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Bank Liability to Non-Customers in a Ponzi Scheme
December 17, 2012
The morning news reports flashes a report that your customer was actually a Ponzi scheme and defrauded numerous people. Of course, this is terrible news for the innocent victims, but, you ask yourself, could my bank be somehow liable…why would anyone want to sue us… we did not defraud anyone, did we?

To paraphrase the infamous bank robber Willie Sutton on why they would sue your bank:

“Ms. Plaintiff’s Lawyer, why do you sue banks?...Because, that is where the money is!”

Banks are always tempting targets for plaintiff lawyers, but this is especially true in the wake of a collapsed Ponzi scheme. The victims want to recover their money but the perpetrators have generally wasted, spent or hidden it. The question then becomes who else may have been complicit, or just aware of the scam – essentially who else can the victims blame. As the victims and their attorneys look around for someone to blame who has deep pockets, the bank comes into sharp focus.

You are probably wondering, should my bank really be afraid…Ponzi schemes do not happen in my community, right? Can my bank really be sued? Do I really have liability for the actions of my customers? How am I supposed to know that a customer is conducting a scam? What can I do to protect my bank? The answers may surprise you.

Should you be afraid? Could it really happen here?

Yes and yes. Ponzi schemes are the country’s most prevalent type of investor fraud. In the past few years, criminals have stolen tens of billions of dollars from unwitting investors. The Securities and Exchange Commission defines a Ponzi scheme as “an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising exceedingly high rate of returns with no or only minimal risk.” The essence of the Ponzi scheme is new investors pay off old investors at high rates of return, which then attracts new investors, and the cycle continues and grows, until it collapses on itself or is discovered. Albeit the essence of this is always the same, the details and setting will vary, and so can be difficult for victims to detect.

There is no typical victim. We should not presume that only the uneducated, the desperate or the greedy are the victims because this is not the case. For example, Bernie Madoff’s victims’ included municipal pension funds, international banks, Hollywood stars, and national and international non-profits. Ponzi victims are generally honest and trusting people or organizations, who are trying to earn a little more money on a purportedly safe investment. Such people are everywhere, as are the criminals who prey on them.

These con men are not just in the big metropolitan areas but are also in small towns and communities. One needs to look no further than the alleged Ponzi scheme operated by Paul Burks. His company, Rex Venture Group was essentially divided into two affiliated operations. Zeek Rewards was the investment arm in which “investors” received up to 50% of the daily profits by completing certain tasks, including bringing in new investors or bidders. Many of these investors would then daily reinvest the funds. Zeekler was a penny auction site. On August 17, 2012, the SEC shuttered the $600 million dollar scam. It may appear small, but through the power of the internet Burk’s Ponzi alleged scheme may end up being one of the largest in the country’s history with more than one million victims—dwarfing the number of victims of prior Ponzi schemes. Burk allegedly orchestrated all of this from a small storefront in Lexington, N.C. Clearly, no one should presume that Ponzi schemes do not happen in their communities because odds are, they do.

Could my bank really be sued by the victims?

Yes. Plaintiff’s success has varied, but banks should be legitimately concerned by the prospect.

Does the bank owe a duty to non-customers?

No. A financial institution in North Carolina does not generally owe a duty to a non-customer.

Then how can the victims successfully recover against my bank?

The two main theories (albeit the line between them can be blurred) to recover from the banks are the bank 1) “aided and abetted” the the Ponzi scheme; and 2) breached its standard of care by not detecting and reporting the Ponzi scheme.

How would the bank “aid and abet” a Ponzi scheme?

First, North Carolina does not clearly recognize claim of aiding and abetting fraud. Our courts have apparently decided essentially if one is “aiding and abetting a fraud”, one is actually committing a fraud. This does not mean a bank would not be sued on this count; it would just be called “fraud.” The liability is the same.

Fraud requires the bank to have knowledge. It is difficult to believe a bank would knowingly allow a fraud to be perpetrated. But do not underestimate the creativity of the plaintiff’s bar. They try to prove aiding and abetting or fraud in several ways. First and most damaging is the someone with the bank had actual knowledge of the scam and helped with it or did not stop it, they can attempt to show that the bank took certain steps to protect itself but did nothing else, or finally that there were so many red flags and danger warnings that they had to have known but kept doing business with the criminal anyway (this point intersects with the theory that the bank breached its standard of care). From all of this evidence, they hope to show that the bank knew about the fraud and the bank materially aided in it.

