You Can't Cheat an Honest Man

by James Walsh

  • Towers Credit Corporation, which purchased commercial accounts receivable and tried to collect them for its own account;

  • Towers Collection Services, which collected past-due accounts receivable for third parties on a contingency basis; and

  • Towers Healthcare Receivables Funding Corporation, which engaged in factoring health care receivables.

  The last subsidiary was the most promising. In the late 1980s, Hoffenberg had gotten into lending money against accounts receivable of financially strapped health care providers. Towers would purchase the receivables—bills owed to hospitals and nursing homes by Medicare, Medicaid and private insurance companies—at a discount from face value.

  The genius of the business was that Hoffenberg convinced the cashstrapped hospitals to give him financing (though they may not have realized this was what they were doing). He’d pay half the cash right away and the another 40 percent or 45 percent after he’d collected the receivables.

  The collection cycle usually took 30 to 90 days, so Towers was earning an annual return on its money of anywhere from 20 percent to 60 percent. Many of the hospitals paid the premium without complaint. One former finance executive at a New Jersey hospital said, “I needed the cash, and I didn’t care what I paid.”

  Hoffenberg ran into some trouble in 1988, when the Securities Exchange Commission discovered that Towers had violated federal securities law by selling $37 million worth of unregistered bonds. But the SEC agreed to close its investigation in exchange for a consent decree which required, among other things, that Towers make a refund offer to the holders of the bonds.

  Towers made the offer—but couched it in such vague terms that only a small percentage of the bondholders took advantage of the chance to get their money back. The company only refunded $440,000 of more than $30 million it had received from the notes in question. As one court would later observe:

  Had a substantial majority of these noteholders reclaimed their investments, Towers, thus being deprived of funds to pay interest on its other notes, would have been forced to default. The Ponzi scheme would then have been over.

  But they didn’t...and it wasn’t.

  Hoffenberg treated his own employees in much the same way he treated investors. He compartmentalized his company, assigning narrow duties to each manager so that only a few people—and maybe only Hoffenberg himself—knew how Towers really worked.

  And there was a lot of expensive bluster. Towers Financial’s corporate offices in Manhattan were decorated with tasteful furniture, plush carpeting and oil paintings. It looked like a prestigious old-line law firm. The image of respectability helped Hoffenberg carry out his fiveyear growth plan, fueled by repeated note and bond offerings.

  Most of the notes were distributed by some 240 small regional brokerdealers, while the bonds were privately placed by Towers itself. In its Offering Memoranda, which paved the way for the various bond offerings, Towers stated that it had developed a remarkably profitable operation. The fat profits allowed it to pay fantastic interest rates.

  Between February 1989 and March 1993, Towers sold over $245 million of bonds to more than 3,500 investors in 40 states. The money raised from these offerings was supposed to go to buying high-quality accounts receivable that the company could collect easily. Hoffenberg didn’t buy many accounts receivable. And, when he did, he bough low-quality, uncollectable ones for pennies on the dollar. He’d then claim this crap was worth 95 percent of face value.

  Another trick he used was to sign deals with corporate clients under which Towers would collect bills which remained the client’s property. He’d then enter these bills on Towers Financial’s books like accounts receivable his company had purchased.

  Towers’ Annual Reports for 1988, 1989 and 1990 stated that the company expected to collect 30 percent of all collection receivables as “fees.” It never kept anything like that amount.

  From 1988 through March 1993, Towers generated almost $400 million in losses—though these losses didn’t show up in any of the company’s financial reports. Hoffenberg was keeping the company operating by misallocating the infusions of cash provided by the bond offerings. He papered over the losses with phony financial reports presenting an upward trend in earnings. Between 1988 and 1992 profits appeared to rise dramatically, from around $4 million to $17 million; in fact, losses were more than tripling in this period, to almost $96 million in 1992.

  Overstating receivables resulted in a reported $25.5 million in shareholders’ equity in 1992; in reality, equity was negative $242.4 million. Reinforcing the illusion of prosperity were slickly produced annual reports. People believed the lies.

