November 21, 2013 Articles

Banking on Liability: Claims Against Ponzi Scheme Professionals

The law neither persecutes nor pardons every professional who worked with the Ponzi debtor.

by Gene R. Kohut, Scott A. Wolfson, and Adam L. Kochenderfer

The past decade brought a string of investment Ponzi schemes that left victims scrambling for sources of recovery. Good options are often few and far between. The bankrupt perpetrators are an inadequate source because, by definition, they ran insolvent businesses that were unable to satisfy their creditors' claims. Their employees are often unwitting victims themselves, and the duped investor who received returns but "should have known better" may elicit sympathy despite deliberate ignorance.

These challenges have spurred bankruptcy trustees across the country to pursue claims against banks, attorneys, accountants, and other professionals who provided services to the Ponzi scheme operators. Large, institutional defendants with reams of records showing the day-to-day activity of a Ponzi scheme are obvious targets. The claims against them often sound in tort and include breach of fiduciary duty, negligence, and aiding and abetting fraud. Variations in state law suggest that some trustees may succeed with those claims whereas others do not.

Trustees: Innocent Wrongdoers
Tort claims against a Ponzi scheme professional face significant obstacles. In the Madoff bankruptcy cases, the Second Circuit Court of Appeals recently affirmed the dismissal of the Madoff bankruptcy estate trustee's claims against banks used by Madoff to perpetrate his scheme. See Picard v. JPMorgan Chase Bank & Co. (In re Bernard L. Madoff Inv. Secs. LLC),721 F.3d 54 (2d Cir. 2013). The defendants included JPMorgan Chase, the bank where Madoff maintained his accounts and "commingled and ultimately washed" hundreds of billions of dollars in a series of suspicious transactions. Madoff, 721 F.3d at 9. JPMorgan Chase conducted due diligence before Madoff was arrested and concluded that "there is a well-known cloud over the head of Madoff and that his returns are speculated to be part of a [P]onzi scheme." Id. at 10. Nevertheless, the bank did not redeem its shares in Madoff's funds until over a year later.

The trustee's claims against the banks included unjust enrichment, breach of fiduciary duty, aiding and abetting fraud, and negligence. One reason the trial court dismissed the claims was that it found that the trustee stood in the shoes of Madoff; therefore, the doctrine of in pari delicto prevented the trustee from recovering against the bank defendants for wrongdoing in which Madoff participated.

Black's Law Dictionary defines the in pari delicto doctrine as follows: "The principle that a plaintiff who has participated in wrongdoing may not recover damages resulting from the wrongdoing." Black's Law Dictionary 794 (7th ed. 1999). Bankruptcy trustees are often said to step into the shoes of the Ponzi debtor and can be subject to the same defenses. "[D]efendants use the in pari delicto defense as a weapon to attempt to bar [trustees and others] from asserting tort claims against them, blaming the damage on the wrongful actions of the corporate debtor's principals." Kathy Bazoian Phelps & Hon. Steven Rhodes, The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes § 14.01 (2012).

However, the Ponzi victim should not assume all is lost. The wave of circuit courts affirming dismissals of trustees' claims under the in pari delicto doctrine does not create a blanket, national rule. Disheartened trustees must remember that state law governs the substance of these tort claims. Even the Madoff court expressly relied on New York law to analyze the applicability of the in pari delicto defense. A trustee must evaluate the bankruptcy estate's claims alongside the language of the applicable state case law to determine the likelihood of success. The variance in this authority from state to state could play a determining factor in the claim's survival.

Most states recognize that public policy considerations can trump an in pari delicto defense. The Michigan supreme court has gone a step further and enumerated specific factors to guide Michigan courts' analysis of in pari delicto and public policy. In Orzel v. Scott Drug Co., 449 Mich. 550, 559–60, 537 N.W.2d 208 (1995), the court held that in pari delicto is "rooted in the public policy" of denying aid to wrongdoers and is applicable when the court must avoid "several unacceptable consequences":

1. By making relief potentially available for wrongdoers, courts in effect would condone and encourage illegal conduct.

2. Some wrongdoers would be able to receive a profit or compensation as a result of their illegal acts.

3. The public would view the legal system as a mockery of justice.

4. Wrongdoers would be able to shift much of the responsibility for their illegal acts to other parties.

Applicability of these guidelines to a convicted Ponzi scheme operator suggests that the in pari delicto defense may not bar a trustee's claims against banks or accountants with actual or constructive knowledge of the scheme. Courts in such a scenario would have already punished the Ponzi scheme debtor and compelled the debtor to take responsibility for his or her illegal acts. Moreover, all proceeds of the trustee's claims would be distributed to creditors in accordance with the Bankruptcy Code. Recovery would not cause a mockery of justice; to the contrary,it would be a mockery to release an aider and abettor from liability based on a legal fiction that an innocent trustee is clothed with the guilt of an incarcerated Ponzi scheme operator.

