You Can't Cheat an Honest Man

by James Walsh

  The Securities Act of 1933 was influenced by Brandeis’ book. As one congressman put it, “The American investor was relying upon the bankers, since faith in the bankers was virtually the only measuring rod for the investor. How certain bankers and brokers have breached that faith is part of this whole sordid story.”

  When this line is crossed—which it still sometimes is—banks can be held liable for Ponzi scheme damages. That’s exactly what happened in the Great Rings Estate Limited Partnership scheme.

  Great Rings was a distant relative of the infamous—and much larger— Colonial Realty pyramid scheme that shook Connecticut money circles in the late 1980s. One of Colonial’s most successful salesmen was Kenneth Zak. In early 1988, after studying with master Ponzi perps at Colonial, Zak left to strike out on his own.

  What he found was Great Rings, which had been started as a limited partnership among several experienced real estate developers. The stated purpose of Great Rings was to purchase four parcels of unimproved land on Great Rings Road in Newtown, Connecticut, upgrade their zoning, and prepare single-family home sites which would then be resold at a profit.

  Zak—who had no experience in developing raw acreage—didn’t care what the stated purpose of the vehicle was. To him, it was a method of raising money. He and the founding general partners agreed on an unusual method of financing. Great Rings would solicit investments in the form of limited partnerships. Investors would borrow the entire purchase price of their shares ($50,000 each) from a bank. Their notes would be directly payable to the bank. The partnership would guarantee a return at 8 percent per annum to the investors, to offset the interest on the notes to the bank.

  Zak claimed that, in two years, Great Rings would have sufficient funds to pay off the principal—and still have many of the parcels left to sell. So, the general partners would raise millions and the investors would never pay a dime out of their own pockets.

  The scheme, while not inherently unlawful, contained a substantial Ponzi element from the very beginning. The raw acreage could not produce income until it was developed and resold, so the only conceivable source of the 8 percent annual return was money from new investors. This aspect of the enterprise was not mentioned in any of the promotional literature or legal filings produced by Great Rings.

  The success of the scheme rested on persuading a bank to go along. Zak approached Connecticut National Bank (CNB). In January 1989, he met twice with Neal Fitzpatrick, then a senior vice-president and regional manager of CNB. The first meeting was at Fitzpatrick’s office, and the second was at a Super Bowl party at Zak’s home.

  Fitzpatrick also met with the other general partners of Great Rings. He agreed that, if the general partners would refer potential investors to CNB, the bank would loan money to those investors that it deemed even minimally qualified. “The bank was dying to get money out there working,” recalls one of the general partners. “The minimal qualifications were that the leads could fog a mirror.

  Fitzpatrick contacted two other regional managers of CNB— in Hartford and in Waterbury—who also agreed to go along. The bankers reached a detailed agreement with Zak that each investor’s loan was to be in the amount of $50,000 (the purchase price of a Great Rings limited partnership share) with an informal maturity date two years later and with interest set at 1 percent over prime.

  The terms were tailored to fit the needs of the Great Rings partners exactly. CNB presented the same terms to every potential investor, with no negotiation on the investor’s part. CNB’s willingness to make these loans was an enormous selling point for Zak.

  Great Rings filed the appropriate paperwork to exempt its limited partnership shares from the registration requirements of the Securities Act of 1933. Its argument was that the limited partnerships didn’t qualify as a public offering under Rule 506 of the Act.

  Rule 506 exempts transactions involving no more than 35 purchasers of securities. In calculating the number of purchasers under the Rule, “accredited investors” are not counted. An “accredited investor” is a person with a net worth—together with his or her spouse—over $1 million or an income over $200,000 a year in each of the two previous years.

  Rule 506 also requires that each purchaser who is not an accredited investor have “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.” Great Rings marketing materials stated:

  Units will be sold only to persons that the General Partners reasonably believe to satisfy the definition of an “accredited investor” under...the Securities Act.

  So, Great Rings was supposed to be a rich person’s deal. Sometimes Warnings Tease Greater Interest

  The various disclaimers included in the marketing materials acted like catnip to greedy strivers of middle-class means. With the marketing pieces circulating around central Connecticut, many people would know that anyone involved in Great Rings had to be rich by the SEC’s reckoning. So, investing in the deal was something like leasing a Mercedes. It was a sign you had made it.

  Of course, Zak didn’t actually follow the disclaimers. He sold Great Rings limited partnership units to accredited and nonaccredited investors alike. And, with CNB rubber-stamping loan applications, a lot of people who wouldn’t normally have $50,000 in cash to invest were able to get involved. As one court later noted:

  The evidence is overwhelming that [he] solved this problem by ...wholesale forgery. When an investor signed his subscription agreement, he was told what to fill in and not fill in. It would not be completed in full. [Zak] would then fill in some cooked up figures on the balance sheet so that the investor’s income and net worth would be sufficiently inflated to make him accredited.

  The Great Rings promoters focused their efforts in Waterbury on the city’s Republican Party establishment. This was a middle-class crowd...with aspirations for bigger things.