  Hoffenberg lived in a Long Island mansion—complete with a pool, tennis court and private beach. For weekends, he kept a home in Boca Raton. When he needed to drive somewhere, he hopped in one of three Mercedes. In 1993, he tried to buy the New York Post. But trouble was looming. When SEC investigators learned about Hoffenberg’s efforts to buy the Post, they accelerated their inquiry.

  In early 1993, bondholder trustee Shawmut Bank began making noises. It had just received the company’s fiscal 1992 annual report (six months after the end of the fiscal year) and found what seemed to be indications that Towers had violated the terms of its various loans. Worse still, Towers wasn’t forthcoming about whether the “possible events of default had been cured.”

  Shawmut declared the health care bonds in default and refused to release any more of the bond-issue proceeds for lending to health care providers. That created a huge problem for Towers: It had already sent money to health care providers after purchasing the receivables backing the bond proceeds at Shawmut.

  Once the money from Towers stopped coming, many providers simply kept the insurance payments. As a result, Towers Financial’s cash flow slowed to a trickle. Realizing his time was running out, Hoffenberg tried to cover his tracks. One attorney would later discover a $6,400 claim against Towers from the Mobile Shredding Corp. of New York that covered work during the last months of 1992. Mobile had shredded ten tons of Towers documents.

  In February 1993, the SEC filed a lawsuit in New York federal court, charging Hoffenberg with securities fraud and demanding the appointment of an SEC trustee to run the company. Towers filed for bankruptcy protection a few days later.

  In March 1993, Alan Cohen—a New York-based workout consultant—was appointed trustee. When he arrived at Towers Financial’s offices, Cohen found Hoffenberg there, still trying to hang on to his control of the company. “I suggested to him that it would probably be better if he didn’t come around anymore,” said Cohen.

  The federal lawsuit charged that Hoffenberg never intended to do anything with money taken from gullible investors except “apply it to [his] own purposes and use it for the payment of interest owing to other investors.” According the U.S. attorney, “Unbeknownst to the investors, the source of the interest they received on the Notes was the principal paid by later Note investors.”

  That’s as succinct a definition of Ponzi scheme as any.

  During its heyday, Towers had referred skeptical investors to Duff & Phelps, a financial credit rating agency which “would provide independent verification and corroboration regarding the creditworthiness of [Towers Financial] and... confirm the positive statements [it] had made.” Duff & Phelps claimed it used what it called a “shadow rating” of Towers Financial. Its staff told a number of investors that it “had conducted extensive due diligence investigations prior to assigning ratings to the bonds.”

  Burned investors eventually sued Duff & Phelps, claiming that it had known that the false information would be used in investment decisions. They said: “At all times Duff & Phelps knew that the false assurances and information it was providing would be... used by the brokers and their clients... to evaluate whether to purchase and/or maintain investments in [Towers Financial].”

  The January 1996 federal court decision Shain v. Duff & Phelps Credit Rating Company considered the complaints agai
nst the rating company. The case had been brought by Myron Shain, who’d invested $200,000 in Towers notes, on behalf of himself and a class of similarly situated suckers.

  The gist of Shain’s complaint was that “Duff & Phelps actively foisted a uniform and consistent set of misrepresentations and omissions on the Duff & Phelps Class via the Class Brokers who reiterated them to, or relied on them for, the Class.”

  Beginning in or about July 1990, “in an effort to lend additional credibility and respectability to its operations, Towers [Financial] hired Duff & Phelps to rate the Towers Bonds.” According to Shain, the relationship between Towers Financial and Duff & Phelps soon became “symbiotic.” Towers paid Duff & Phelps fees and Duff & Phelps helped Towers promote itself to the investment community.

  Duff & Phelps had never directly solicited Shain or other individual investors. Instead, Shain argued, the firm had “solicited” the sale of Towers notes to the investors by communicating with brokers.

