Judicial Opinions Creating Ponzi Law Obtained by Brace While Prosecuting Ponzi Schemes
Bailey v. Empire Blue Cross/Blue Shield (In re Consolidated Welfare Fund ERISA Litigation), MDL 902, 856 F. Supp. 837 (S.D.N.Y. 1994). The Bailey case was a medical insurance Ponzi scheme targeting employees with pre-existing conditions. In Bailey, Judge Pollack of the Southern District of New York ruled that aiding and abetting liability for breach of fiduciary duty required proof of actual knowledge by the aider and abettor of the primary wrong being committed by the primary wrong doer. The allegation that the defendant medical expense certification company “knew or should have known” the insurance being sold with pre-existing conditions covered was bogus was not sufficient under Restatement (Second) of Torts, section 876. An allegation of “should have known” was an admission by the plaintiffs’ that the defendant “did not know.” The rule for pleading aiding and abetting liability is to avoid alleging “should have known.”
Rusty Brace represented a class of employee policyholders of fraudulent health insurance plans bought by their multiple employers. The MDL case settled for over $12 million against numerous insurance producers who sold the health insurance to the employers of the defrauded employees.
Lloyd v. Paine Webber, Inc. et al., 1996 U.S. Dist. LEXIS 22628 (S.D. Cal. 1996). In this insurance Ponzi scheme, Judge Barry Ted Moskowitz concluded that the bankruptcy trustee and state appointed insurance receiver (Janice Lloyd) of a fraudulent offshore insurer (“First Assurance Casualty”) had no standing to sue Paine Webber for participation in the intentional torts committed by the client (First Assurance), a fraudulent insurer. The insurer was a sham entity used by its human owners to steal the insurance premiums. The Federal District Court did rule, however, that a class of policyholders of First Assurance owned viable causes of action against Paine Webber for aiding and abetting the fraud and the class action, as contrasted to the Receiver’s action, could proceed. The bad acts of Paine Webber’s errant employee created potential vicarious liability against the employer.
Judge Moskowitz ruled that the class of policyholders had viable claims against Paine Webber for fraud, negligent hiring, and RICO pursuant to Brady v. Dairy Fresh Products, 974 F.2d 1149, 1155 (9th Cir. 1992). Rusty Brace represented the BK trustee, the Receiver, and the class. The case settled for a significant percentage of the unpaid insurance claims.
Lloyd v. Paine Webber, Inc. et al., 208 F.3d 755 (9th Cir. 2000). This part of the First Assurance Casualty case was an important contest over the standing of a representative successor (a Receiver or BK trustee of an entity) to sue attorneys for malpractice for losses suffered by the entity. The entity was used by its owners to commit fraud against third parties. The case has been cited in 36 subsequent opinions. Janice Lloyd, the Bankruptcy Trustee and Receiver of First Assurance, sued a law firm working for First Assurance for malpractice. The legal work kept the insurer in business while its owners stole the premiums and pushed the entity deeper into insolvency.
The Ninth Circuit concluded that a bankruptcy trustee had standing to sue for malpractice even if the entity client was an admitted sham corporation used adversely by its shareholders to operate an insurance Ponzi scheme. The Appellate Court also concluded that a sham corporation may suffer an injury cognizable under Article III even if the sole purpose of it was to serve as an engine of fraud for its owners. The Court held that the corporation’s injury is the debt which it still owes as a legal entity established by statute. Causation could be established by the increase in debt from the time of the malpractice to the time of liquidation.
Rusty Brace represented the bankruptcy trustee in the legal malpractice case. The policyholders of First Assurance did not have a case because there was no attorney client relationship with the attorneys. The case against the law firm was dismissed on the grounds of the scope of duty owed to the entity client. There was no evidence the law firm had actual knowledge the shareholders were looting First Assurance and there is no automatic duty owed by a lawyer to independently investigate a client’s business before agreeing to act as its lawyer.
