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When Ponzi Schemes Collapse, Service Providers May Be in the Cross-Hairs

DC Solar Solutions Inc. described itself as a designer, manufacturer, and lessor of renewable energy products. More recently, though, it has been described in court documents as a massive Ponzi scheme and has been implicated in an $810 million investment fraud.

Ponzi schemes take their name from Charles Ponzi, who became notorious for his use of such a scheme in the 1920s, and they continue to be an economic force today. According to Ponzitracker.com, the average size of the 47 Ponzi schemes uncovered in 2018 was $34.1 million. The total investor funds involved in these schemes was about $1.6 billion.

Stating what may be obvious, the chicanery involved in a modern-day Ponzi scheme does not take place in a vacuum, affecting just the wrongdoers and their investor victims. Those orchestrating high-stakes fraudulent schemes often enlist both the knowing and unknowing services lawyers, accountants, banks and other financial institutions, and payment processors in the execution of their schemes. Savvy schemers recognize that reputable service providers may convey a necessary air of legitimacy to their illicit enterprises. When a scheme collapses, however, victims often seek recoveries from those service providers.

Financial Institutions

After Ponzi schemes collapse, service providers regularly find themselves in the cross-hairs when victims and their court-appointed representatives seek restitution. Banks and financial institutions appear especially susceptible to exposure because most schemes, at some stage, utilize bank accounts. Those individuals who are most harmed are quick to argue that legitimate financial institutions have a heightened duty to protect the general public because banking regulations impose an obligation on financial institutions to look for, identify, and/or deter such fraud.

Those harmed by the fraud often assert that the financial institution’s failure to identify or stop the scheme establishes the institution’s liability. Victims argue that the financial institution’s involvement with the fraudulent company rises to the level of “aiding and abetting” the wrongdoer in committing the fraud. The financial institution has to address assertions of financial damages from the scheme, as well as any attempt by litigants to require disgorgement of the fees earned in the “servicing” of the fraud.

Recent high-profile examples of this type of litigation include the infamous multibillion-dollar Ponzi schemes perpetrated by Thomas Petters in Minnesota and Bernard Madoff in New York. In both cases, court-appointed trustees commenced litigation against some of the largest and most well-known financial institutions in the world.

The Madoff Ponzi scheme, in particular, demonstrates that pursuing third-party service providers can be lucrative. In that case, HSBC Bank paid $62.5 million, while JP Morgan agreed to pay more than $1.7 billion to settle claims and end costly “aiding and abetting” litigation.

Despite such highly publicized victories, proving liability can be anything but a sure thing in a litigation context. Rather, success is highly dependent upon the specific provable facts and relevant controlling state law. The recent decision in TelexFree Inc. is particularly illustrative of these potential obstacles. In re TelexFree Securities Litig., No. 4:14-md-02566-TSH, 2019 WL 362288 (D. Mass. Jan 29, 2019).

TelexFree effectively executed a massive pyramid scheme that operated from February 2012 to April 2014 and affected nearly 2 million participants across the globe. TelexFree claimed to provide internet service, but its real business was raising funds from investors. Promoters secured the investors and were promised large returns in connection with the approval of ads that would appear on the internet.

Unlike the Madoff Ponzi scheme, TelexFree largely targeted low-income minority investors. The scheme came to a halt when governments and authorities froze the company’s activities and commenced criminal prosecutions. Ultimately, the company filed for protection under Chapter 11 of the U.S. Bankruptcy Code, and the case was heard in Massachusetts, where TelexFree’s headquarters was located.

With the collapse of the fraud came the onslaught of litigation. TelexFree’s victims commenced separate actions in several federal district courts against dozens of defendants, including banks, payment processing companies, and the principals allegedly involved in the fraud. Those actions were consolidated by a Judicial Panel on Multidistrict Litigation to be decided by the U.S. District Court in Massachusetts.

In the consolidated litigation, plaintiffs sought recoveries from TD Bank and Bank of America N.A. Using the playbook of similar litigation, the plaintiffs argued that liability had been established because the banks had aided and abetted TelexFree in the execution of the pyramid scheme. The plaintiffs also argued that the banks should disgorge banking fees, as they should not be unjustly enriched as a result of the massive fraud.