  The court ruled that Shain’s theory that Duff & Phelps “solicited” investors through brokers was too convoluted to work. It wrote: “the district court decisions in this circuit consistently have held that persons are not liable...for solicitation unless they directly or personally solicit the buyer.”

  In April 1995, Hoffenberg pleaded guilty to running an investment scam, fraudulently selling notes and bonds to investors and using some of the proceeds to pay interest owed earlier investors. A year later, he asked to withdraw his guilty plea because he had been suffering from mental illness. A federal judge ordered psychiatric tests.

  In March 1997, Hoffenberg was sentenced to 20 years in prison. District Judge Robert Sweet also ordered him to pay $463 million in restitution and a fine of $1 million. “There has been tremendous suffering here,” Sweet told Hoffenberg. “You have not accepted responsibility for these securities frauds.”

  Hoffenberg said he would appeal.

  CHAPTER 22

  Chapter 22: Fight Like Hell in Bankruptcy Court

  All Ponzi schemes eventually collapse. After a scheme has ground to its inevitable conclusion, filing for bankruptcy protection—sometimes voluntarily, but usually court-ordered—is all that’s left.

  In order to get anything out of the bankruptcy process, a burned Ponzi investor has to fight like hell at each of several stages. This will usually require lawyers, various kinds of professional fees and enough fellow burned investors or creditors to raise a collective voice.

  Even though the effort is complex and expensive, it can be worth the effort. And you don’t have to be a lawyer to make the decision whether you should fight or—within some limits—how. You only need to know a few basic points about how Ponzi schemes work their way through bankruptcy proceedings.

  To start, federal appeals court judge Richard Posner has written:

  Corporate bankruptcy proceedings are not famous for expedition.... So, the last resort for the burned Ponzi investor is to look for some restitution in bankruptcy court. The law treats Ponzi investors a little better than shareholders of a legitimate company when it comes to court-ordered liquidation...but only a little better.

  A more important distinction is the one between a Ponzi investor and a creditor of a Ponzi company. Sometimes there isn’much of one. In its 1924 decision Cunningham v. Brown—which involved Carlo Ponzi’s original scam—the U.S. Supreme Court wrote that a “defrauded lender becomes merely a creditor to the extent of his loss and a payment to him by the bankrupt within the prescribed period...is a preference.”

  What’s more: the Bankruptcy Code allows a court to consider any transaction which occurs within the last 90 days before a filing inherently preferential—simply because of the time at which it took place. This protects “those investors who transfer monies to the scheme within the ninety day pre-petition period who receive nothing in return due to the collapse of the scheme, yet whose funds are used to pay earlier investors.”

  Bankrupcty law discourages creditors “from racing to the courthouse to dismember the debtor during his slide into bankruptcy.” Instead, it tries to set a framework within which a debtor can “work his way out of a difficult financial situation through cooperation with...creditors.”

  Burned investors often argue that these goals have “no rational application” in the context of a Ponzi scheme—since Congress could not have intended to protect such a debtor so as to enable it to perpetuate fraudulent activities. Courts don’t always agree. As one noted:

  [Congress’s] intention to avoid a debtor’s dismemberment may rationally apply even to a Ponzi scheme when one considers that creditors of such a debtor may include non-investors. For example, if a Ponzi scheme uses telephone services and its telephone company remains unpaid, preventing investor creditors from rushing to dismantle the debtor as it slides into bankruptcy would serve to protect the [telephone company’s] interests....

  Avoiding preferences in a Ponzi scheme serves the primary purpose— to equalize distribution to creditors and, to a lesser extent, to discourage a race to the bankrupt company’s assets. Invariably, this directs a lot of responsibility to one person.

  The Trustee Determines a lot

  One of the critical aspects of a bankruptcy proceeding is the naming of a trustee. This person serves as a combination of CEO and defense counsel during the liquidation. While the trustee is not directly responsible for protecting burned investors (technically, the responsibility is to the bankrupt corporate entity), he or she is instrumental in setting the tone for the proceedings.