Craft v. Sunwest Bank, N.A., 84 F. Supp. 2d 1226 (D.N.M. 1999). Judge Bruce Black of the Federal District Court in New Mexico granted the Receiver of a fraudulent insurance company (“Meadowlark Assurance Company”) standing to sue a bank (“Sunwest Bank”) for breach of the terms of an NAIC trust established by the insurer as a prerequisite to doing business in the United Sates. The trust was intended to protect policyholders from insurer insolvency. The NAIC trust was supposed to contain $1.5 million in cash or cash equivalent assets. Instead, the owners of Meadowlark Assurance deposited with Sunwest Bank assets with overstated values worth only $200,000 and not $1.5 million.
Judge Black ruled that Craft, as the Receiver of Meadowlark, could proceed against Sunwest Bank, the trustee of the NAIC trust, for up to $1.3 million if Meadowlark owned sufficient assets at the time of the funding of the NAIC trust which could have been deposited into the trust. The duty of a trustee to collect and protect the trust res is limited to the existence of assets owned by the settlor that could be deposited into the trust. If the assets did not exist than the bank’s failure to collect and protect the trust res did not cause any loss to Meadowlark or the insureds of Meadowlark.
Rusty Brace represented the Receiver. The case settled for a significant percentage of the unpaid insurance claims.
Hawkes v. Qualified Exchange Services, et. al., 2008 U.S. Dist. LEXIS 118509 (D. Nev. 2008). Hawkes involved the theft of IRC 1031 trust assets. The litigation was filed against CitiGroup and other large financial institutions for aiding and abetting the Ponzi scheme committed by Don McGhan. In the related case of Sorrell v. Qualified Exchange Services, Rusty Brace was appointed class counsel to represent a class of IRC section 1031 exchangers who lost approximately $100 million in the McGhan Ponzi scheme. In the MDL litigation Rusty recovered, with other lawyers, approximately $100 million from multiple defendants.
In the above opinion, Judge Jones concluded that Citigroup was chargeable with the collective knowledge of two defalcating employees and subject to vicarious liability for aiding and abetting the primary tortfeasor. One employee was receiving money on the side from the scheme and was deemed an active participant. Citigroup was not dismissed from the case even when the errant agent’s conduct was unlawful and against the policies of Citigroup. Citigroup paid $22 million to settle the case against it. Other institutional defendants contributed an additional $80 million.
Hunter v. Citibank, N.A., et al., 2010 U.S. Dist. LEXIS 61912 (N.D. Cal. 2010) arose out of the Edward Okun 1031 Exchange Ponzi scheme highlighted on CNBC’s American Greed in March of 2014. Ed Okun was sentenced to 100 years in prison.
In the often-cited opinion, Judge James Ware outlined the elements for aiding and abetting the intentional tort of the primary tortfeasor. Judge Ware also concluded that a bankruptcy trustee of an entity used in a Ponzi scheme does not own the tort claims of the defrauded creditors of the scheme. The trustee was barred from asserting claims for the injury to others and could only sue for injury to the debtor. See also Hunter v. Citibank, N.A., et al., 2011 U.S. Dist. LEXIS 154102 (N.D. Cal. 2011).
Rusty Brace was counsel for the class in this Ponzi scheme case which caused over $100 million in damages. With the help of others, he recovered over $100 million in settlements from third parties. In the Okun case, Rusty entered into a joint sharing agreement with the Bankruptcy Trustee to share the proceeds from all the litigation 50/50 because the creditor constituency and the class of creditors were the same. The ownership of some claims was ambiguous, and a dual simultaneous attack by the entity and the creditors of the entity made it difficult for the defendants to defend. The unique and successful 50/50 sharing agreement was approved by both the Bankruptcy Court and the Federal District Court before the commencement of the litigation.
In re § 1031 Exchange Litigation., 716 F. Supp.2d 415 (D.S.Carolina, June 2010). In the LandAmerica Ponzi scheme case, Rusty Brace was counsel to the class with losses of more than $100 and combined recoveries by the Bankruptcy Trustee and the class of over $100 million.
