You Can't Cheat an Honest Man

by James Walsh

  After this meeting, the Schwartzes decided that the best tactic was to admit their theft. The candor was disarming. An investor who attended the second meeting, in Manhattan, recalled: “I looked straight at Stuart and said, ‘Did you ever invest any money? Did you ever have any bridge loans?’ And he said, ‘No, we used it personally.’”

  Most of the STS Acquisition investors were so shocked that they left the meetings without extracting any repayment—let alone liquidation—plan from the Schwartzes. But the shock wore off and, by early 1993, various investor groups turned the case over to prosecutors for criminal charges and moved in civil court to have the Schwartzes declared bankrupt.

  When word of the fraud spread, the Schwartzes became pariahs in the Old Westbury social circle. In a strangely naive turn, Stuart was surprised by this. He continued going to the club and acted insulted when one member said “Hello, crook” in the locker room.

  Ponzi perps don’t usually play stupid about their deeds. And acting indignant about being called a crook after admitting to investors that he’d stolen their money seems downright weird. But, one Old Westbury member offered this insight into Stuart Schwartz: “He was the son of a well-known man. He probably didn’t have the brains or the guts that [Sidney] had. It might be true that he didn’t mean for things to turn out the way they did. But that would be because he didn’t have complete command of what was going on.”

  What was going on was that the Schwartzes really were—by just about any standard—crooks. Government investigators discovered that they’d duped two pension funds and dozens of individuals into giving them nearly $8 million. (And they may have taken even more. Investigators for the U.S. Attorney only checked records back to 1989, though several STS Acquisition investors said the scam started earlier. One problem: Many investors failed to file complaints because they were embarrassed or because they invested to avoid taxes or to launder illicit money.)

  Instead of using the money to make bridge loans, the Schwartzes paid off other investors and spent on themselves. Over the three years that investigators checked, Sidney and Stuart bought several Mercedes, homes on Long Island and in Florida, fancy dresses for their wives and various other trinkets of wealth.

  In May 1996, Sidney and Stuart were both named in a 50-count federal indictment accusing them of conspiracy and mail and wire fraud. Their lawyers quickly arranged a plea bargain.

  The Schwartzes claimed that all of the money raised in the scheme was gone. But many investors had doubts. Their homes were in upper-middle-class neighborhoods—but they weren’t mansions. (And, because they were both mortgaged, the lenders quickly foreclosed.) Their tastes may have been nouveau riche and vulgar, but the Schwartzes didn’t spend the big money that some Ponzi perps do— on things like yachts and private jets. Neither had a gambling or drug habit to eat up the cash. So, some of the old boys at Old Westbury grumbled that Sidney and Stuart had stashed the proceeds. “I’m sure there’s money in a shoe box or a vault,” said a member who’d invested in STS Acquisition.

  In July 1996, Stuart started a 43-month sentence at the federal prison in Fort Dix, New Jersey. “I think he’s contrite,” said Stuart’s courtappointed lawyer. “He’s suffered from the day he was arrested. He has lost all his friends. He’s lost his assets.”

  Sidney had wrangled several medical postponements but, in August, he was sentenced by U.S. District Court Judge Arthur D. Spatt who said, “There have been few cases involving a defendant of 80 years of age—in fact I could not find any. Maybe the reason is that people, when they get to [this] age, don’t commit crimes like this.”

  Federal sentencing guidelines suggested 30 to 37 months. Sidney’s lawyer pleaded for a reduction because of the old man’s age and history of a stroke and heart irregularities. Spatt noted that the guidelines allowed for reduced terms for illness but not age: “This defendant is a youthful 80 years. He played golf up to the time these occurrences took place, and while in his 70s he knowingly cheated his friends and relatives of millions.” In the end, however, the judge took pity on Sidney and sentenced him only to 18 months in jail.

  At his sentencing, Sidney read a prepared statement in a halting but unemotional voice. “I must confess that I have sinned,” he said. “I have been shamed and disgraced.” He said his health problems were God’s punishment for the money he stole from friends and family.

  God’s punishment for leading his childish and naive son into a major criminal enterprise would, no doubt, come later.

  What Constitutes an Innocent Spouse?

  If your husband or wife runs a Ponzi scheme but keeps you in the dark, will the courts hold you liable for the resulting damages? Usually not. However, the Feds may try to tax you for your significant other’s ill-gotten gains.

  The IRS has practice guidelines for dealing with married couples who have big legal problems. When one of the spouses turns out to be a crook, the other will usually try to avoid responsibility for the wrongdoing by claiming protection under the innocent spouse doctrine. The twin 1992 U.S. Tax Court decisions Phyllis M. Curtis Berenbeim v. Commissioner of Internal Revenue and Jerome P. Berenbeim v. Commissioner of Internal Revenue deal with this issue.

  Jerome and Phyllis Berenbeim had each been married before when they met in the mid-1970s. However, they got along well and decided to try once again—with each other.

  Since graduating from UCLA in the mid-1950s, Jerome had been an insurance salesman and a financial adviser. From 1972 to 1974, he sold tax shelters to high-income neighbors in suburban Orange County. As part of this business, he held himself out as a financial consultant with expertise in insurance, real estate, pension and profit sharing plans, tax shelters and tax return preparation.

