As noted earlier, it is common for the SEC to seek a receiver in Ponzi scheme cases, because there are often the fraudulent sale of unregistered securities. Normally, the Court enters an injunction to prevent any investor from filing claims against the company or principals of the Ponzi scheme. However, investors can often file claims against third parties.
Oftentimes, the Ponzi scheme operator raises investments through third parties, such as brokers, financial advisors, accountants, and yes, even attorneys. The attorney for the investor must first, make sure that the investor files a “proof of claim” in the bankruptcy or in the assignment of benefit of creditors case, and second, analyze the potential liability of the third party promoters of the investment.
Indeed, in one case, the Court appointed Trustee for the bankruptcy of Louis Perlman’s businesses made it crystal clear that investors should hire counsel to explore their legal rights against the third party promoters who brokered the sale of the investment. On his website, the Trustee told the investors the following, in a “frequently asked questions” segment of the site:
Q. I was introduced to this investment by a sales agent or a broker or some other intermediary. Are these intermediaries liable personally or professionally?
A. This is the subject of each individual fact specific legal analysis for which you need to seek independent legal advice.
Q. If these agents were not “licensed” to deal in these securities, misrepresented them and continued to sell them even though the OFR [Office of Financial Regulation] had notified Trans Con not to offer them any more, aren’t they liable personally and professionally?
A. This is the subject of each individual fact specific legal analysis for which you need to seek independent legal advice.
Q. Wouldn’t a good paper trail to follow be the bank accounts of all the T-con officers and the agents and why aren’t their assets seizable since they are also guilty of gross illegalities?
A. While this may present an avenue for asset recovery which the Trustee is and will investigate, the legal process to achieve this is complicated and time consuming.
Q. How broadly are you planning to stake your claim to any recoveries that investors make from third parties?If, for example, an investor wins a judgment against an independent sales agent who sold the EISA plan, or wins a judgment against others involved in the scam, would you (as Trustee) sue the investor to claim the award for the bankruptcy estate?
A. These questions raise complex legal issues that would require some in-depth analysis on the rights and claims of the individual investors as opposed to the rights and claims that I have as the Chapter 11 Trustee for Pearlman, TCA and other related companies for which I may be named Chapter 11 Trustee in the future. These are complex legal questions that require the advice of a lawyer and depend on the facts that exist for each case. Each investor may have a different fact scenario. I am not in a position to provide legal advice. [“Q” and “A” added].1
The common theme is easy to see: the Trustee may have competing claims with the investors against third parties who brokered the sales of the investments. For example, the Trustee might choose to sue the brokers to the extent of commissions paid to them as fraudulent conveyances under the Uniform Fraudulent Transfer Act or as voidable preferential transfers under Section 548 of the Bankruptcy Code, while the investors might have simultaneous claims against the brokers for violations of the Uniform Securities Act, for the sale of unregistered securities. Accordingly, bankruptcy trustees will not overtly encourage investors to sue the brokers of the investments because of competing claims to the same assets or liability insurance.
The investor’s attorney, therefor, must act quickly to look to their state’s securities act as a primary vehicle to file an action to recover the investor’s money, and other common law claims that might be covered under liability insurance.
The Uniform Securities Act, adopted by most states, holds the seller liable to the buyer: SECTION 509. CIVIL LIABILITY.
(a) [Securities Litigation Uniform Standards Act.] Enforcement of civil liability under this section is subject to the Securities Litigation Uniform Standards Act of 1998.
(b) [Liability of seller to purchaser.] A person is liable to the purchaser if the person sells a security in violation of Section 301 or, by means of an untrue statement of a material fact or an omission to state a material fact necessary in order to make the statement made, in light of the circumstances under which it is made, not misleading, the purchaser not knowing the untruth or omission and the seller not sustaining the burden of proof that the seller did not know and, in the exercise of reasonable care, could not have known of the untruth or omission. An action under this subsection is governed by the following:
(1) The purchaser may maintain an action to recover the consideration paid for the security, less the amount of any income received on the security, and interest [at the legal rate of interest] from the date of the purchase, costs, and reasonable attorneys’ fees determined by the court, upon the tender of the security, or for actual damages as provided in paragraph (3).
(2) The tender referred to in paragraph (1) may be made any time before entry of judgment.
