by James Walsh
The bankruptcy estate would recoup the difference between the price Cohen paid and the amount paid to Cohen by the scheme participants to whom the goods were transferred.
The trustee’s theory was that the act of delivering $114,500 vehicles to people who had paid Cohen $80,000 was a transfer distinct from the $114,500 purchase at the dealer.
This second transfer gave Cohen value only to the extent of extinguishing his $80,000 refund obligation to the person who took delivery. So, this did not qualify for the Bankruptcy Code safe harbor that protects transferees, including merchants, to the extent value is given in good faith “to the debtor.”
Seven of the deals had taken place within one year before Cohen filed bankruptcy, so the federal Bankruptcy Code gave the court the power to reverse them. California law and the Uniform Fraudulent Transfer Act (UFTA), which expanded the trustee’s range of options under so-called “strong arm” authority, allowed the court to reverse the other 10 deals.
However, the court chose not to reverse the sales—even though the various laws would have allowed it. It disagreed with the trustee’s theory, concluding instead that there were no fraudulent transfers because Cohen had received value from the dealers equal to the retail price that he paid.
The trustee appealed. The 1996 federal appeals court decision In re Stanley Mark Cohen considered the appeal. In that decision, a Bankruptcy Appellate Panel considered the technical details of the trustee’s argument and held that:
The Bankruptcy Code makes [Cohen’s] purchases from the merchants fraudulent transfers because [he] intended to hinder, delay, or defraud creditors when purchasing goods that were central to the Ponzi scheme. But the merchants have no ensuing liability because they qualify for the safe harbor that shelters transferees who give full value to the debtor in good faith.
UFTA, in contrast, makes the transfers not avoidable against the merchants because, although they were made with actual intent to hinder, delay, or defraud creditors, the merchants took debtor’s money in good faith for a reasonably equivalent value.
Under this concept, Cohen’s payment in full with checks that his bank honored limited any further duty the Mercedes dealers had. Cohen had what is known as “equitable title” in the cars.
When the lucky scheme participants received their cars, a separate transfer occured—in this case, Cohen handed his equitable title in the cars to the participants.
Evidence that the bankruptcy court considered had established that Cohen had the requisite intent to hinder, delay, or defraud creditors when he’d purchased vehicles in furtherance of his Ponzi scheme. So, the transfers were actually fraudulent. However, that didn’t answer everything.
The differences between the Bankruptcy Code and UFTA forced divergent analyses of the avoidability of Cohen’s transactions.
The seven vehicles purchased during the year before bankruptcy could be considered fraudulent transfers under the Bankrupcty Code. Under UFTA, though, the other 10 transfers could not be avoided because the dealers operated in “good faith and for a reasonably equivalent value” when they sold for a market price.
The appeals board upheld the bankruptcy court’s decision in favor of the dealers. The trustee would have to look elsewhere for deep pockets. It concluded:
None of the transfers are avoidable under the Uniform Fraudulent Transfer Act because the dealers took Cohen’s money in good faith for reasonably equivalent value. Although some of the transfers are avoidable under Bankruptcy Code, the dealers qualify for the safe harbor demarked by good faith and value given to the debtor and are entitled to retain the money they received.
Long story short: Cohen may have been stealing money from some of the scheme participants; but that didn’t mean the trustee could go after the dealers. They had operated in good faith. And they were probably the only characters in the story who had.
CHAPTER 20
Chapter 20: Go After the Lawyers and Accountants
Trusting someone who turned out to be a smarmy crook is bad enough. What’s even worse is realizing that a bunch of smarmy lawyers and CPAs ran up big fees advising the crooks, got paid and then claimed that they didn’t know what was going on the whole time.
This is why the second lawsuit filed by most burned Ponzi investors is against any yuppie scum who advised in the scam. Even though it’s usually the second suit filed, it’s usually the most successful. Why? Lawyers and CPAs usually have professional liability insurance.
In March 1993, a top-notch law firm found itself in legal hot water over work it did for Stockbridge Funding Corp., the New York mortgage-brokerage business that turned out to be a Ponzi scheme preying on Eastern European immigrants.
Court-appointed trustee David Kittay who was charged with liquidating what was left of Stockbridge claimed that New York-based Battle Fowler, the law firm which had advised Stockbridge’s management during its thieving heyday, should be held responsible for the ment during its thieving heyday, should be held responsible for the lawyer firm “aided and abetted” the fraud by “drafting, editing and supervising illegal and fraudulent advertising” placed in newspapers geared toward Eastern European immigrants.
Battle Fowler answered that it had been unaware of any wrongdoing. Spokesmen for the law firm said it had tried to ensure that Stockbridge abided by the law—but that its efforts had been sabotaged by Stockbridge’s owners. “There’s not a scintilla of evidence that any of the lawyers at Battle Fowler knew what these characters were doing. They didn’t know what these crooks were doing any more than anyone else [did],” the lawyers’ lawyer said.