LandAmerica 1031 Exchange Services, Inc. (“LES”) was a qualified intermediary owned by Land America Financial Group, Inc. (“LFG”). LFG borrowed money from SunTrust Bank. LES banked at SunTrust Bank. LES invested the §1031 exchange funds deposited in account 3318 at SunTrust Bank in auction-rate securities (“ARS”) backed by government guaranteed student loans.
The ARS market froze in February 2008 from lack of bidding reducing the value of the ARS to fire sale prices. Instead of stopping new § 1031 business and the intake of new money to be deposited at SunTrust Bank, LES received §1031 exchange funds from new customers to pay for the closing of exchanges of existing customers whose funds invested in ARS were frozen. The class action Plaintiffs contended that SunTrust Bank knew LES was insolvent and running a Ponzi scheme after February 2008 and it assisted the breach of LES’s fiduciary duties owed to the members of the class so that LFG had enough time before filing for bankruptcy to repay SunTrust the money the bank had loaned to LFG.
In the cited opinion, Judge Joseph F. Anderson dismissed the complaint with leave to amend stating that for aiding and abetting by a bank, the plaintiffs must show that SunTrust Bank knew that “no assets of any kind existed to complete pending § 1031 transactions, that new Exchange Funds were being deposited in the 3318 Account, and that LES was using the new Exchange Funds on deposit from the Customers, rather than investments, to complete transactions for individuals whose funds were tied up in ARS” Id. at 423.
The Plaintiffs’ amended complaint was also dismissed by Judge Anderson at Terry v. SunTrust Banks, Inc. (In re IRS §1031 Exch. Litig.) 2011 U.S. LEXIS 63996 which was affirmed by the 4th Circuit at Terry v. SunTrust Banks, Inc. 2012 U.S. App. LEXIS 13632 (4th Cir. S.C., July 2, 2012) In short, both courts ruled that the exchange contracts disclaimed the existence of any fiduciary duty owed by LES to the exchangers so SunTrust Bank could not aid and abet LES’s breach of a fiduciary duty that did not exist.
Dillon v. Continental Casualty Company, 278 F. Supp. 3d 1132 (N.D. Cal. 2017) is another IRS §1031 Ponzi scheme case involving surety coverage issued by Continental Casualty for the theft of exchange funds by the owners of the qualified intermediary pending the close of the §1031 exchanges. Thomas Dillon was the court appointed Receiver for Vesta Strategies, LLC which was owned by John Terzakis and Robert Estupinian. Terzakis and Estupinian were arrested, convicted of fraud, money laundering and conspiracy, and sentenced to years in prison for the theft of exchange funds held in trust by Vesta. Terzakis used the trust funds to invest in Chicago real property held in his own name before the collapse of the real estate market starting in 2006. Continental insured Vesta for the theft of exchange funds by the owners of Vesta so coverage on the $5 million surety policy should have been easy.
Continental’s first argument to defeat its financial responsibility was accepted by the trial court at 2014 U.S. Dist. LEXIS 41709 but reversed by the Ninth Circuit at 649 Fed. Appx. 417, 2016 U.S. App LEXIS 7350 (9th Cir. Cal., Apr. 22, 2016). Continental argued that Terzakis and Estupinian, as the sole owners of Vesta, could not benefit from their intentional torts with the purchase of insurance to pay for the losses caused to their company, Vesta. The District Court agreed with Continental that California Insurance Code §533 prohibited an insured (Vesta) from receiving indemnification for willful misconduct as no one can take advantage of their own wrong. The Court agreed that the knowledge of an agent acting adversely to the principal is not imputed to the principal. However, the Court went on to rule that when the agents (Terzakis and Estupinian) are the sole owners of the principal (Vesta) – the “sole actor doctrine” applied as an exception to the exception for the non-imputation of knowledge. In short, the bad acts of Terzakis and Estupinian were imputed to Vesta to defeat the coverage for Vesta to pay for the theft of exchange funds owned by the exchangers.
