Financial Fraud Litigation
Richard W. Bale
The issues confront professionals, directors
and officers, and their insurers.
Richard W. Bale,
is a partner with Larson • King who represents a broad
spectrum of clients in high stakes litigation. He concentrates his practice primarily in the areas of insurance,
product liability, commercial real estate, environmental
and professional liability. Rick has experience representing corporations of all sizes in litigation involving mortgage lending, contract disputes, trade secrets, intellectual property, and employment matters. Rick has tried
to verdict coverage and subrogation recovery claims
arising out of flood. fire and other types of losses before
juries and arbitration panels. This article is based on an
article the author prepared for seminar sponsored by
the ABA’s Tort and Insurance Practice Section. The statements herein are solely those of the author and do not
reflect the views or opinions of any other party. The author can be reached at rbale@larsonking.com.
On December 11, 2008, the authorities arrested
Bernard L. Madoff, a former chairman of the NASDAQ
exchange and founder of Bernard L. Madoff Investment
Securities, LLC. The ensuing investigation revealed that
Madoff had perpetrated the largest financial fraud in
history, a $65 billion Ponzi scheme that may have operated for more than 30 years. On June 18, 2009, Robert
Allen Stanford surrendered to the FBI and was indicted
that same day for operating a multi-billion dollar fraud
through his company, Stanford Financial Group. Stanford
was accused of selling as much as $8 billion in high-yield
certificates of deposit (CDs) issued by the Stanford Financial Group’s bank in Antigua, allegedly backed by reverseengineered financial statements that reflected non-existent
investment returns.
The downfall of Madoff and Stanford was a harbinger
of things to come. According to a study by the Associated
Press, more than 150 Ponzi schemes were exposed in 2009.
See
www.law.com/jsp/article.jsp?id=1202437299784.
This was a substantial increase over 2008, when the AP’s
study indicated that there were 40 Ponzi schemes uncovered. In 2009, the estimated losses amounted to more
than $16.5 billion. Id. Compared to 2008, SEC restrainThe Practical Litigator | 41
42 | The Practical Litigator
ing orders against Ponzi scheme operators were up
82 percent and Commodity Futures Trading Commission civil filings against Ponzi schemes doubled
in 2009. Id. The Madoff investor and feeder fund
litigation includes at least 19 federal securities class
actions, over 50 lawsuits filed in state court, and
eight insurance coverage cases, according to a list
maintained by Kevin LaCroix’s D&O Diary Web
site. See, Madoff Investor and Feeder Fund Litigation: The
List, available at www.dandodiary.com.
An early 2009 estimate by Aon Benfield’s Actuarial and Enterprise Risk Management practice
predicted $1.8 billion in direct insurance payouts on
behalf of feeder funds, banks and other investment
firms for Madoff-related liabilities, although payouts
could go as high as $3.8 billion. See, Aon Benfield Forecasts Potential Impact on the Insurance Industry Resulting
from the Alleged Madoff Scandal, available at http://aon.
mediaroom.com/index.php?s=43&itme=1445.
Reports of Ponzi scheme-style financial frauds
have become almost commonplace. Unfortunately
these frauds were only slightly less disastrous for
investors than those perpetrated by Madoff and
Stanford. Minnesota businessman Tom Petters,
whose company Petters Group Worldwide had acquired the Polaroid brand and Sun Country Airlines, was convicted in December 2009 in a criminal case arising out of a $3 billion Ponzi scheme
involving the faked sale of electronic goods. Petters
and his accomplices solicited billions of dollars in
loans on the basis of fake purchase orders and invoices for electronic goods that were to be sold to
big discount chains. The money from new loans
was used to pay off old loans and to finance Petters’ lifestyle and business pursuits. The fallout from
the scheme lead to the bankruptcy filing of Sun
Country Airlines and criminal charges against an
investment manager that directed funds to Petters’
operation. See, Tom Petters Found Guilty of Ponzi Scheme
Fraud, available at http://www.reuters.com/article/
idUSN024978920091202.
March 2011
In a scheme that ran from 2005 to 2009, a south
Florida attorney sold supposedly lucrative investments in confidential legal settlements that turned
out to be completely fake. See, US: Fla lawyer who
ran Ponzi scheme deserves more lenient sentence because of
undercover work, available at http://www.foxnews.
com/us/2010/06/07/prosecution-wants-yearsprison-fla-lawyer-ran-billion-ponzi-scheme/. He
managed to continue to operate the Ponzi scheme
for years by initially promising and paying significant returns. As his scheme unraveled, the attorney
fled in a private jet to Morocco with $500,000 in
cash after wiring $16 million to an account that he
controlled there. The scheme robbed thousands of
investors of an estimated $1.2 billion. In Arizona, a
concert promoter was accused of running a Ponzi
scheme that took $25 million from approximately
140 investors between 2004 and 2007.