Battle Fowler’s attorney said Kittay’s suit was a creative—but unjustifiable—attempt to search for deep pockets to repay investors. If anything, he said, Stockbridge owed Battle Fowler money. The law firm had only been paid $50,000 for the legal work it did; it was still owed another $40,000.
Apparently, Battle Fowler went too far in fighting Kittay’s claim. In an order, the judge presiding over the early stages of the dispute rebuked Battle Fowler’s lawyers for attempting to “terrorize” immigrant investors by sending out notices demanding that they bring immigration documents with them for pretrial questioning.
The pushy approach didn’t work. Battle Fowler ended up settling with Kittay in exchange for a quiet end to the suit.
The RICO Connection
Generally, the legal rule is that companies that were part of Ponzi schemes can’t sue under RICO. Only investors can. However, this leads to an inherent conflict: the receiver’s primary responsibility is to the corporation—not the burned investors.
This means that receivers aren’t usually good advocates for what most people would consider justice in the wake of a Ponzi scheme. Their proper role is to liquidate whatever assets are left as quickly and costeffectively as possible.
The 1995 federal appeals court decision Hirsch v. Arthur Andersen & Co. illustrates why receivers in Ponzi cases have so much trouble going after lawyers and accountants.
In Hirsch (which was one of many legal spin-offs of the massive Colonial Realty1 scheme), the receiver sued Colonial’s accountant—Arthur Andersen—alleging, among other things, violations of the RICO Act. He argued that Colonial participated with Andersen in fraudu
1. For more on Colonial Realty see Chapter 12.
lently issuing memoranda to induce individuals to invest in bogus limited partnerships.
The bulk of the receiver’s complaint alleged a scheme to defraud investors; but the only alleged damage to the Ponzi company was the generation of some unpaid accounting bills. The accused accounting firm argued that the receiver lacked legal standing because the claims “really” belonged to the scheme’s investors and that any claims the companies might make were prohibited by virtue of their own participation in the fraudulent scheme.
The court ruled that the receiver hadn’t alleged any distinct way in which the companies were damaged by the wrongdoing of the CPAs. It dismissed the claims and went on to explain that, be
cause the receiver had alleged that the injury to the companies was coextensive with the injury to the investors, “the trustee has done no more than cast the [companies] as collection agents for the [investors].”
If—as the court suspected—the facts of the complaint suggested that the claims actually belonged to the investors, “a blanket allegation of damage to the debtors will not confer standing on the [receiver].” (The investors had already filed separate lawsuits against the law and accounting firms.)
The appeals court, affirming the lower court ruling, noted that the claim against the accounting firm relied on the distribution of misleading memoranda to investors. So, only the individual limited partners could make the claims against Andersen.
Unfortunately, there are exceptions that confuse matters by suggesting that a receiver can sometimes go after professionals on behalf of investors. The 1988 federal appeals court decision Regan v. Vinick & Young offered an example. In the case, a Ponzi scheme bought and sold rare coins for its customers—but the principals stole significant assets from the company, which eventually led to its collapse.
A court-appointed trustee sued the company’s accountant and auditor for certifying reports which summarized rare coin transactions. His complaint alleged negligence, breach of contract, negligent misrepresentation, and unfair and deceptive acts or practices. The damages sought included: the cost of the accountant’s services, the misappropriation of assets by the company’s principals, certain sales commissions paid by the company, the costs of its bankruptcy filing and an $11.8 million fine from the FTC.
The accountants argued that the claims filed by the trustee belonged only to investors, a group the trustee did not represent. The court disagreed, ruling:
The trustee steps into the shoes of the [failed company] for the purposes of asserting or maintaining its causes of action, which become property of the estate. [Any] confusion may stem from the trustee’s repeated assertions that the accountant’s wrongdoing caused [investors] to lose money. This emphasis... appears to result from the $11.8 million claim filed on their behalf... and from the concern that the estate may be held jointly and severally liable with the accountant in any eventual actions.
So, these concerns were legitimate. The trustee could go after the accountants. If he won, the money would go into the company’s bankruptcy estate and—all would hope—eventually to the investors.
Lawyers and accountants can’t just take money from Ponzi perps without asking any questions about its origins. As one federal court has written:
The court’s ruling in no way condones the acts of an attorney who blindly handles substantial sums of money for a client with no inquiry into its source if the attorney has reason to suspect the legality of the origins of the funds or if the attorney has reason to suspect his or her client’s right to ownership of those funds. The attorney is clearly subject to disciplinary sanctions according to ABA [guidelines]. Moreover, he or she may be liable under conspiracy or aiding and abetting theories, or even under other theories not pled by plaintiff.
The American Bar Association guidelines were designed to prevent lawyers from playing stupid when advising drug dealers. They apply equally well to lawyers playing stupid when advising Ponzi perps. The civil conspiracy angle mentioned by the court might make sense in some situations. Burned investors stand on stronger legal ground if they allege a conspiracy existed between lawyers or accountants and the Ponzi perps. The problem here: While the theory of a conspiracy makes a better argument, it requires a lot more evidence than a negligence claim.