  In fact, if a trustee is found to be asserting claims belonging to creditors rather than the debtor, the court—which ultimately supervises the proceedings—can overturn any activity.

  Very often, burned Ponzi investors will argue that any claims asserted in a bankruptcy case “really” belong to them. This argument usually stems from the mistaken assumption that the investors are the ones who will receive the money anyway, so they should be able to pursue the wrongdoers themselves.

  That’s not how bankruptcy—or a bankruptcy trustee—works. It’s not a debt collection device. Indeed, the trustee’s job is to investigate the debtor’s financial affairs, liquidate assets, pursue the debtor’s causes of action, and acquire assets through avoiding powers in order to make a distribution to creditors. Whether a trustee considers a burned investor an ally or adversary depends on the burned investor’s standing in a case. And this standing isn’t always clear.

  There are some lessons to be learned from existing cases regarding how a trustee in bankruptcy should plead a claim against a third party participant in a Ponzi scheme. A trustee will usually be careful not to plead for a recovery based on any injury to investors or creditors, even though fraud against investors may be a part of the background allegations.

  In alleging background facts, trustees often explain how investors have been defrauded. These background facts, however, should not be confused with the actual claims. A trustee will usually be careful not to plead damages as an amount equal to the funds invested in the debtor’s Ponzi scheme (the investor’s biggest concern); instead, the trustee will measure damages based on funds improperly paid out.

  There is a difference between a creditor’s interest in claims held by the corporation against a third party, which are enforced by the trustee, and the direct claims of the creditor against the third party. Only the creditor can enforce a direct claim; and this has to take place in civil court, not bankruptcy court.

  But a reciever or trustee can protect a Ponzi company’s interest, which indirectly helps burned investors get at least some of their money back. As Judge Posner has noted:

  We cannot see any legal objection and we particularly cannot see any practical objection. The conceivable alternatives to these suits for getting the money back into the pockets of its rightful owners are a series of individual suits by the investors, which, even if successful, would multiply litigation; a class action by the investors—and class actions are clumsy devices; or, most plau
sibly, an adversary action, in bankruptcy, brought by the trustee in bankruptcy of the corporations if they were forced into bankruptcy.

  For a burned investor, the last of these three methods is almost always the fastest...and the most cost-effective.

  The Trustee Lays Claim

  If—as a burned Ponzi investor—you can convince a bankruptcy trustee to file a lawsuit (what Posner called “an adversary action”) on behalf of everyone, the work has only begun.

  By definition, the property of a bankrupt estate is a scarce commodity. The reason companies declare bankruptcy—voluntary or forced—is that their assets are no longer sufficient to repay creditors fully. These creditors, eager to assert their entitlement to whatever assets do remain, will often lay claim to the property by filing claims outside of bankruptcy court.

  As the administrator of the bankrupt estate, the trustee is charged with marshalling all available assets of the estate, reducing these assets to money, and distributing this money to the estate’s creditors, in a manner that ensures each similarly situated creditor of the bankrupt debtor an equitable share.

  Therefore, the trustee—like the creditor—is concerned with laying claim to any property that could conceivably belong to the estate. This “any property” usually includes lawsuits against the perps who tanked the company in the first place. The trustee’s concern isn’t only for money, though; it’s also for order. As one federal court noted, the trustee wants:

  to avoid numerous lawsuits by individual creditors racing to the courthouse to deplete the available resources of the estate and thereby thwart the equitable goals of the bankruptcy laws.

  To accomplish these goals, the trustee is given statutory power to sue and be sued as a representative of the estate.

  In practical terms, it means that money paid to Ponzi investors is the property of the scheme. The Bankruptcy Code allows “fraudulent transfers made in furtherance of a Ponzi scheme” to be reversed. Specifically, it allows the trustee to avoid a payment made within one year of filing, if the scheme “made such transfer...with the intent to defraud any entity to which the debtor was...indebted.” And all Ponzi payments are made with that intent.