Ponzi and financial fraud schemes have spawned
a complex tangle of criminal and civil litigation.
State and federal authorities are likely to bring
criminal prosecutions. The Securities and Exchange
Commission (SEC) may bring either criminal or
civil actions for violations of federal law. See, The
Investor’s Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation,
available at http://www.sec.gov/about/whatwedo.
shtml. Receivers and bankruptcy trustees may seek
to recover assets for distribution to victims by using fraudulent transfer laws and other theories of
recovery. Investors themselves may commence private party litigation in individual or class actions.
In turn, the defendants will pursue any potential
benefits from their insurance policies. Corporate directors and officers will turn to their directors’ and
officers’ (D&O) coverages. Investment advisors, accountants and other professionals will look to their
errors and omissions (E&O) policies. Coverage also
may be sought under fiduciary policies, financial
service institution policies, and even crime loss policies, depending on the circumstances. Some investors have gone directly to their own fiduciary, crime
Financial Fraud Litigation | 43
loss, and homeowners policies for coverage. The
panel will discuss these and other aspects of Ponzi
schemes and related financial frauds, and the effect
on professionals, directors and officers, and their
insurers.
THE ANATOMY OF A PONZI SCHEME • A
Ponzi scheme is a fraudulent investment operation
that pays investors with money received from new
investors rather than from bona fide profits from the
investment. See generally, Common Fraud Schemes, Federal Bureau of Investigation, available at http://www.
fbi.gov/majcases/fraud/fraudschemes.htm#ponzi.
A Ponzi scheme may operate for months or years if
there is a sufficient income stream from new investors to pay “returns” to existing investors. To entice
new investors, Ponzi scheme operators often promise unusually high or steady investment profits.
A Ponzi scheme begins to collapse when the operator is unable to recruit new investments that are
sufficient to pay off the growing list of existing investors. Ponzi schemes share the fatal flaw of being
increasingly difficult to sustain over time. Success,
i.e., the accumulation of investors expecting returns
on their investment, leads to increasing demands
for new investors. Eventually the operator is unable
to bring in sufficient investments to satisfy the commitments to existing investors and the scheme collapses. See, Ponzi Schemes — Frequently Asked Questions,
U.S. Securities and Exchange Commission, available at http://www.sec.gov/answers/ponzi.htm.
Ponzi schemes take their name from the now
infamous fraud orchestrated by Charles Ponzi between 1919 and 1921 in Boston, Massachusetts. Mr.
Ponzi enticed investors by purporting to arbitrage
international reply coupons for postage stamps.
Ponzi enticed 40,000 investors to put money into
his scheme by promising astronomical returns of 50
percent within 45 days and 100 percent within 90
days. Cunningham v. Brown, 265 U.S.1, 7-9 (1924) (describing Charles Ponzi’s fraud). Eventually the math
caught up with Mr. Ponzi, his scheme was exposed,
and he went to prison.
PRIVATE PARTY CLAIMS • The nature of
Ponzi schemes and related financial frauds means
that investors oftentimes have very little prospect of
recouping their losses from the perpetrators themselves, who have invariably either paid out the investment income to maintain the fraud, or spent the
money to support an extravagant lifestyle. As result,
victims of such schemes have looked to other entities
— investment firms, banks, accounting firms, employee benefit plan fiduciaries, insurers, among others, in their attempts to recover their losses. Several
Web sites and blogs regularly report on the progress
of financial fraud and Ponzi scheme litigation affecting professionals, directors, and officers, including Kevin LaCroix’s D&O Diary (www.dandodiary.
com) and the PLUS Blog (www.plusblog.org).
Investors have employed a number of theories
in their attempts to obtain the recovery of their lost
investments. Plaintiffs often allege common law
claims for breach of fiduciary duty, negligence, misrepresentation, fraud, fraudulent transfers, and aiding and abetting fraud and the breach of fiduciary
duties. In addition, plaintiffs have brought claims
for violations of state Blue Sky laws and violations
of the fiduciary duties imposed upon employee benefit plan administrators under the Employee Retirement Income Security Act (ERISA).
In MLSMK Investments Co. v. JP Morgan Chase
& Co., JP Morgan was sued for negligence, commercial bad faith, aiding and abetting a breach of
fiduciary duty, and racketeering by an investment
company that lost money in the Madoff scheme.
See, Complaint, 20009 WL 1246206 (S.D.N.Y April
23, 2009). The complaint alleges that JP Morgan
Chase became aware of Madoff ’s fraud in 2008 as
the result of its own investment in Madoff funds
and its due diligence relating to that investment.
The plaintiffs allege that despite this direct knowledge JP Morgan Chase continued to provide Ma-