Tender requires only notice in a record of ownership of the security and willingness to exchange the security for the amount specified. A purchaser that no longer owns the security may recover actual damages as provided in paragraph (3).
(3) Actual damages in an action arising under this subsection are the amount that would be recoverable upon a tender less the value of the security when the purchaser disposed of it, and interest [at the legal rate of interest] from the date of the purchase, costs, and reasonable attorneys’ fees determined by the court
Fortunately, some states, like Florida, do not require proof of “loss causation” or even “scienter” to succeed on a Uniform Securities Act Claim.2 Therefor, the securities practitioner should seriously consider filing this claim.
One of the drawbacks of a state Uniform Securities Act claim is the liklihood that the broker/promoter of the Ponzi scheme will not be covered by his/her liability insurance. Many insurance policies reviewed by this author specifically exclude coverage for violations of state or federal securities law. Therefor, it is recommended that a claim for breach of fiduciary duty, negligence and gross negligence be filed as well.
Sometimes, the broker/promoter of the Ponzi scheme is an accountant or an attorney. One of the interesting issues to raise in a claim for the investor is a professional malpractice claim predicated on the violation of the duty of confidentiality that most accountants and attorneys owe to their clients, and for conflicts of interest.
Sometimes, a negligence or professional malpractice claim can be predicated on the fact that the accountant or attorney “misused” confidential information to target certain clients to sell the investment to, based on the accountant’s or attorney’s use of confidential financial information learned during the accountant/client or attorney/client relationship. It is the misuse of that confidential information that gives rise to a clear breach of fiduciary duty claim in some states, which oftentimes is a covered claim under a liability policy.
For example, in Profit Sharing Trust for MarProwear Corp. vs Lamf,Lipkind Prupis, Petigrow and Labue, P.A., the Court upheld a jury verdict for the Profit SharingTrust, finding that the Lampf Lipkind law firm was liable to the Trust [its client], for recommending a failed investment while in a conflict of interest. The law firm, acting as a promoter/broker, approached the client/Trust to make an investment in Southeastern Insurance Group (SIG), and explained that the investment was “safe and conservative.” The law firm also represented that it was investing its own money in the deal.
The private placement memorandum even disclosed that some of the attorneys of the law firm were officers of the company. Based upon these representations and without benefit of any independent counsel or other advice, the Trust invested some $449,600.00 in a complex package of stock, debentures and other securities that comprised two “units” of an investment in SIG.
In upholding the jury verdict, the Court noted that there were grounds for the jury to find that the law firm had misused confidential information to target its own client as an investor: Lipkind failed to advise the Trust in writing of both the conflict of interest and the need to get independent counsel. Moreover, there was no evidence of the Trust’s consent to the conflict in writing. Lastly, Wasserman claimed that R.P.C. 1.8(b) [FN3] was violated because Lampf-Lipkind used its knowledge of the Trust’s financial wealth as a basis for targeting the Trust as a potential investor. Wasserman did not render any opinion on proximate causation.
R.P.C. 1.8 CONFLICT OF INTEREST: PROHIBITED TRANSACTIONS
(a) A lawyer shall not enter into a business transaction with a client or knowingly acquire an ownership, possessory, security or other pecuniary interest adverse to a client unless (1) the transaction and terms in which the lawyer acquires the interest are fair and reasonable to the client and are fully disclosed and transmitted in writing to the client in manner and terms that should have reasonably been understood by the client, (2) the client is advised of the desirability of seeking and is given a reasonable opportunity to seek the advice of independent counsel of the client’s choice on the transaction, and (3) the client consents in writing thereto.
FN3. “R.P.C. 1.8(b) provides: “A lawyer shall not use information relating to representation of a client to the disadvantage of the client unless the client consents after consultation.”
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Ultimately, the Court upheld the jury verdict, rejecting the law firm’s claims of lack of proximate cause, mostly on policy grounds:
“If proximate cause is ultimately a question of fairness and policy, imposing liability on these facts is both fair and good policy. Lawyers who fail to inform clients of their own interests, fail to advise clients to seek other counsel, unabashedly sell their clients the notion that an investment with them or their colleagues is a good and safe one, and use their clients as sources of investment funds, must accept responsibility for the outcome. Lawyers may not burrow their way into their clients’ confidences and then exploit those confidences for their own ends. This is the law in New Jersey. This Court will no more tolerate the hoodwinking of helpless clients out of funds in a business venture that is essentially for the benefit of the lawyer than it will outright misappropriation of funds.3 The Rules of Professional Conduct bar such conduct. Such conduct is reprehensible and foreseeable damages are proper, if so found by the jury.