The Ninth Circuit reversed by holding that Insurance Code §533 did not apply to surety contracts and the Continental policy issued to Vesta was a surety contract issued for the benefit of the 1031 exchangers. As with all surety contracts, Vesta as the primary obligor remained liable to Continental as the surety so Vesta could not benefit from the fraud committed by Terzakis and Estupinian.
Continental’s second defense to payment on the policy was the running of the time for Vesta to discover the loss. Continental argued that the loss had to be discovered by Vesta between the commencement of the policy period on January 9, 2004, and October 15, 2004. Dillon argued that the contractual discovery date must be tolled until Dillon was appointed Receiver because Terzakis and Estupinian, who controlled Vesta and were stealing the funds from Vesta, were adversely dominating Vesta. The criminals would never give Continental notice of their own thefts, citing Admiralty Fund v. Peerless Insurance company, 143 Cal. App. 3d 379 (1983). The trial court agreed.
Rusty represented Dillon the Receiver for Vesta as well as the 1031 exchangers who lost their exchange funds and were creditors of Vesta. Rusty recovered $14.8 million to pay $12.6 million in damages suffered from the thefts by Terzakis and Estupinian.
Evans v. ZB, N.A., 779 Fed Appx. 443 (9th Cir. 2019). The Evans case arose out of the Sacramento Ponzi scheme operated by Deepal Wannakuwatte (“Deepal”) as seen in the episode titled Medical Gloves with Holes on CNBC’s American Greed in August of 2016. Deepal pled guilty to fraud and the Federal Criminal Court sentenced him to 20 years in prison.
Rusty Brace and Michael Denver are counsel to Ronald Evans, Joni Evans and Dennis Treadaway in a civil class action filed against ZB, N.A. (“ZB”), a Utah bank, for aiding and abetting Deepal’s fraud. ZB is and was doing business as California Bank & Trust (“CB&T”) in Sacramento, California. We use the name “CB&T” to describe the activities of the parent entity “ZB.” The action is still pending.
Deepal used International Manufacturing Group, Inc. (“IMG”) as the entity to commit his fraud which caused $70 million in losses to the members of the class. In exchange for cash the investors received promissory notes issued by IMG and signed by Deepal. IMG banked at CB&T, so CB&T had 24/7/365 access to the banking records of IMG. IMG deposited the investors’ money at CB&T in the IMG Wholesale Account. Deepal represented that the investors’ money was used by IMG to finance the manufacture of medical gloves in Asia to be sold to the hospitals run by the Veteran’s Administration and other governmental buyers of medical gloves.
While investors were loaning money to IMG to fund the production and importation of gloves, CB&T was also loaning money to IMG and acting as the principal depository bank for the receipt and disbursement of hundreds of millions of investors’ moneys. CB&T issued IMG a series of nine loans totaling $21 million. The express purpose of the bank’s loans to IMG was the same purpose as the defrauded investors – IMG was to import gloves from Asia, sell the gloves in the USA, and repay the loans from the proceeds of the glove sales.
As a federally insured lender, CB&T had to underwrite the loans to IMG as well as each of the forty plus modifications and extensions on those loans. CB&T also paid hundreds of checks written by Deepal with insufficient funds on deposit to pay for the checks. Honoring bad checks is the equivalent of loaning money. Honoring bad checks also required underwriting by CB&T. Underwriting means that CB&T had to investigate and understand the use of the proceeds of the loans and the source of the funds for the repayment of the loans. CB&T had to know what Deepal was doing with the money and how he was going to pay it back – the same information a parent would want to know when loaning money to a child.
The Evans’ plaintiffs contend that in October of 2009, CB&T was forced to foreclose on the security that IMG had pledged for the largest of its nine loans – a nine-million-dollar loan. The security was money owned by a Seattle investor and its bank. IMG was not paying CB&T back on the nine-million-dollar loan even though CB&T had opened a lock box account in its name and under its control where IMG was contractually obligated to deposit the proceeds of glove sales to repay the loan. No money was deposited by IMG into the lock box account, so CB&T was forced to foreclose.
