Red flags flying - Ben Cook

In 2008, former NASDAQ chairman Bernard Madoff admitted that his wealth management business was the biggest Ponzi scheme in history – having defrauded investors of $18bn – and the shocking impact has reverberated around the finance world since. So how could it happen and who’s responsible for ensuring it doesn’t happen again?

Ben Cook

How safe is the money you’ve invested? If you ploughed it into a scheme that promised no-risk ‘guaranteed returns’ of more than ten per cent per year, you really should go back and check out the credentials of the organisation to which you have entrusted your cash. Why? Well, according to fraud experts, investment schemes that make such promises bear the hallmarks of a Ponzi scheme. It’s virtually impossible for financial regulators to detect every scam designed to dupe investors, so lawyers are frequently called in to clean up the mess when fraudsters are uncovered.

Ira Nishisato, a partner at Canadian firm Borden, Ladner Gervais, and Vice-Chair of the IBA’s Litigation Committee, says that there are an increasing number of remedies made available by legislatures, regulators and the courts for victims of Ponzi schemes and that the onus is on lawyers to be creative in adopting a strategy that best suits the case in question. He adds that it is also vital that when developing these strategies, lawyers work in partnership with the other interested parties. ‘Ponzi schemes challenge lawyers to deploy the full range of remedies available across multiple areas of law and indeed across jurisdictions,’ he says. ‘Counsel must work collaboratively with trustees, regulators and other officials, to design and execute on the most effective recovery strategies – counsel need to be innovative in every case and tailor remedies to the circumstances.’

Untangling the web of deceit associated with Ponzi schemes can be fiendishly complicated, and ultimately, a host of professionals who come into contact such schemes are in danger of being held liable.

So what exactly is a Ponzi scheme? Kathy Bazoian Phelps, a partner in the Los Angeles office of Diamond McCarthy and author of two books on Ponzi schemes, defines them as a ‘fraudulent arrangement in which investors are promised returns, but there is no underlying legitimate business generating the promised returns – rather, returns that are paid to earlier investors are funded by after-acquired funds from later investors’. The US Securities and Exchange Commission website says that the organisers of Ponzi schemes often solicit new investors by promising to invest funds in opportunities ‘claimed to generate high returns with little or no risk’. It adds: ‘In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors to create the false appearance that investors are profiting from a legitimate business.’

A brief history lesson: Ponzi schemes are named after Charles Ponzi, an Italian conman who ran such a scheme in the US in the 1920s. In her book Investment Ethics, Sarah Peck explained that Ponzi got the idea for the scheme when a friend from Spain sent him a letter containing a reply coupon that cost one cent in Spain but could be redeemed for a six-cent stamp in the United States. Peck continues: ‘Ponzi recognised the arbitrage opportunity. Arbitrage involves taking advantage of different prices for the same commodity in different markets. Ponzi realized he could purchase reply coupons for one cent in Spain and redeem them for a six-cent stamp in the United States and make five cents.’ Ponzi seized the opportunity. He decided to offer investors a 50 per cent return in only 45 days, with the result that demand for coupons quickly outstripped supply. But this didn’t stop Ponzi, who had a lavish lifestyle to fund. He stopped investing in the redemption coupons and instead paid off the early investors with funds from new investors. In the meantime, he skimmed off some of the cash for himself – within a few months, Ponzi had more than $20m.

Perhaps the most famous Ponzi scheme in more recent times was that dreamed up by Bernard Madoff. In what has been described as the largest such scheme in history, Madoff – who was sentenced to 150 years in prison – defrauded investors out of a total of £18bn. Other high profile Ponzi schemes include that run by Allen Stanford, who was convicted by a court in Texas in 2012 for swindling a total of $7bn out of around 30,000 investors. Meanwhile, in 2009, Minnesota businessman Thomas Petters received a 50-year prison sentence for running a $3.65bn Ponzi scheme.

Making the impossible possible

So how is it possible for Ponzi schemes to happen? Robert Morfee, a consultant in the litigation team at Clarke Willmott who is representing victims of a £10m Ponzi scheme run by a Scottish company called Cameron Farley, says such schemes are an ‘easy fraud to commit’. He adds: ‘The fundamental problem is human psychology – you have a fraudster who is a sociopath with no conscience and who can lie convincingly and convince others that they are genuine. Meanwhile, the investor is greedy and wants to think he is clever. Investors often don’t believe they have been cheated. They are at first disbelieving and say the police have stopped the business.’ Morfee adds that the Cameron Farley scheme was allowed to flourish because the UK’s Financial Services Authority (FSA) – as it was then known – was inadequate when it came to investigating unauthorised financial advisers, though Morfee acknowledges that the regulator has ‘beefed up its resources’ in its new guise as the Financial Conduct Authority (FCA).