Some courts have reached this conclusion in addressing the in pari delicto defense. In a case that did not involve a Ponzi scheme, Waslow v. Grant Thornton LLP (In re Jack Greenberg, Inc.), 240 B.R. 486, 491–93 (Bankr. E.D. Pa. 1999), the debtor falsified its financial records and submitted the erroneous information to its accounting firm, Grant Thornton. Grant Thornton then used the data to render accounting services to the debtor. After the company filed for bankruptcy relief, its trustee filed an adversary proceeding against Grant Thornton alleging aiding and abetting, negligence, and fraud. Grant Thornton argued that these claims must be dismissed because the trustee stood in the debtor's shoes. The court disagreed:

While a party may itself be denied a right or defense on account of its misdeeds, there is little reason to impose the same punishment on a trustee, receiver, or similar innocent entity that steps into the party's shoes pursuant to court order or operation of law. Moreover, when a party is denied a defense under such circumstances, the opposing party enjoys a windfall. This is justifiable as against the wrongdoer himself, not against the wrongdoer's innocent creditors.

Id. at 503.

The court relied on this reasoning and held that the trustee's claims against the accounting firm could proceed.

The mixed blessing of examining public policy considerations under express guidelines is that any analysis must be highly fact-specific. If a state's case law focuses on whether the wrongdoer is evading responsibility for his or her actions, it may matter whether the Ponzi operator received a "slap on the wrist" or is serving a multiyear sentence in a federal penitentiary. If the public's opinion of the legal system is considered to be a relevant factor, as instructed in Orzel, the court may consider whether the bank, accountants, or other professionals had actual knowledge of the fraud or had constructive knowledge, having missed "red flags" indicative of a Ponzi scheme. These wrinkles, along with the fact that there are 50 different state laws that will vary in this analysis, require bankruptcy trustees to take a methodical and nuanced view of bankruptcy estates' tort claims against third-party professionals.

Call of Duty: Asserting Victims' Assigned Claims
As described above, the trustee may file tort claims on the bankruptcy estate's behalf. However, if victims assign their claims to the trustee, the trustee may also bring those claims. Although assignments avoid the in pari delicto defense because now the trustee is standing in the shoes of the victim instead of the wrongdoer, they bring their own set of challenges.

For example, do the Ponzi operator's bankers or accountants owe a duty to a third-party investor with whom they have no direct relationship? The duty element is one of the central issues of any Ponzi victim's tort claims against third parties. The trustee must again look to state law to determine whether a duty is present. Many states take a flexible approach, eliminating any privity requirement and examining the nature of the parties' relationship to determine whether a duty exists. Courts across the country have used this flexibility to hold that a defendant may be held liable to a third party for the wrongdoer's misappropriation when three circumstances exist: (1) There is a fiduciary relationship between the wrongdoer and the third party; (2) the defendant knows or ought to know of the fiduciary relationship; and (3) the defendant has actual knowledge that a diversion is to occur or is ongoing.

For example, in Lerner v. Fleet Bank, N.A., 459 F.3d 273, 278 (2d Cir. 2006), a Ponzi scheme operator convinced investors to give him money, claiming that he would invest it on their behalf, but instead misappropriated it for personal expenses and ordinary day-to-day business costs. The operator used the defendant as his bank for conducting seemingly routine transactions. After the scheme collapsed and the operator entered bankruptcy proceedings, investors filed a claim against the bank for negligence and aiding and abetting breach of fiduciary duty. The court held that the bank owed a duty to the investors under New York law because it knew that the operator was diverting deposits:

[A] bank may be liable for participation in [such a] diversion, either by itself acquiring a benefit, or by notice or knowledge that a diversion is intended or being executed. Adequate notice may come from circumstances which reasonably support the sole inference that a misappropriation is intended, as well as directly. Having such knowledge, [the bank is] under the duty to make reasonable inquiry and endeavor to prevent a diversion.

Id. at 287–88 (citations and internal quotations omitted).

Anyone worried that banks or accounting firms may have unlimited liability when their clients conduct a Ponzi scheme should be comforted by this standard. It is insufficient for the defendant to have merely received "red flags" indicating that its customer may be engaged in suspicious activity. The defendant must have actual knowledge or clear notice that a misappropriation is occurring. Moreover, records showing that the Ponzi operator has received funds from a person and suspiciously transferred them do not create a duty; the defendant must know or "ought to know" that a fiduciary relationship exists between the Ponzi operator and the investor. If the defendant did not know its customer's business as a purported broker in detail, it may be difficult for a plaintiff to meet this standard. A trustee filing an assigned claim must carefully examine the defendant's knowledge of the duped investor's existence and the evidence that a misappropriation had occurred.

Although there is a significant body of court decisions dismissing bankruptcy trustee claims against a Ponzi debtor's banks and other professionals, nuances in both fact and law require trustees to analyze these potential avenues of recovery carefully. There is no one-size-fits-all approach. The likelihood of success depends on (1) whether the claims originally belonged to the bankruptcy estate or have been assigned, (2) applicable state law, and (3) the knowledge and circumstances of the relevant parties. The law does not impose liability on every professional who worked with the Ponzi debtor, but neither does it assume that the only liable parties are the perpetrators who sit behind bars.

Keywords: litigation, commercial, business, actual knowledge, constructive knowledge, due diligence, in pari delicto, Ponzi scheme, trustee

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