  More than 40 investors ultimately joined Great Rings, contributing more than $2 million. Monthly payments to cover the interest payments on the CNB loans started in September 1988. They continued for about a year until the fall of 1989. At that point, the money stopped coming—and explanations were in exceedingly short supply. Only one thing was certain: CNB still expected to be paid.

  By this time, Zak had left Great Rings. The money that the company had raised was gone. The partnership had acquired two relatively small parcels of land, totaling 10 lots; and even these parcels were eventually foreclosed on by CNB.

  The lawsuits started in early 1990. Angry investors sued every person and entity connected to Great Rings—the company itself, Zak, the other general partners and CNB. The bank turned around and sued many of the investors, holding them personally liable for loans taken against the worthless Great Rings partnership units.

  One of the most important ruling on these cases was the 1993 Connecticut state court decision Connecticut National Bank v. Robert A. Giacomi et al. Clearly astounded by CNB’s actions, the court wrote:

  Bankers are regarded in popular folklore as shrewd, tightfisted individuals, unwilling to lend money to anyone unable to prove that he doesn’t need the money in the first place. This case involves bankers of a very different description.... [CNB] made a deal with the promoters of a speculative real estate scheme to give unsecured loans to the investors in that scheme. [R]ather than employing the traditional close scrutiny of a lending bank, it dished out loans to investors it had never seen with a cursory abandon that left the recipients slack-jawed with astonishment.

  Of course, there’s no law against loaning money with cursory abandon. But the court was troubled by the shady histories of people like Kenneth Zak. It went on to write:

  The promoters here were, essentially, common criminals, who engaged in numerous acts of fraud, forgery, and outright theft of the invested funds. The bank openly allied itself with the promoters and, in effect, became a promoter. ...[T]he general atmosphere of fraud and betrayal in this case [and] the fact that no satisfac
tory accounting of funds has ever been made...irresistibly lead to the conclusion that the investors’ money was simply stolen.

  The court acknowledged that some of the investors had criminal backgrounds themselves—and may have been looking for an easy profit from a sleazy deal. But the argument against CNB—namely, that the bank was a part of the scheme—held up. CNB was in trouble.

  The court cited Learned Hand’s statement that, in order to be held as an aider-and-abettor, a person or entity must “associate himself with the venture, participate in it as something that he wishes to bring about, [and] seek by his action to make it succeed.”

  CNB associated itself with the venture, participated in it as something it wished to bring about, and sought by its actions to make it succeed. Its involvement was “affirmative, substantial and wrongful.” The court concluded that CNB should not be permitted to recover against the investors. “In a case like this, when the bank went out of its way to act as bait, it cannot complain that the fish were eager to bite.”

  When Stockbrokers Push People into Ponzi Schemes

  More often than banks, stock brokerages will end up promoting Ponzi schemes. But stock brokerages aren’t always linked so closely with the investments they sell; the key to establishing a brokerage’s liability is proving that it was a “control person.” The 1992 federal appeals court decision Harrison v. Dean Witter Reynolds held one brokerage liable on these grounds.

  The Ponzi perps in the case had used Dean Witter’s office space, telephone services, and employee trading accounts in order to perpetuate their scheme. The local management failed to enforce Dean Witter’s own rules to prevent such fraudulent practices.

  The same appeals court later upheld a jury finding of liability in a related case, based on the brokerage firm’s:

  failure to detect and halt its employees’ fraudulent activities, the complete lack of supervision over their abnormal trading activities, and the firm’s refusal to investigate the obvious rule violations committed by its agents.

  In that later decision, the court noted the existence of :

  [ S]ufficient evidence for a reasonable jury to determine that had Dean Witter not shut its eyes to the various fraud signs available to it, as it did, the whole scheme could have been detected and shut down by Dean Witter far earlier than when it collapsed.

  The problem with the investment world is that it mixes conservative vehicles with high-risk ones, often in close quarters. Few brokerage firms investigate all of the investments they sell—and they don’t make false promises about doing so. A New York lawyer who sits on arbitration panels that hear investment disputes lays out the terms:

  As long as the stock brokerage isn’t dumping worthless stock that it owns or coercing a person to make an investment he’s said he doesn’t want to, the operating rule is “Buyer beware.” It’s really hard to find a broker liable for a client’s losses. Whether or not they should, the rules assume an investor knows what he’s doing.

  As a result, some of the most egregious schemes are able to market themselves through legitimate brokerages.

  In April 1989, Thomas Mullens started Omni Capital Group in Boca Raton, Florida. He employed commissioned salespeople, secretaries, and receptionists for the corporate office in Boca Raton and sales offices in New Jersey, California and Ohio.

  Omni Capital sold loosely-defined “investment opportunities” in the form of shares, contract rights and participation rights in limited partnerships. Mullens told investors the limited partnerships were formed to buy and sell small, privately held companies for a profit. He published promotional materials claiming he’d sold 22 companies and his investors had averaged 24 percent annual returns.

  In reality, Omni Capital was a Ponzi scheme. Mullens and his staff were able to convince about 150 greedy people to invest some $27 million in the scheme between 1988 and 1992. The investors, mostly elderly retirees, were promised annual returns of at least 15 percent on their investments. (But Mullens promised some investors returns of up to 15 percent each quarter.) “He customized his deals. If he needed money he’d promise you any interest rate,” said Thomas Tew, a Miami lawyer who worked on the case. This is a familiar theme.