In general averments, the plaintiffs alleged that the banks received significant funds from TelexFree and other defendants to provide banking services, maintain accounts, and receive and execute transfers for the benefit of TelexFree. Plaintiffs also asserted that both banks had actual knowledge of TelexFree’s illegal conduct and noted that one of the institutions had previously been sanctioned in connection with a different Ponzi scheme.

The complaint asserted two legal theories against the banks: first, aiding and abetting causes of action under federal and Massachusetts law, and second, a claim for unjust enrichment asserting that plaintiffs conferred a benefit to the banks in connection with the fees and interest the institutions earned from their engagement with TelexFree.

The court ultimately dismissed the complaint as against the banks. First, the court concluded that there was no private aiding and abetting claim recognized by the Massachusetts law cited by plaintiffs, or by the Federal Trade Commission Act or the 1934 Securities Exchange Act. The court also dismissed the plaintiffs’ cause of action seeking damages for tortious aiding and abetting. Ultimately, the court found that the banks only performed routine banking services.

With respect to the unjust enrichment cause of action, the court concluded that Ponzi scheme victims did not have standing to recover fees paid by the company that victimized them. It further noted that it was not unjust for the banks to retain fees for their services. The 8th U.S. Circuit Court of Appeals made a similar finding recently in R.J. Zayed v. Associated Bank, 913 F.3d 709 (2019). The Zayed court found that under Minnesota law, a bank could not be held liable for performing routine professional services that had the unintended effect of assisting a schemer.   

Lawyers, Accountants

Lawyers and accountants are not immune from litigation in connection with unraveled Ponzi schemes.

Arthur Lamar Adams, through his companies Madison Time Company LLC and Madison Timber Properties LLC, executed a Ponzi scheme that defrauded hundreds of investors. Adams’ victims believed that their investments were being used to purchase timber from Mississippi landowners to sell to lumber mills at a higher price. Investors received fake timber deeds to secure their investments. It is alleged that in the one-year period prior to April 19, 2018 (the date Adams surrendered and confessed to federal authorities), Madison Timber took in approximately $164.5 million, with debts to investors of more than $85 million.

In December 2018, Madison Timber commenced proceedings against Madison Timber’s former attorneys, asserting that without their encouragement and assistance, the Ponzi scheme could not have grown so large. The receiver alleged that the lawyers lent their influence, professional expertise, and even their clients to Adams.

Investment firms Fairfield Greenwich Group and Tremont Group Holdings were two feeder funds in the Madoff Ponzi scheme. In connection with their losses, investors commenced litigation against PwC and Ernst & Young, asserting that the firms’ audit work should have uncovered the Ponzi scheme. That litigation resulted in substantial recoveries for those investors.

More recently, in late 2017, the U.S. Securities and Exchange Commission sued luxury real estate developer Robert Shapiro and his Woodbridge Group of Companies in connection with an alleged $1.2 billion Ponzi scheme. According to the complaint, Shapiro defrauded more than 8,400 investors, including many elderly clients. In October 2018, two of those investors commenced a federal court lawsuit against an accounting firm that employed a Woodbridge sales agent.

Servicers Beware

Successful Ponzi schemes leave a trail of litigation in their wake, often targeting knowing or unknowing service providers whose paths the fraudsters crossed. There is no doubt this reality will continue to be a potential source of recovery for Ponzi scheme victims, as well as a fountain of work for professionals.

Maureen Bass

Maureen Bass

Cullen and Dykman LLP

Maureen Bass is a partner in the Bankruptcy and Creditors Rights practice of Cullen and Dykman LLP in New York. She has extensive restructuring, commercial bankruptcy, and workout experience, with a focus on litigation arising from such matters. She provides advice to distressed companies, financial institutions, special servicers, executives, and management in connection with in- and out-of-court restructurings. Bass holds a law degree from Syracuse University College of Law and an undergraduate degree from Tulane University.

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