by James Walsh
First Interstate Bank, representing a group of burned investors, argued that “the subsequent bond issues were the inevitable result of the defendants’ need to acquire funds to avoid defaulting on the [initial] issue.” It also argued that but for the law firm’s misleading statements, it would have avoided the investment. These arguments worked at trial but were eventually reversed.
The appeals court dismissed the bank’s charges and ruled that “something more than but-for causation is required.” It concluded that while the issuance of the bonds might have been foreseeable, the misuse of the bond proceeds “constitute[d] a superseding event” and, therefore, the attorneys were not liable.
The second charge, omission, is more difficult to articulate. To begin, a burned investor has to show that the lawyer or accountant had a specific fiduciary duty or “other relation of trust” to the investors. (This usually isn’t the case, any duty they have usually goes to the company that is paying their bills.)
As the U.S. Supreme Court explicitly stated in its Central Bank decision, “[w]hen an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak.”
There’s a slight benefit to this more difficult standard. If a burned investor can establish that a lawyer or accountant has made a material omission, positive proof of reliance is not necessary if the investor can show that (1) the withheld facts were material, and (2) defendant had a duty to disclose the facts. The two charges are often so closely linked that both—or either—can be made by a burned investor. For that reason, many make both claims. The courts are left to sort through somewhat confusing law and absolutely confusing facts.
As one court noted: “Like standing dominoes, however, one misrepresentation in a financial statement can cause subsequent statements to fall into inaccuracy and distortion when considered by themselves or compared with previous statements.”
In the end, the courts themselves aren’t clear about the distinctions between misrepresentations and omissions. In the federal appeals court decision Little v. First-California Company, the court stated:
The categories of “omission” and “misrepresentation” are not mutually exclusive. All misrepresentations are also non-disclosures, at least to the extent that there is failure to disclose which facts in the representation are not true. Thus, the failure to report an expense item on an income statement, when such a failure is material, ...can be characterized as (a) an omission of a material expense item, (b) a misrepresentation of income, or (c) both.
One of the issues that kept the Home-Stake Mining Ponzi scheme in the courts for more than 20 years was whether its lawyers could be held liable. Even the question was complicated. One of the appeals courts asked whether the lawyers:
aided and abetted the fraudulent conduct...in the preparation of registration statements...either with actual knowledge as attorneys of the misrepresentations and the omission of material facts set forth in the registration statements and prospectuses in which their names appeared, with their consent, or, in the alternative, under circumstances where in the due exercise of their professional responsibilities these attorneys should have known of such....
The answer, in either case, turned out to be “yes.” The professional liability insurance companies for several of the firms settled with the burned investors to make the case go away.
How Two Young Ponzi Perps Conned Lots of Accountants
Barry Minkow was a decade-of-greed oddity who started an unlikely company—it cleaned rugs—when he was 16 and crashed before he was 25. His company, called ZZZZ Best Carpet Cleaning, was nothing more than a particularly aggressive Ponzi scheme. But it stands as a testament to how easily greedy professionals can be convinced to lend an air of legitimacy to a bogus enterprise.
ZZZZ Best started out cleaning carpets in people’s homes in the suburban San Fernando Valley, north of Los Angeles. For a short time, it was a legitimate business—driven by Minkow’s cloying boyish chutzpah. In the mid 1980s, Minkow started talking about big contracts he was signing to clean carpets for L.A.’s biggest companies and for insurance companies rehabilitating fire-damaged buildings.
The high-margin insurance work was all fiction. Minkow and a handful of advisers (who may have had organized crime connections) borrowed money from loan sharks, repaid it with money borrowed from investors and sloshed the whole thing around several corporate bank accounts to make ZZZZ Best look bigger than it was.
The company expanded its Ponzi scheme by selling shares to the public (at one point, it had a market capitalization of more than $200 million). This is where the craven accountants came into play.
Mark Morze, the financial architect of the ZZZZ Best scam, said the insurance restoration division was a good example of how accountants are willing to be misled about a scam. “No one ever checked those receivables. Not the auditors. No one. Think about that. If you were having construction done on your home, you’d check the contractor’s references and you’d ask about licenses and maybe whether the company’s employees were bonded.”
The accountants’ unwillingness to do basic, “shoe leather” investigation allowed Minkow and Morze to move a few million dollars through dozens of accounts and make the company look like it was worth hundreds of millions of dollars. By learning a little accounting jargon and focusing on winning CPAs over “as friends,” Minkow and Morze were able to win professional support in the due diligence process that was required before the stock offering. “We tried to befriend the auditors, to get them to look at us as people, and not just credits and debits,” Minkow said.
He also made sure ZZZZ Best paid its lawyers and accountants well...and on time.
Basically, Minkow said ZZZZ Best’s auditors—a predecessor of the accounting firm Ernst & Young—never took the time to learn the details of the business. If the auditors had known anything about insurance restoration work, they would have caught the fraud easily.