  Phyllis was also well-educated, with a master’s degree in education and a supervisory credential for teaching in California. She worked for the Orange County public school system in various capacities as a music teacher and administrator.

  When they got married, Jerome—who had a history of money problems—didn’t own a house. But he compensated for this by spoiling Phyllis with smaller indulgences. He gave her a grand piano and a diamond ring. He leased her a Datsun 280ZX, even though she already owned a late model Toyota Celica and an older Jaguar. And, most personally, he paid for some plastic surgery for Phyllis in the early years of their marriage.

  The Berenbeims’ day-to-day financial arrangement was fairly standard. Phyllis paid household expenses out of her checking account and Jerome would contribute any amounts in excess of Phyllis’s salary needed to run the household.

  He was in charge of the long-term financial planning. Which was too bad, because he was running a Ponzi scheme the whole time they were married. Selling tax shelters was just Jerome’s premise to getting to know potential investors. His real job was convincing neighbors, friends and acquaintances that he was a successful financial dealmaker who earned huge profits on money that wealthy clients invested with him.

  Although Jerome’s pitch varied somewhat according to each potential investor, the basic premise remained consistent. He said that he worked with a regular group of entrepreneurs whose small, fast-growing business needed growth capital quickly—and somewhat unpredictably. These businesses were accustomed to paying high interest rates and bonuses for loans. This was the nontraditional world of venture capital and factoring, high-risk financing that potentially paid big money.

  Jerome said his operation was different because, by diversifying his loans, he eliminated the risk that other financiers faced. He called his operation “The Fund” and told potential investors he’d pay between 20 percent and 30 percent on invested money.

  An investor would send money to Jerome, who would then execute a note in the amount of the investment along with interest to be paid monthly for a set period of time. At the end of that period, the principal of the note would be repaid to the investor. He usually asked investors to give him cashier’s checks in amounts less than $10,000 to avoid the reporting of currency tran
sactions to the Internal Revenue Service.

  In one case, an investor gave Jerome $30,000 in four separate cashier’s checks. Jerome produced a $30,000 note, providing for $750 monthly interest payments (that’s 30 percent per annum) for a period of two years. The note matured at the end of the two years—but the holder could redeem it at any time, with 24 hours’ notice.

  To provide himself with some cover, Jerome told investors that The Fund paid him a commission on investments that he arranged. He kept the details of these commissions vague, saying only that they came out of The Fund’s end.

  In reality, there were no wealthy or successful businessmen. Jerome was paying interest on the notes from the money received from investors and converting some part of the funds received to his own personal use.

  He used money from the Ponzi scheme to invest in real estate up and down the California coast. While he made some money from these investments, it wasn’t anywhere near enough to generate big profits for his investors.

  Jerome was able to keep the scheme going for about two years. (Basically, until the oldest notes started maturing.) A few investors got their money out; but, by the latter part of 1982, The Fund started missing monthly interest payments. Some investors were having difficulty reaching Jerome. In a few cases, he’d failed to return principal amounts at the end of the investment term.

  By the end of the year, Jerome’s Ponzi scheme had collapsed. Numerous civil lawsuits followed, with burned investors seeking the return of their money plus damages. Between 1983 and 1985, several dozen of these lawsuits resulted in judgments against Jerome. When he didn’t pay these damages, criminal charges followed.

  In 1986, Jerome was charged with 24 felony counts related to the scheme. He eventually pleaded guilty to three felony counts involving the willful and unlawful taking of money from others. He was sentenced to a prison term of one to three years.

  One of the ugly facts that emerged from the investigations: Jerome and a former wife had been sued in the 1960s for fraud connected to the sale of tax shelter investments. The Fund was actually Jerome’s second failed Ponzi scheme.

  Beginning in early 1986, IRS agents attempted to discuss the Ponzi scheme and related income tax matters with Jerome, but he was uncooperative. So, the IRS pieced together a history of The Fund from interviews with investors and local law enforcement authorities—and research into evidence used in Jerome’s trials. The difference between funds received and disbursed by Jerome was considered to be taxable income. His total take during the life of the scheme was $1,120,551.

  Because the Feds considered the Berenbeims a married couple filing their taxes jointly during Jerome’s fraud, they tried to hold Phyllis jointly liable for his debt. At this point, she made her innocent spouse argument.

  The earnings of either spouse during marriage are both spouses’ community property. However, according to the tax code, the innocent spouse doctrine excludes items of community income from a spouse’s taxable income where all of the following four requirements are met: 1) the spouse seeking relief did not file a joint return for any taxable year;

  2) the income item omitted from the gross income of the spouse seeking relief is treated as the income of the other spouse;

  3) the spouse seeking relief establishes that she did not know of and had no reason to know of such item of community income; and

  4) under the facts and circumstances, it is inequitable to include such item of community income in the income of the spouse seeking relief.

  To meet this standard, it’s not enough to show a lack of knowledge. An innocent spouse must also show that he or she had no reason to know about an understatement. In order to do this, he or she must convince a court that a reasonably prudent person—with a comparable level of education and experience and with equal knowledge of the circumstances—would not have known about the wrongdoing.