Based on the adversarial act of foreclosing, CB&T learned that: (i) Deepal was operating IMG as a Ponzi scheme; (ii) there were no gloves being imported from Asia to be sold to the federal government as was being claimed by Deepal; and (iii) there were no purchases of gloves by IMG or the selling of those gloves to the government because the bank records in CB&T’s possession and control revealed there were no purchases, or sales of gloves. The only money coming into IMG at CB&T was from investors and the money going out was primarily to make lulling payments back to the investors.
In October 2009, CB&T prepared a letter to Deepal “severing” its banking relationship. The CB&T severance letter was not sent by the bank to Deepal. Instead, Deepal continued to do business with CB&T through to the collapse of IMG in 2014. The class of victims were the investors in the Ponzi scheme between 2009 and 2014.
IMG repaid CB&T the $21 million by February 2011. The repayment and the retention of the $21 million could not have occurred if the Ponzi scheme had collapsed in 2009. The Evans’ plaintiffs contend that the bank had a strong motive to assist the scheme long enough to get its money back. The source of funds used to repay CB&T on its loans to IMG was money provided to IMG by investors with funds deposited into IMG’s Wholesale Account at CB&T. Internal documents show that CB&T tracked the source of funds to paydown the IMG loans as coming from the deposits by investors. After CB&T was repaid its $21 million by IMG investors, CB&T allowed IMG to continue to operate the Wholesale Account at the bank until 2014 where investor money was continuously deposited and then looted.
Evans was filed on May 26, 2017. The case was dismissed by the District Court on December 20, 2017 because the Plaintiffs had not provided sufficient facts giving rise to a plausible inference that CB&T knew IMG was misappropriating funds. The Evans plaintiffs appealed the dismissal to the Ninth Circuit, which reversed the trial court on June 24, 2019
In Evans v. ZB, N.A., 779 Fed Appx. 443 (9th Cir. 2019) the Ninth Circuit outlined the facts alleged in the complaint and concluded, on de novo review, that the bank’s knowledge of the Deepal Ponzi scheme was plausible because the bank had twenty four hour access to IMG’s financial information, it had an obligation to itself to know the use of the loan proceeds and the sources of repayment, and it possessed the motive to recoup its investment in IMG before IMG’s inevitable collapse. The Court said:
“If anything, CB&T’s representation that it conducted audits before granting extensions per federal regulations requiring CB&T to ensure IMG had sufficient resources to meets its obligations, see 12 C.F.R. 1.5(b), cuts against CB&T. Coupling CB&T’s alleged investigation into IMG’s business income with the allegation that by fall 2009, CB&T decided to terminate its lending relationship (because there was no repayment on the outstanding balances), we can reasonably infer CB&T knew there was no income from latex gloves sales.” Id at 446.
After remand, a First Amended Complaint (“FAC”) was filed by the Plaintiffs on October 15, 2019. The District Court refused to dismiss the FAC based on a statute of limitations argument made by the bank at Evans v. ZB, N.A. 2019 U.S. LEXIS 218432. The bank argued that the three-year statute of limitations for fraud is the same time limit for filing a claim for aiding and abetting the fraud; and the three-year statute started against CB&T for aiding and abetting when Deepal pled guilty to fraud on May 8, 2014. The District Court disagreed and held that the statute of limitations for aiding and abetting fraud is three years, but the statute does not start running against an accessory until the victim discovers facts to implicate the aider and abettor. In Evans, the three-year statute against CB&T did not start to run until the Bankruptcy Trustee for IMG (Beverly McFarland) filed her fraudulent conveyance complaint against CB&T on May 6, 2016. That pleading, as a report from the creditors’ representative, disclosed previously unknown confidential financial information about IMG and CB&T’s lending relationship with IMG which started the statute running.
The case is proceeding through discovery, a motion for class certification and trial.