It’s a short step from alleging a civil conspiracy to alleging an organized crime operation under RICO (and RICO’s triple damages). However, the federal courts severely limit RICO’s applicability to lawyers or accountants. In its 1993 decision Reves v. Ernst & Young, the Supreme Court explained theRICO restrictions.
The defendants in Reves were accountants who drafted misleading financial statements and were subsequently sued for both securities fraud and RICO violations. A jury found that the accountants had engaged in securities fraud; but the U.S. Supreme Court upheld the dismissal of the RICO claim, holding that the mere drafting of statements based on information supplied by the perp did not constitute sufficient participation in the operation or management of the enterprise. So, even if the accountants had engaged in intentional fraud, they could not be held liable under RICO.
In short, the Supreme Court ruled that lawyers or accountants do not incur RICO liability for the traditional functions of providing professional advice and services. It ruled that in order to be liable under RICO, an outside professional must have “participated in the operation or management of the enterprise itself,” and must have played “some part in directing the enterprise’s affairs.”
Some courts have given the matter some leeway. In the 1994 decision Friedman v. Hartmann, a federal court in New York ruled:
[I]t will not always be reasonable to expect that when a defrauded plaintiff frames his complaint, he will have available sufficient factual information regarding the inner workings of a RICO enterprise to determine whether an attorney was merely “substantially involved” in the RICO enterprise or participated in the “operation or management” of the enterprise.
But other courts, citing the Reves decision, have dismissed RICO claims without giving plaintiffs an opportunity to conduct discovery. Establishing Fiduciary Duty—to the Investors
In order to make a claim of professional negligence or breach of fiduciary duty, a burned investor has to show that the lawyer or accountant owed some direct fiduciary duty. This usually isn’t the case, since the professionals are hired by the company—and owe their duty to it.
This guideline stems back at least to a 1930s decision written by federal judge (and later U.S. Supreme Court Justice) Benjamin Cardozo which held that an accounting firm owes a duty of due care only to those in “privity of contract” with it or to “those whose use of its services was the end and aim of the transaction.”
This is still generally the law on the duty. However, the duty of accountants in some states has been expanded to include reasonably foreseeable reliance provided it lies “within the contemplation of the parties to the accounting retainer.” The 1985 New York Court of Appeals decision Credit Alliance v. Arthur Andersen & Co. also created a test which can expand Cardozo’s limits. The court ruled:
Before accountants may be held liable in negligence to noncontractual parties who rely to their detriment on inaccurate financial reports, certain prerequisites must be satisfied:
1) the accountants must have been aware that the financial reports were to be used for a particular purpose or purposes;
2) in the furtherance of which a known party or parties was intended to rely; and
3) there must have been some conduct on the part of the accountants linking them to that party or parties....
This so-called “Credit Alliance test” usually requires some evidence of a “nexus between the [professionals] and the third parties to verify the [professionals’] knowledge of the third party’s reliance.”
The 1988 New York case Crossland Savings v. Rockwood Insurance Co. involved a bank that loaned money to a crook in large part because the crook’s lawyer wrote several opinion letters attesting— wrongly—to the crook’s financial viability.
After the scheme collapsed, the bank sued the lawyer’s professional liability insurance company. The insurance company didn’t want to pay; it argued that the circumstances didn’t meet the Credit Alliance test. The court agreed with the bank: “When a lawyer at the direction of her client prepares an opinion letter which is addressed to the third party [namely, the bank] or which expressly invites the third party’s reliance, she engages in a form of limited representation.”
Under such circumstances, the “opinion letters do not constitute advice to a client, but rather were written at the client’s express request for use by third parties.”
Misrepresentations and Omissions
/>
Under Securities and Exchange Act Rule 10b-5, burned investors can go after lawyers and accountants, alleging liability for either “material misrepresentations” or “omitting to state a material fact necessary to render the statements made not misleading.”
The first of these charges, misrepresentation, is easy to articulate in legal theory but difficult to prove. A burned investor has to establish that the lawyer or accountant affirmatively stated something untrue about the scheme or its perps. Most professionals—even determinedly crooked ones—can manipulate language enough to avoid this direct connection.
This is why the prospectuses for Ponzi investments will often include critical boilerplate language stating that the securities are not traded on any securities exchange, not approved by the SEC or both.
If the burned investor can establish that the lawyer or accountant has affirmatively made false statements, the investor “must demonstrate that he or she relied on the misrepresentation when entering the transaction that caused him or her economic harm.”
A charge of aiding and abetting liability against a lawyer under Rule 10(b) is especially tough to prove if there was no fiduciary relationship between the lawyer and the investor. In such a situation, the investor has to argue that the lawyer display an “actual intent to aid in [the] primary fraud” instead of mere “recklessness.”
The 1988 federal appeals court decision First Interstate Bank v. Chapman & Cutler dealt with a case in which the defendant—a law firm—had allegedly made misstatements in connection with an initial bond offering to finance a nursing home. In a “classic Ponzi scheme,” the proceeds of subsequent bond offerings were used to repay the initial offering.