  Jerome had kept Phyllis from knowing about the fraudulent nature of his scheme. And he didn’t do this to protect her; he did it because he was stealing from her. Between 1978 and 1983, Phyllis loaned Jerome $76,590 to help him pay some old debts and get his business started. He repaid a few thousand dollars to her directly...but convinced her that he was investing money for her in The Fund.

  In 1983, as The Fund was approaching collapse, Phyllis became suspicious because of inquiries from various friends and acquaintances concerning Jerome’s failure to make monthly payments. She asked him about The Fund and his other investment activities. He said he was having some probems—but that The Fund was basically sound. She believed him.

  She trusted Jerome and permitted him to manage their financial and tax matters. She was prone to accept his explanations without question.

  The IRS didn’t care how naive the woman was. Its lawyers argued that Phyllis didn’t meet the burden of proving all of the necessary elements of an innocent spouse claim. Specifically, the IRS argued that she did have reason to know about Jerome’s scheme. Therefore, it was equitable to include one-half of his income in her taxable income calculation.

  The tax court ruled that Phyllis had reason to know that Jerome was underreporting the money he made on his real estate investments. She would be responsible for her share of that income—about $42,000. However, it ruled that she did not have reason to know that he was running a Ponzi scheme. So, she was not responsible for any part of that income—over $1 million.

  It concluded with a useful observation about one spouse’s duty to investigate another:

  We are cognizant of the marital relationship here and considered whether it would have been reasonable for Phyllis to check with [the IRS] as to whether Jerome had in fact filed [accurately]. Marital relationships are usually based upon mutual trust and such unprecipitated inquiries would not foster a trusting relationship.

  Case Study: Bennett Funding Group

  Bennett Funding Group (BFG) was born in 1977, when Edmund “Bud” Bennett started leasing office equipment out of a former gas station in upstate New York. He was the CEO and his wife, Kathleen, was the president. Their children, who were in high school and college, helped out.

  BFG quickly dominated the business of originating, purchasing and selling commercial leases of copy machines and other office equipment in its part of the country. For several years during the 1980s, Inc. magazine listed BFG as one of America’s fastest growing firms.

  The Bennetts were financially savvy. They organized groups of leases into portfolios, which they pledged as collateral for bank loans. Cash flow from the portfolios would easily cover principal and interest payments on the loans.

  Because BFG made its payments in a timely manner, the banks were always willing to loan more money. Usually, a bank would draft a standard loan agreement and then take a file of documents as collateral. The documents included:

  • a bill of sale;

  • an assignment of contract from BFG of all of its interest in the equipment leases;

  • a promissory note from BFG ; and

  • copies of the original leases, including a description of the leased equipment, as well as the identification of the lessee and a schedule of payments to be made by the lessee.

  Bankers were usually satisfied with this paper trail. As the business grew, though, the bankers started to demand more reporting and better performance standards. Most of the banks believed that the equipment-leasing business was so service-intensive that no company could expand beyond a regional base.

  So, BFG looked beyond traditional bank financing. Modifying its package slightly, the company started offering the portfolios to individual investors. They were even more eager than the banks to get involved.

  BFG would organize a portfolio of 30 photocopy machines leased to a city or federal agency. An investor would then buy a short-term note backed by the income BFG expected to receive on the leases. BFG would offer an interest rate of between 7 percent and 10 percent, depending on the portfolio’s size and risk factors. It would make monthly or quarterly distribution payments c
overing some combination of interest and principal.

  Investors were invited to reinvest the distribution payments in new notes. Many did. “Retirees loved it,” said one Washington, D.C., stockbroker who sold BFG lease securities. “It was so in demand, there was a waiting list.... They would just keep buying and buying and buying.”

  Bud Bennett’s son Patrick took over day-to-day management of BFG in the early 1990s. The father and son weren’t much alike. Bud had few pretenses, preferring to be low-key and cagey; Patrick was slick and aggressive. Bud seemed to have the hard-earned pride of a man who’d built a company from scratch. Patrick seemed to have contempt for BFG’s humble origins.

  While his title was Chief Financial Officer, Patrick was clearly running the company. He talked about bringing in more professional management to raise BFG’s profile. What he actually accomplished was something else entirely. Impatient to grow, he began selling investors millions of dollars of notes backed by fictitious office-equipment leases. He kept the notes current with proceeds of later note offerings.

  What started out as an aggressive tactic to create some extra capital quickly became a full-fledged Ponzi scheme. Between 1991 and 1996, BFG sold over $422 million of bogus lease-backed notes. Patrick commingled these proceeds with other company funds, creating a pool of more than $900 million. He transferred that money to a shell corporation—which, in turn, used some of the money to make payments to investors.

  He used the rest of the money to buy a racetrack, a hotel, gambling casinos and a yacht. The titles to these various acquisitions were held in the names of individual Bennett family members. Specifically:

  •

  • foot Lady Kathleen. The boat and its owners spent winters in Florida and summers in the Thousand Islands—near where the St. Lawrence River flows out of Lake Ontario.