardner (1992) 9 Cal.App.4th 1205, 1212-1213.) Where injustice would result but for the finding of alter ego liability, courts tend to find for piercing the veil, especially in the context of a tort. (Mesler v. Bragg Management Co. (1985) 39 Cal.3d 290, 300; Cascade Energy & Metals Corp. v. Banks (10th Cir. 1990) 896 F.2d 1557, 1577.) “The essence of the alter ego doctrine is that justice be done.” (Mesler, supra, 39 Cal.3d at 301.) Ultimately, alter-ego liability is a two-step process: establishing some of the “Associated Vendors” factors; and that is injustice will occur if the veil is not pierced.
What I have come to see in these schemes is that the orchetrator has control of several corporations. The orchestrator typically layers the ownership of the companies in a way to protect his own assets. For instances, Company 1 holds all the shares to Company 2 who holds all the shares for Company 3. What you typically find in these schemes is that between these corporations, there is rampant commingling, overlap in officers and directors and that all the companies are severely undercapitalized. You will also find that if any board meetings exist, it is usually the “parent company” who is making the decisions for all of the companies. Assessing the viability of an alter ego theory regarding these secondary companies may provide some assets for the victims of the financial fraud.
No scheme of any significant magnitude can be executed alone. The sophisticated schemes add perceived legitimacy to themselves by including numerous layers of accountants, attorneys, officers, and other companies. These other “persons” need to be explored to understand whether or not liability can be triggered against them.
Although the Ponzi scheme would only be concocted if the orchestrator and the participants can successfully pull monies out of the stream of income for themselves, if the scheme drags out long enough, some of the earlier investors may actually come out ahead. Obviously, by definition, if it is a Ponzi scheme and there are some winners, there will be many more losers to support them and the schemers. In essence, the investors who came our ahead had earned false profits.
Given that many investors had received false profits which were actually monies coming from new investors, in the context of bankruptcy or the appointment of a receiver, “clawbacks” may be applied. Clawbacks are efforts, typically by an appointed receiver who seek to recover the false profits obtained by innocent investors who actually gained monies from their investment in the scheme, usually those who have invested in the Ponzi scheme long ago. (See Janvey v. Adams (5th Cir., 2009) 588 F.3d 831, 834; SEC v. Wealth Mgt. LLC (7th Cir., 2010) 2010 U.S. App. LEXIS 25437 pp. *27-28 fn. 8.) The goal of the clawback is to attempt to make all investors whole in the amount of their principal investment (or on a pro rata basis), obviously not including the false return that was assigned to their investment. If a receiver is appointed, a clawback seeks an action against each and every innocent investor who came out ahead, to recoup the false profit they have obtained. This can be a time consuming and costly enterprise.
The potential of a clawback is another factor that you may need to look to in determining whether of not your client had recovered his initial investment in the scheme and may be exposed to liability himself. If so, any monies earned above the initial investment may be subject to a clawback in the matter is pulled into bankruptcy or if a receiver is appointed.
The areas of inquiry in both evaluating and prosecuting a Ponzi scheme are multifaceted. This article serves only to raise some of the issues that would need to be assessed in many of these schemes. However, each scheme must undergo an individualized factual inquiry to determine who the direct and secondary players are and the extent of any remaining assets. By looking to secondary actors, you may be able to make your client whole.