Here the PPM provides a convenient yardstick as to the foreseeable consequences.
While, given their own large investment in SIG, there is little doubt but that LampfLipkind honestly believed, as did the attorney in In re Smyzer, supra, at 57, 527 A.2d 857, that the investment was a good one, there is also little doubt that they understood the risks. Risky investments are not barred; they are essential to our economic system.
Lawyers, however, cannot use their clients to bankroll such risks.4
In addition to professionals such as attorneys and accountants, it is common for the Ponzi scheme operator to have a network of licensed or unlicensed promoters selling the investment for a commission. In In re World Vision Entertainment, Inc.5 the Ponzi scheme operator/debtor did not directly sell most of the promissory notes used to defraud investors.
Instead, the Ponzi operator actively solicited and recruited a network of brokers, primarily insurance agents, to sell the notes in exchange for a generous commission. Commission rates ranged from 12 to 15 percent.6 Brokers received a commission payment both when notes were sold and also when notes were renewed. The receiver sued the note brokers alleging a fraudulent transfer under the Bankuprty Code, 11 USC 5487, alleging many of the brokers fraudulently received commissions averaging 14 percent of the total notes sold.
The Court noted that the brokers’ sole job was to sell the fraudulent notes or mortgages to investors. In trying to determine whether the notes were sold in good faith, the court observed, the brokers often have long-term relationships with their clients. The clients usually are elderly and financially unsophisticated. The clients rely on the brokers for financial advice. Therefore, the issue is whether these brokers act in good faith if they make no or little effort to verify the legitimacy of the debt instruments they market. Stated differently, can a broker simply rely on promises made by a dishonest and fraudulent debtor and still act in good faith?
Good faith is not a precise, defined term. Good faith is judged using an objective standard. See In re M & L Business Machine Co., 84 F.3d at 1337-39 (good faith should be measured using an objective standard which examines whether circumstances would place a reasonable person on inquiry of a debtor’s fraudulent purpose); Hays v. Jimmy Swaggart Ministries, et al., 263 B.R. 203, 211 (M.D.La.1999) (“Good faith is determined on a case-by-case basis using an objective standard …”); but see Independent Clearing House Co., 77 B.R. at 862 (good faith is a subjective question).8
Importantly, the Court in World Vision found that these brokers had at least a minimal duty to investigate the product and the company before they sold it to unsuspecting investors: The Court accepts Sand’s testimony that any broker selling short-term promissory notes, even unregistered promissory notes such as the debtor’s notes, has a minimal duty of care owed to investors. Before selling the notes, the broker must review *655 available investment ratings from qualified financial rating services.
The broker must request and review with a critical eye audited financial statements of the company as well as other literature provided by the company discussing its sales history and the background of key employees. A broker cannot rely only on slick, marketing brochures or insurance coverage, refrain from asking hard questions about the legitimacy of the product, and then assume a proper investigation was completed. In some cases, other types of investigation may be merited. However, unless these minimal steps are taken, a broker selling a short-term promissory note is not performing the minimum standard of care required throughout the United States.9
In the end, the Court in the World Vision case found all of the brokers’ liable, rejecting their claims that they acted in good faith.10
What is a note-broker’s minimal duty? Any broker selling short-term promissory notes has a duty to conduct a reasonable investigation into the legitimacy of the notes.11 As general rule, before selling the notes, a reasonable broker must review available investment ratings from qualified financial rating services.12 The broker also must request and review audited financial statements of the company as well as other literature provided by the company discussing its sales history and the background of key employees.13
“A broker cannot rely only on slick, marketing brochures or insurance coverage, refrain from asking hard questions about the legitimacy of the product, and then assume a proper investigation was completed.”14 Other types of investigation may also be merited. In short, “unless these minimal steps are taken, a broker selling a short-term promissory note is not performing the minimum due diligence required throughout the United States.”15