The ride didn’t last long after the offering. By the middle of 1987, the ZZZZ Best empire collapsed under the weight of its financial fraud. After the deluge, more than a dozen people were indicted. Everyone except Minkow reached plea bargains with the prosecutors; the boy wonder decided to take his chances with a jury.
The jury found Minkow guilty of 57 counts of stock fraud, bank fraud, mail fraud and tax evasion. In March 1989, Minkow was sentenced to 25 years in prison and ordered to pay burned ZZZZ Best investors $26 million in restitution from future earnings. “You’re dangerous, because you have this gift of gab, this ability to communicate,” the judge said, as he sentenced Minkow. “You don’t have a conscience.”
Case Study: J. David & Company
One of southern California’s biggest Ponzi schemes—and that’s saying something—was resolved fairly well for burned investors because of a law firm that was held liable for its bad advice.
In the late 1970s, Jerry Dominelli was a stockbroker working at conservative Bache and Company in San Diego, California. In 1980, Dominelli left Bache with Nancy Hoover, a co-worker with whom he was having an extramarital affair. The two formed J. David and Company, the centerpiece of several related investment vehicles. They set up offices in the ritzy La Jolla area to sell tax shelters, manage investors’ money and trade foreign currency.
The people who bought into the scheme were told that their money was going to be used to trade foreign currencies through a far-off tax haven, the Caribbean island Montserrat.
Hoover used political connections that she had in the San Diego area to lend an atmosphere of legitimacy to the operation. “I just didn’t believe Nancy Hoover could be involved in a scam,” one investor said. “I made an error in judgment.” Indeed he did. The entire J. David business was a fraud. Donimelli didn’t trade foreign currency; he just paid off old investors with money from new ones.
And many of J. David’s investors were on the shady side from the beginning. “These people all suspected Domenelli was laundering money...or something,” says one lawyer familiar with the scheme
. “His story never made sense. Really, all he was doing was promising big, tax-free profits. And winking the whole time. Anyone could see this was too good to be true.”
Many of the investors figured they’d keep their money in for a short time—a few months or so—and then pull out. This was a textbook example of the greater fool theory. And, for a short time, there were enough greater fools that some San Diego high-rollers came away from J. David with fat profits. Word of these early wins attracted money from people with more greed than brains.
At the height of J. David’s success in the early 1980s, the scheme was attracting hundreds of thousands of dollars a week. Dominelli and Hoover divorced their spouses, moved in together and vied for prominence among San Diego’s financial and political elite.
By early 1984, Dominelli’s business empire was heading toward trouble. The buzz in the moneyed circles of La Jolla and Del Mar had changed from hushed awe about his success to world-weary recognition of a Ponzi scheme. Once the high-rollers pulled out, Dominelli and Hoover were left with hundreds of smaller investors. This created logistical problems that the couple couldn’t manage. J. David checks were being returned routinely because of insufficient funds in the company’s checking accounts. At this point, even the smaller investors started to figure out what was happening.
On February 13, 1984, involuntary bankruptcy petitions were filed against Dominelli, J. David and several related entities. Louis Metzger, a retired Marine Corps general, was named trustee to oversee the liquidation. A few weeks later, Dominelli was jailed for refusing to give up J. David assets. He was released, after agreeing to cooperate with authorities investigating the collapse of the scheme.
Beginning about May of 1984—and lasting almost ten years—several groups of burned J. David investors started bickering over which of their groups was most legitimate, who should represent them, and how the liquidation should be handled. After sorting through the disagreements, the trustee recognized investor claims of about $112 million in the bankruptcy action. However, none of the investors could be paid until money was recovered and creditors were repaid.
In March 1985, Dominelli pleaded guilty to stripping investors of $80 million through his Ponzi scheme. Although he’d made sophisticated promises, his actions were simple. He did little, if any, shelter-building or currency trading for his 1,500 investors. He simply paid early investors with money from later ones. A federal court sentenced Dominelli to 20 years in prison.
Dominelli suffered a stroke early in his sentence, while talking with Hoover by phone from jail. Not long after, Hoover married a wealthy man from central California who invested $2 million in her defense. She was eventually sentenced to 10 years in prison but served only 30 months because she cooperated with government investigators.
By early 1988, about $30.6 million had been recovered. The main source of this money had been the sale of company assets, including artwork, horses, several airplanes and cars. (One of the cars was a 1956 Gullwing Mercedes-Benz that brought $117,000.)
Of this money, about $8.4 million was used to repay secured debts. About $5.4 million was paid to lawyers, accountants and other professionals involved in the case. Another $1.5 million went to administrative costs and related fees. That left a little less than $15 million which would eventually go to investors and unsecured creditors. The trustee planned to keep that money until he’d explored settlements of various claims he had made against lawyers and accountants who’d advised J. David during its criminal heyday.
Allan Frostrom (who started out as Metzger’s assistant) completed the J. David bankruptcy proceeding in late 1993. Despite their complaints, the investors did pretty well—most got back about 82 cents on the dollar. Of this amount, about 20 cents came from liquidating company assets and 62 cents came from lawsuits against law firms and accountants. Most of the professional liability money came from the law firm of Rogers & Wells, which paid $40 million to make a flurry of J. David-related lawsuits go away.
One lawyer who represented some burned J. David investors said that the Rogers & Wells settlement was more than should be expected in the wake of a fallen Ponzi scheme:
That firm was looking at some major liability. There were boxes full of smoking guns showing that [its] lawyers had signed off on contracts and other documents they knew—or should have known—were bogus. Maybe they were just stupid. But there were so many documents that the stupid defense was going to be hard to make....
Rogers & Wells restructured its partnership after the J. David settlements. But one person who was with the firm at the time said it—like most J. David investors—was fooled by Dominelli and Hoover’s local prominence. For lawyers, that’s an expensive mistake.
CHAPTER 21
Chapter 21: Go After Banks and Financiers
After greedy lawyers and accountants, the next best place to turn for some recovery is the financial sector. A burned investor will sometimes have success suing the banks, brokerages and institutional financial supporters that help Ponzi schemes flourish. (Often, burned investors will turn to the finance people first. That’s a mistake. Professionals are usually insured against bad advice. And—regardless of what the law says—professionals are usually more culpable.)
A burned Ponzi investor can almost always make a couple of charges against banks and financial institutions. The first is the same charge that works for lawyers and accountants—namely, that these outsiders materially supported the fraud by making mistatements or omissions that led the greedy naifs to invest. The second charge is that banks, by supporting the Ponzi scheme aggressively, became promoters of the fraud. All things being equal, this charge is easier to make against institutions than individuals—though an investor can make it against either group.
Finally, the burned investor can charge that the bank or financial institution actually participated in the scheme. This charge is usually made against brokerages and financial marketing companies...but sometimes it works for banks.
Some angry investors try to implicate a bank simply because it allowed a Ponzi perp to keep a checking account in one of its branches— and cashed the investors’ checks. This argument almost never works. Banks have a long history of court decisions on their side, which says that they’re not responsible when customers use their accounts to perpetrate crimes.
One example of a pro-bank ruling sums up this defense:
Banks handle a high volume of transactions and cannot be required to supervise the checking account activity of their customers, nor should they be potentially liable for the fraudulent activities of their customers.
And another elaborates:
Facts which warrant suspicion would not necessarily cause the bank to know, or have reasonable cause to know, that the Ponzi [perp] was bankrupt, or that he was a swindler. Banks are under no duty at law to warn the investing public as to the financial condition of their depositors. Investors may be assumed to keep themselves reasonably informed as to the financial capacity of persons with whom they are dealing in their investments.”
Key Standards of Bank Culpability
In the 1988 federal appeals court decision Williams v. California 1st Bank, the Ponzi company—a distributor of Mexican seafood—sold investment contracts to individual investors, with a bank serving as the depository.
After the investment program collapsed, the trustee sued the bank on behalf of the estate and the investors, alleging securities law violations arising out of the bank’s involvement in the scheme. Since the trustee and the estate would recoup only administrative costs from a favorable judgment, and the investors would receive the bulk of any recovery, the court noted that the “investors plainly remain the real parties in interest in these actions.”
As a result, the court held that the trustee lacked standing because the money was owed to the investors, not the estate. The appeals court held that the investors, and not the trustee representing the distributorship, had standing to sue for the loss. In reaching this conclusion, the court no
ted that because the seafood company and the bank were—effectively—partners in committing the fraud, the bankrupt company had no claim against the bank.
Of course, a burned investor could pursue a claim. But even the burned investor will run into some problems. The Supreme Court’s 1994 decision Central Bank of Denver v. First Interstate Bank of Denver restricted the degree to which aiding and abetting liability can be applied to banks and financial institutions that assist Ponzi schemes.
In that case, burned investors sued a trustee on the theory that it aided and abetted Rule 10(b) violations by “recklessly ignoring its oversight duties.” Ruling that the claim could not stand, the Supreme Court found that Rule 10(b) “prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act.... The proscription does not include giving aid to a person who commits a manipulative or deceptive act.”
While the Central Bank decision severely curbed actions against secondary actors, the court admitted that such actors are not “always free from liability under the securities acts.” Specifically, it wrote:
Any person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator....
So, a burned investor has to prove that the bank—or its personnel— were actively involved in promoting the scheme. Of course, the relationship between a Ponzi perp and his bank isn’t always clear. Many perps use unwitting banks—or groups of banks—to create whole systems of bogus transactions intended to hide their tracks. The bank’s liability may seem larger here; but it can be even harder to prove.
When Banks Become Promoters
In his 1914 book Other People’s Money, which studied the concentration of power among New York investment bankers, future Supreme Court Justice Louis Brandeis wrote:
[T]his enlargement of their legitimate field of operations did not satisfy investment bankers.... They became promoters, or allied themselves with promoters.