Dion Hayes, a partner at McGuireWoods who spoke at a session on Ponzi schemes at the IBA’s Annual Conference in Boston, says greed on the part of investors is one of the major factors in Ponzi schemes. ‘Investors are chasing high returns and they are ignoring red flags – in a good economy, people are not shocked by [promises of] high returns, while in a bad economy, people take bigger risks,’ he says. Hayes adds that anti-money laundering regulations are ineffectual when it comes to eliminating the risk of Ponzi schemes. ‘Anti-money laundering regulations are not adequate and regulators are not timely or aggressive enough – there is also a reliance on banks to enforce them, but banks have a desire to be cooperative with good customers.’ Hayes also argues that the banks that did business with Madoff, for example, ‘lent legitimacy’ to his scheme. Similarly, the orchestrators of Ponzi schemes often seek to attach themselves to political parties to appear more legitimate, Hayes points out. He cites the examples of Madoff, who was a donor to the US Democratic Party, and Scott Rothstein – sentenced to 50 years in prison in 2010 for running a $1.4bn Ponzi scheme – who provided funding for both the Republican and Democratic parties.

One London-based lawyer, who wishes to remain anonymous because of his role representing one of the parties involved in litigation relating to the Madoff case, says banks need to ask more questions of the individuals and businesses they are dealing with in an effort to ensure their activities are legitimate. He adds that the recent fine imposed on JP Morgan in relation to the Madoff scam should ‘improve sensitivity’ to this issue – the US Attorney for the Southern District of New York, Preet Bharara, imposed a fine of $1.7bn on the investment bank in January this year for violations of the Bank Secrecy Act, a federal law that requires banks to alert authorities to suspicious activity.

No such thing as zero risk

However, Roger Buffington, managing partner at California-based Buffington Law Firm, says fraudulent investment schemes will always be established and that it is a mistake to believe that government regulation will eradicate the problem. He adds: ‘Most government regulators are lawyers who do not understand trading very well and do not understand why Ponzi schemes are often fraudulent.’  Buffington says Ponzi schemes have certain universal identifying traits such as a promise of a guaranteed return at zero risk, as well as a return of more than ten per cent per year. ‘No investments have zero risk,’ he says. ‘Any guaranteed return is a huge red flag.’ Buffington also points out that another key characteristic of Ponzi schemes is that the victims are unable to articulate what it is that the investment programme does that results in such good and risk-free returns. In addition, Buffington explains that if a Ponzi scheme organiser refuses to immediately return a large portion of an investor’s money, they often say they will be able to do so imminently because other investors are going to be putting in funds. ‘This is an explicit admission that investors are getting their money from newer investors – the precise definition of a Ponzi scheme.’

So, if Ponzi schemes cannot be eradicated altogether, how can the risk of investors falling victim to such a scam be minimised? Phelps, who has written a book called Ponzi-Proof Your Investments: An Investor’s Guide to Avoiding Ponzi Schemes and Other Fraudulent Scams, says the onus is on investors to verify the credentials of the scheme. ‘Investors must assume responsibility for conducting due diligence and vetting the investment products in which they choose to place their money – most frauds can be detected with the right questions and independent investigation.’ Phelps argues that while governmental regulatory agencies exist for the protection of investors, it is impossible for them to be aware of every investment programme and product. ‘The agencies establish licensing and registration requirements to ensure that certain standards are met, and they investigate frauds that are brought to their attention – if investors do not even check with those agencies to attempt to verify licenses, then neither the investors nor the agencies are made aware of the problem until it is too late.’

Morfee says one of the problems with fraud cases involving Ponzi schemes is that the civil courts are pretty powerless in terms of obtaining redress. ‘What’s lacking is sufficient opportunity for victims to inflict punishment – the civil courts are impotent against fraudsters,’ he says. ‘It’s important the law offers compensation and deterrence – we don’t prosecute fraud very well, the civil courts are not up to it, that could be looked at, the consensus is it should be dealt with in the criminal court rather than the civil court, but I don’t think that is the complete answer.’ Morfee also argues that the UK’s Financial Conduct Authority needs to ensure independent financial advisers (IFAs) have more robust insurance policies. He says: ‘Insurance policies are not always as protective as they could be – they can be avoided [by insurers], for example due to non-disclosure by an IFA. The FCA needs to make sure IFAs have insurance that does stand up – IFAs need a stronger scheme along the lines of the solicitors’ professional indemnity scheme, otherwise fraudsters can always escape via bankruptcy.’