  To keep investors involved as long as possible, Mullens spent some of the money on false account statements reflecting annual rates of return of 20 percent to 30 percent. As with the typical Ponzi scheme, he used some of the contributions from later investors to pay off returns promised to earlier investors, thus convincing at least some people that Omni Capital was a successful enterprise.

  Mullens spent some of the fraudulently acquired money on symbols of success: a million-dollar home, an airplane, country club memberships, glossy brochures full of empty boasts about Omni Capital, and elegantly detailed offices.

  The scheme began to totter in 1991. First, the SEC began an investigation based on promises Mullens was making. In the course of that investigation, a group of Omni Capital employees learned that Mullens was a twice-convicted felon who’d spent three years in prison in the 1970s for operating a pyramid scheme in New Jersey.

  Some of these employees had invested money with Omni Capital. They demanded refunds and Mullens paid them about $1 million, buying himself a little more time. But the collapse came quickly in April 1992 when word of the SEC investigation leaked to the local press—and investors rushed to liquidate their holdings. Omni Capital repaid about $4 million and then filed bankruptcy in May.

  Using Omni Capital’s books and bank records, the bankruptcy trustee was able to trace all but about $7 million of the funds invested with Mullens. Of course, this didn’t mean the trustee could recover the money. About $15 million was lost.

  In October 1992, federal prosecutors charged Mullens with dozens of counts of conducting financial transactions to promote a fraud, conducting monetary transactions with its proceeds and criminal conspiracy. A few months later, Mullens pleaded guilty to 47 criminal counts of defrauding investors and admitted that Omni Capital was a pyramid scheme with no tangible operations. A federal court in Miami sentenced Mullens to 35 years of in prison and ordered him to pay $27 million in restitution.

  Many investors suspected that Mullens had diverted several million dollars to foreign bank accounts, but these suspicions couldn’t be supported by facts. So, investors had to look elsewhere.

  Mullens said that believed the people who sold partnerhsip units had known that he’d run pyramid schemes in the past. That testimony set the stage for suits against the salesmen, including stockbrokers who referred clients to Omni Capital—in exchange for cash payments.

  In April 1993, three Miami-area Prudential Securities stockbrokers were accused of taking money from Mullens to steer their clients into Omni Capital. Two separate suits filed in federal court claimed that the Prudential stockbrokers helped Mullens raise at least $15 million. (Both suits named Prudential—with its deep pockets—as a co-defendant.) Burned investors said they were told that Omni Capital was a conservative investment that Prudential employees bought for their own families.

  One of the brokers had boasted that he’d raised $8 million for Omni Capital—for which he received more than $500,000 in commissions— during the 18 months prior to the scheme’s collapse.

  To connect Prudential to the misdeeds, the suits claimed that Prudential supervisors were aware the brokers were selling Omni Capital to clients and that neither Prudential nor its brokers did any due diligence to verify claims Mullens made in a prospectus. One lawyer for the burned investors said Prudential should be held responsible for allowing brokers to recommend investments that were not screened by management and to accept money from an outside source.

  Prudential Securities spokesman William Ahearn insisted his firm never had a relationship with Omni Capital. “Anyone who invested with Omni did so directly with that company,” he said. “They made the check out to Omni, there was no solicitation by us formally.”

  Ahearn said that the stockbrokers who took money from Omni Capit
al did so only after leaving Prudential. Still, Prudential settled with the shareholders for a small amount.

  “The main lesson in the [Omni Capital] case is that some deals are just so sleazy the bankers and brokers will pay money so that they aren’t associated with them,” says one lawyer familiar with the Prudential case. “And you might think that these deals are rare. But every office of every brokerage in the country has at least one that it’s peddling right now.”

  Financial institutions get involved in Ponzi schemes because of two weaknesses which they share with many investors. First, they are drawn to strong profit-and-loss statements, which—in the early stages and with some manipulation—Ponzi schemes can have. Second, they operate in competitive arenas, so their decision-makers are often nervous about missing opportunities.

  Together, these traits lead many insitutions to reach what one banker calls “false positives.” Sometimes these miscues are foreign countries; sometimes they’re local Ponzi schemes. All financial institutions have their share.

  Case Study: Towers Financial Uses Duff & Phelps

  Steven Hoffenberg’s Towers Financial was a false positive. Hoffenberg dropped out of the City College of New York in the late 1960s to go into business. While he had no particular passion for any one line of work, he was a good negotiator. In a few years, he was buying small businesses in the New York area and reselling them to bigger competitors at decent profits.

  In the early 1980s, Hoffenberg stumbled onto the business that suited him best: debt collection. He started a company that specialized in collections, receivables purchasing and factoring. These are activities that make most people—even most business people—flinch. They’re the hardest, ugliest part of commerce.

  Hoffenberg, with his facile knowledge of financial terms and aggressive, Brooklyn-bred personality seemed like the perfect person to handle the ugly work. Within a few years, Towers Financial operated through a number of subsidiaries, the largest of which were: