by James Walsh
The lawsuit asked for $2 million in civil penalties and restitution for consumers affected by the scheme. In addition, it asked for an injunction prohibiting the company from further violations of the California Consumer Protection Law.
UGC president Steven Lee started out defending his company’s practices vigorously...maybe a little too vigorously: “All of this talk of Ponzi schemes, a house of cards, fraud... is completely incorrect. This is not a fraud and nobody’s being ripped off.”
But this aggressive tactic didn’t last long. In an April meeting with deputies from the attorney general’s office, UGC agreed to a preliminary injunction, which allowed it to remain in business but prohibited it from selling any new distributorships without the appropriate registration. The injunction also prohibited the company from making any further misrepresentations.
UGC suspended its California operations a few weeks later, blaming its problems on media attention to the lawsuit. Telephone calls to the company were answered with a recorded message that told UGC coupon holders that they’d soon be able to use the coupons to get discounts on name-brand pantyhose. The record message concluded, lamely: “Both the attorney general’s filing and unfavorable media coverage have had a devastating effect on UGC’s ability to generate new revenues and to operate its day-to-day business.”
The message did manage to blame someone, though. It said that UGC had tried to restructure but “could not overcome the stigma that was created by the negative publicity heaped on UGC by the media back in March and April of this year.”
Word of the state attorney general’s suit stunned coupon holders and officials at NFP’s and schools that had used UGC coupons.
Southern California’s Irvine Education Foundation, which ran a fundraising event in the fall of 1995, was one of the first big groups to use UGC’s coupon books. IEF Executive Director Elizabeth Thomas said that her group had netted about $15,000 from a fund-raising drive in late 1995. It was considering a rebate to everyone who’d bought books.
At C.H. Taylor Elementary School in West Valley City, Utah, students had sold 200 coupon books valued at $6,000. According to school principal Orwin Draney: “Of that, $2,000 was for us and $4,000 went to [UGC].” He was hoping to offer some other service in place of the coupons.
By August, UGC’s recorded announcement had changed from whining about the Attorney General to saying that it had begun a liquidation under Chapter 7 of the bankruptcy code.
Most of the NFPs that had sold UGC coupons felt liable for returning money to supporters—though they weren’t, legally.
Albert Sheldon, an assistant attorney general in California, explained that people who’d bought coupons were creditors. They would receive notice of UGC’s bankruptcy when it was filed. But they would be standing in a long line of creditors—headed by Federal Express, which claimed more than $400,000 in unpaid delivery bills. “There really isn’t much [coupon holders] can do,” Sheldon said. “Our investigation has led us to believe there aren’t any huge sums of money lying around to make restitution.”
Using the NFP Structure to Build a Ponzi Scheme
An even more creative approach is to set up an NFP as a vehicle for Ponzi fraud. A perp who starts a “nonprofit” can take advantage of the presumption of goodwill that many people feel toward the things. And, in some cases, it’s not only people who make the mistaken presumption...it’s sometimes banks or governments that do.
Lee Sutliffe exploited this goodwill with a Missouri-based NFP called First Humanics Corporation (FHC). FHC turned out to be a Ponzi scheme—and serves as a good illustration of the mechanics of an NFP fraud.
The company was incorporated in the 1970s as Faith Evangelistic Mission Corporation, a tax-exempt NFP which was intended to own and operate church-affiliated nursing homes in the Midwest. In July 1984, Sutliffe gained control of the company and changed its name to First Humanics. He used FHC’s tax-exempt status to issue so-called “Section 103 bonds.”
The interest paid by these bonds is often high and always exempt from federal income tax. The bonds, which aren’t registered or rated like corporate bonds, are usually issued by local governments; but NFPs that provide public services can issue them, too.
Between 1984 and 1987, FHC acquired 21 nursing homes and paid for the purchases by issuing a total of over $80 million in Section 103 bonds. Sutliffe—a Kansas City financier with a long history of troubled bond deals—treated the municipal bond market as his sucker investor, selling it round after round of new bonds pledged against the same 21 nursing homes. “He knew underwriters all over the county and bond lawyers,” said one former business associate. “He was familiar with the bond industry.”
Sutliffe shrouded his questionable deals in a cloak of legitimacy by hiring top-flight accounting firms to give advice. From 1984 until 1986, Deloitte & Touche provided financial forecasts and feasibility studies in connection with FHC’s bond issues. But, as the scheme grew, a new accounting firm was brought in. Starting in 1986, Price Waterhouse advised FHC with its bond issues.
An important note: Neither Deloitte & Touche nor Price Waterhouse audited FHC’s finances. They were merely brought in to do consulting work—and lend their names.
In 1987, FHC ran into problems. The Illinois Department of Public Health reported substandard conditions at some of its nursing homes. Among other things, state inspectors found untended elderly patients tied to wheelchairs for hours at a time. Daily food budgets at some of the homes had been cut to as little as $2.15 per day per patient.
In the next 18 months, FHC’s nursing homes saw an exodus of residents. While this was happening, the company moved deeper into its Ponzi scheme. It raided the proceeds from each of several new bond offerings to pay the holders of previously issued bonds. This kept existing, troubled nursing homes from financial failure.
But the scheme couldn’t last forever. In the fall of 1989, the company defaulted on the bonds connected with one of its nursing homes. Sutliffe insisted that the default was a technicality: “The bank just screwed up and paid more money to the nursing home instead of covering the bond debt service first.”
Within a few weeks, though, anxious bondholders had forced FHC to file a petition for relief under Chapter 11 of the Bankruptcy Code. After the filing, Sutliffe’s story changed. He blamed the bankruptcy on inconsistent Medicaid and Medicare reimbursements that forced the outside management company FHC had contracted to run the nursing homes to shift funds from financially healthy locations to those suffering cash flow problems.
The bondholders didn’t agree. In court papers, they claimed that FHC “was ever falling behind on its debt service and other obligations, was ever short of adequate cash flow and working capital, and was having to make up such shortfalls by borrowing revenues from other projects and by closing more and later bond-financed deals.”
By September 1989, FHC had sold $82 million of bonds against assets worth no more than $30 million. And the $82 million couldn’t be fully accounted. FHC had spent only $54 million to purchase the 21 nursing homes. As the bankruptcy proceeded—and a criminal investigation began—the trail of the missing money emerged:
• FHC had used two separate corporations, Zandlo and Associates Inc. and Shoreline Design Inc., to certify falsely that repairs had been made to nursing homes it acquired. Both corporations were owned by Sutliffe’s girlfriend, Carol Zandlo. She received fees of between $19,000 and $30,000 for each project.
• Sutliffe’s daughter, who served on the FHC board of directors, also worked for a company called Premiere Development— which identified potential nursing homes for acquisition. Premiere Development had received fees from the bond offerings.
• Sutliffe, as “developer” of the nursing home deals and bond offerings, received fees ranging from $100,000 to $300,000 from each offering.
Like any NFP bankruptcy, FHC’s case was a tough one. NFPs don’t have owners in the traditional sense, so finding liable parties is difficult. Sutliffe, who never hel
d an executive position with FHC, said his involvement with the company was limited to consulting on potential acquisitions and financing opportunities. Several months into the bankruptcy proceeding, Sutliffe told a local newspaper: “If I went back and billed First Humanics for all of the money and expenses and so forth that I have incurred on their behalf, I probably would be the number one unsecured creditor.”
But he didn’t stick around to collect. By the end of 1990, Sutliffe and Zandlo were living in Fort Meyers, Florida, aboard a yacht they named Vagabond II.
In the meantime, the wheels of justice ground slowly. By February 1991, after months of delays and dozens of reorganization proposals, a federal bankruptcy court judge approved a plan that gave FHC bondholders control over 15 of the company’s 21 nursing homes. (Of the remaining six homes, one had already been sold, another turned over to an institutional investor, and the rest would be sold by the FHC bankruptcy estate to pay bills.)
In March 1993, Sutliffe pleaded guilty to one count of mail fraud in connection with criminal charges brought by the Justice Department over the bond offerings. He was sentenced to serve 15 months in prison and to pay $1 million in restitution.
Under the plea agreement, Sutliffe confessed that he had “obtained money and property from investors and trustee banks by means of false and fraudulent pretenses, representations and promises, well knowing at the time that the... promises were and would be false and fraudulent when made.”
As part of the same settlement, other FHC defendants—including Deloitte & Touche and Price Waterhouse—settled for about $45 million. “The assumptions that were used to generate the feasibility studies were unrealistic and Touche knew they were,” said David Donaldson, an attorney for some FHC bondholders. “Price Waterhouse had even more reason to know there were problems because they came later on.”
Later, the trustee running what was left of FHC tried to squeeze some more money out of Deloitte & Touche and Price Waterhouse. He claimed that the accounting firms had been negligent in relying on financial information from Sutliffe.
But, in a December 1995 decision, a federal court in Kansas City ruled that FHC couldn’t seek damages against the accounting firms because “a participant in a fraud cannot also be a victim entitled to recover damages, for he cannot have relied on the truth of the fraudulent representations, and such reliance is an essential element in a case of fraud.”
The court went on to make a legally important distinction:
Sutliffe and his hand-picked company insiders did not loot FHC, but used FHC for the purpose of committing a fraud against outsiders, in this case the municipal bond purchasers.... FHC benefited from Sutliffe’s activities. It prolonged its life as a corporation through the machinations of Sutliffe and had some $30 million in assets at the time of confirmation of its bankruptcy plan.... Driving a corporation into bankruptcy is not to be equated with looting that corporation.
Even though he lost the case, the FHC trustee did have one legitimate point. Like most Ponzi perps, Sutcliffe had had a long history of run-ins with the law. The accounting firms—or someone connected to the FHC bond offerings—could have looked up Sutliffe’s background. But, then again, they were inclined to trust the NFP. That’s why it was such a successful scam.
Case Study: The Foundation for New Era Philanthropy FHC was unusual, in that it used an NFP mechanism to commit a Ponzi fraud. Most NFP Ponzis play on misplaced idealism.
Hundreds of non-profit groups, philanthropists like Lawrence Rockefeller and prestigious organizations like the Philadelphia Orchestra were duped by a structurally simple Ponzi scheme called the Foundation for New Era Philanthropy.
New Era stands out as a shining example of how well suited the nonprofit sector is for buying into Ponzi schemes. The Pennsylvania-based scheme was started, as a tax-exempt charity, in 1989. Founder John G. Bennett1 solicited contributions from a variety of nonprofit organizations. He said that New Era had assembled a small group of anonymous donors that would match the funds that participants deposited with New Era for three to six months.
Bennett described the process as a hard-headed approach to charitable fund-raising. If the non-profits were willing “to put your money to work” with New Era, it would reward the investment with huge returns. Exactly what “work” the money was doing was never explained. Most of the investors assumed it was some sort of charity.
1 This Bennett is no relation to the family of Ponzi perps in New York who ran the equipment-leasing scam Bennett Funding Group. (At least none that either side will admit.)
In most situations, this kind of offer would be laughed off as too weird and too sketchy to be taken seriously. But the non-profit world is insular and trusting. Bennett knew a few key people in the Philadelphia non-profit world; these contacts gave him credibility.
Large and experienced entities fell for New Era’s pitch. Among the investors: the University of Pennsylvania, Harvard University, Princeton University, the Nature Conservancy, several foundations controlled by former U.S. Treasury Secretary William E. Simon and foundations controlled by mutual fund guru Peter Lynch.
Bennett played on the close quarters of NFP circles. He encouraged prospective investors to talk with the early participants. They were usually impressed with the stature of these players. The phone calls almost always sealed the deal. All the while, Bennett pocketed millions. The one-time high school chemistry teacher entertained highbrows at his Main Line home, drove a big Mercedes, traveled to Caribbean resorts and dressed...expensively.
The first groups to invest money with New Era did, of course, double their returns. About 600 charities and non-profits invested about $350 million in New Era between 1989 and 1995.
Albert Meyer, an accounting professor at Spring Arbor College in Michigan, burst the balloon. He was suspicious of New Era’s big promises and vague explanations. Meyer contacted the American Institute of Certified Public Accountants (AICPA) and explained why he thought New Era was a Ponzi scheme. When he concluded the AICPA hadn’t moved decisively, Meyer contacted the SEC.
SEC investigators examined New Era’s structure and finances and realized that Meyer might be right. The Feds contacted several banks and brokerages doing business with New Era.
The downward spiral accelerated when Prudential Securities demanded immediate repayment of a $44.9 million margin loan that Bennett had personally guaranteed. When he didn’t pay off the loan in a timely manner, Prudential sued Bennett and New Era. That suit opened the floodgates of trouble.
In May 1995, New Era sought bankruptcy protection. At a tearful meeting with New Era staffers, Bennett admitted the anonymous donors had never existed.
The Chapter 11 reorganization filing was quickly converted to a Chapter 7 liquidation. In June 1995, New Era’s creditors held a meeting in Philadelphia, where an interim trustee told them that the net losses totaled about $107 million and that the shortfall eventually could be around $41 million.
The interim trustee claimed that 163 investors were owed money and 74 investors had taken out net profits at the point New Era declared bankruptcy. He wanted the winners to give back the money so that other creditors could recoup some of their losses. He was ousted days later by a committee of creditors and investors frustrated with what it considered slow response. The committee voted in Arlin M. Adams, a former federal judge in Philadelphia, as trustee.
By September 1995, hundreds of New Era investors had filed more than $725 million in claims, many seeking not only the money they lost but also the promised returns on their investments. New Era’s bankruptcy estate had about $31 million in cash assets. So, there were going to be a lot of unhappy people.
In October 1995, Bennett released a videotape that contained his first detailed comments since New Era had declared bankruptcy. Apparently speaking with the aid of a teleprompter, Bennett apologized for the pain and suffering he had caused. “Please hear me when I say I never intended to hurt any one of you,” he said. “I know that I’ve done that, however
. And I’m so sorry.”
He said that his shortcomings as a manager played a role in New Era’s failure.
Management was never my talent. Administration was never my expertise. But the responsibility rests with the chief executive, so the buck stops here.... I was at the helm when the ship sank and I should have long before attacked those weaknesses and paid attention to other needed areas of responsibility. Did I ever intentionally set out to hurt anyone? No. My professional life has been motivated toward helping people, not hurting them.
But Bennett whined that he couldn’t provide any details about his personal role until his attorneys had more time to review New Era’s documents. “I’ll be in touch with you as soon as the facts can be disclosed,” he said. Not that his investors were looking forward to that. But Ponzi perps often have an egocentric need to explain themselves. (“For some of these people, the confession is a thrill,” says one federal agent. “It’s part of the drama.”)
In January 1996, Adams—the new trustee—filed for court approval of a settlement under which Bennett would turn over about $1.2 million from a house, car, stocks, retirement savings and other sources. Bennett described these things as “literally all of my assets.”
One attorney representing some New Era investors was ambivalent about the settlement: “On the one hand, [we’re] pleased with the job the trustee has done in capturing most of Bennett’s available assets. On the other hand, the assets captured pale in comparison to the extraordinary damage done to nonprofits.”
Adams and a group of more than 30 investors sued Prudential for $90 million, alleging the brokerage firm was a “co-conspirator” in the New Era fraud. “Prudential’s involvement in the Ponzi scheme not only legitimized the venture to the charitable community, but was the crucial element that enabled Bennett and New Era to overcome any skeptics,” the lawsuit said. Prudential and Bennett “privately agreed to release the money directly to Bennett and New Era to use as they saw fit.”