With regard to the Cameron Farley case, Morfee – who is representing more than 300 clients who lost money as a result of the scheme – is proposing to claim back losses from two bodies that, in his opinion, let investors down, namely Gain Capital and HM Treasury. In Morfee’s view, Gain Capital, a foreign exchange platform that traded in the UK through Cameron Farley, did so without being properly authorised. ‘I do not believe that Gain, which knew about UK regulation, and which received millions of pounds of investors’ money from Cameron Farley, ever bothered to check if Cameron Farley were authorised.’ Morfee says HM Treasury also let down investors in Cameron Farley. ‘The responsibilities for ensuring compliance with EU law, which regulated these matters, lies with the Treasury – it is permissible under EU law, in certain circumstances to sue the Government for not implementing or enforcing EU law.’ Morfee says that the FSA visited Cameron Farley’s offices in April 2007 and discovered what was going on, but failed to close the business down until September 2008. ‘The FSA knew exactly what Mr Farley was doing, yet did nothing for years,’ Morfee says. ‘In the meantime, members of the public had continued to ‘invest’ with Mr Farley and significant amounts of their money were lost.’ Consequently, a claim has been issued against HM Treasury on behalf of Cameron Farley investors who lost money. Meanwhile, Gain has applied to strike out the claim against it on the grounds that the claimants are bound to lose the judge's decision on Gain’s application is expected by mid-February 2014.

A rare case of full recovery

In addition, Michael Hales, a partner at Australia-based Minter Ellison, and Co-Chair of the IBA Litigation Committee, says it is vital that, if a Ponzi investigation encompasses a number of jurisdictions, the legal teams in each jurisdiction work in tandem and coordinate any action. ‘You can’t have someone jumping the gun in one jurisdiction,’ he says. He cites the example of freezing injunctions in, say, three jurisdictions: if a freezing injunction is obtained in one of the jurisdictions before similar injunctions are secured in the other two, the money in the remaining two jurisdictions may be removed. ‘Teamwork is important – working with accountants and other professionals in jurisdictions such as the Cayman Islands and Luxembourg, where these schemes often occur – if you don’t do this, you risk delaying uncovering the fraud or you risk not finding the money at all.’

Hayes says Ponzi schemes present a number of challenges and opportunities for lawyers. ‘It’s work intensive and involves significant investigation,’ he says. Hayes adds that in addition to handling litigation, lawyers need to investigate insurance policies and possible aiders and abettors, for example banks. Another difficulty is that lawyers seeking to recover money for creditors can find themselves competing with criminal forfeiture funds in a battle to recover cash.

Potential liability ‘lurks just about everywhere’ in Ponzi scheme cases, according to Phelps. In the case of the Rothstein Ponzi scheme – which was valued at $1.4 billion – a number of parties, including lawyers, could potentially be held liable. In August 2013, the Federal Bureau of Investigation confirmed that two lawyers – Douglas Bates, who was a partner at Law Offices of Koppel and Bates, and Christina Kitterman, who worked at Rothstein’s firm Rothstein, Rosenfeldt and Adler (RRA) – had been arrested and charged with conspiracy to commit wire fraud, in violation of Title 18, United States Code, Section 1349. Meanwhile, in April 2012, a judge ordered the Lexington Insurance Company, which provided liability insurance for RRA’s accountants Berenfeld Spritzer Shechter & Sheer, to pay $10m to Razorback Investors and an RRA trustee. Hayes says there is ‘projected to be full recovery’ of the losses in the Rothstein case, though he acknowledges that full recovery of losses in Ponzi cases is rare.

David de Ferrars, a partner at Taylor Wessing, who has been acting for the ‘trustee in bankruptcy’ of Madoff’s former company since 2010, says anyone involved in a Ponzi scheme could be held liable for losses, and that could include directors of the company organising the scheme or banks that transacted funds. De Ferrars adds that, in English law, anyone who is found to have provided ‘dishonest assistance’ to the organisers of a Ponzi scheme, or is found to have been in ‘unconscionable receipt’ of funds, could be held liable for losses. Dishonest assistance refers to instances where a non-trustee becomes personally liable for breaches of trust committed by one or more trustees – liability arises where the non-trustee is an accessory to the breach of trust (whether by inducing or assisting in the breach) and has acted dishonestly. Meanwhile, unconscionable receipt means where a person receives trust property in the knowledge that the property has been passed to them in breach of trust, the recipient will be personally liable to account to the trust for the value of the property passed away.

Indeed, the finger of blame for Ponzi schemes could ultimately be pointed at any number of individuals. Phelps says: ‘A varied cast of characters may also be on the hook for roles that they may have played during the duration of a Ponzi scheme. These potential targets could be individuals or entities either inside or outside of the Ponzi scheming organisation, such as: officers, directors, attorneys, auditors, sales people, and financial institutions.’ She adds that there is a considerable range of offences that could be pinned on individuals involved in running Ponzi schemes. ‘There are a wide variety of legal theories that can be used to seek recovery from third parties, such as breach of fiduciary duty, fraud, negligence, aiding and abetting, or securities violations, just to name a few.’ But, ultimately, liability for the losses associated with a Ponzi scheme will depend on the individual circumstances of each case. Phelps says: ‘Recipients of property from the Ponzi schemer have a few possible defences available to them, such as the good faith value defence, so potential liability has to be examined on a case-by-case basis.’  


Ben Cook is a freelance journalist. He can be contacted at ben.cook@hotmail.com