In the Bernie Madoff matter, the bankruptcy trustee brought claims against numerous feeder funds, hedge funds and banks, including JP Morgan Chase (JPM) and HSBC. For example, he sued JPM for $ 19 billion in damages for aiding and abetting Madoff’s fraud as his primary banker. Putting aside the numerous red flags that he says JPM missed, the trustee alleged more than 14 months prior to the scheme’s collapse that there were internal JPM emails where the executives speculated Madoff’s returns were too good and were part of a “Ponzi scheme,” and several months before Madoff’s scam collapsed JP Morgan began to withdraw its own monies from Madoff’s feeder funds. It did not notify anyone of its concerns until, two months before the collapse, when JPM warned British agencies that Madoff’s returns were “too good to be true.” However, JPM did not notify customers or anyone in the U.S. and kept doing business with him and facilitating his transfers. Likewise, the Trustee sued HSBC, which marketed Madoff’s funds, for more than $9 billion for being “willfully and deliberately blind to the fraud.” He argued that HSBC was notified by its accountants of the “serious risks” associated with Madoff. HSBC’s “financial sophistication” alerted them to the scam earlier than others but HSBC continued to do business with him, develop derivative products for him and lend their prestige to his operation. Although both suits were later dismissed because of the trustee’s lack of standing under New York law, HSBC later settled a class action brought by some of the victims by paying $62.5 million. It can be expensive and disastrous (both in reputational and monetary risk) to continue doing business with someone you suspect is conducting a Ponzi scheme.

How am I supposed to know if my customers are orchestrating a Ponzi scheme so as to breach any standard of care?

The second theory is that the bank was negligent by failing to detect and report the fraud. In other words, the bank should have detected the “red flags” through its internal controls and alerted the appropriate authorities the potential scam. It is not necessary to prove knowledge. In my opinion, this is the more potentially serious and difficult to defend claim in North Carolina.

The Bank Secrecy Act/Anti-Money Laundering Examination manual has 8 pages of potential “red flags” for money laundering, which are also relevant for Ponzi schemes. A few red flags are
  • Significant increases in the number or amount of transactions
  • Transactions that are not consistent with the customer’s business or income level
  • Transactions designed to lose the paper trail
  • Circumvention of internal control procedures
  • Lavish lifestyle of customers, which should not be supported by present income
  • Customers with multiple accounts
These “red flags” were evident in the Scott Rothstein Ponzi scheme in Florida. Coquina Investments (“Coquina”) sued the perpetrator and TD Bank (TD)—Rothstein’s bank. Although Coquina’s claim was aiding and abetting, the “red flags” that it details are very illustrative of what bank employees should be on the lookout for.

Coquina claimed that Mr. Rothstein was only able to perpetrate the Ponzi scheme due to the involvement and prestige of TD Bank. Coquina’s claim was bolstered by Mr. Rothstein statements. In what has to be one of the most unwelcome testimonials ever, Mr. Rothstein testified in a deposition that on a scale of 1 to 10, that TD was a 10 in the amount of assistance that he received – he could not have done it without them in other words. Some of this “assistance” included
  • The bank’s own money laundering software issued 21 “red flags” for the Rothstein accounts but no SAR were filed
  • TD allowed Rothstein to meet his investors in TD conference rooms
  • TD employees would provide letters, which Rothstein’s office wrote, on its letterhead to Rothstein during the meetings
  • Some of these letters provided to investors on TD letterhead stated that certain accounts had been “locked” although TD had no system or way to “lock” accounts
  • TD allowed Rothstein to transfer millions of dollars between accounts without question, including in October 2009 when almost $500 million went through the account
  • Rothstein had regular overdrafts from his firm’s trust account, which although illegal under Florida law, were never reported
  • TD executives met with investors to underscore the safety of their investments
The result of this “assistance” was a $67 million judgment against TD. (In this decision’s aftermath, TD paid out tens of millions of dollars more to settle some of the other pending matters stemming from Rothstein.) TD continues to appeal, but regardless of any final decisions, the Rothstein Ponzi scheme will costs it tens of millions of dollars and a have deleterious effect on its reputation.

What can I do to protect my bank?

The first line of defense is the education and training of your employees, especially those that are in personal contact with the customers. They need to be on the lookout for “red flags” and other suspicious behavior. To help the front line employees, the bank should not only have a strong “Know Your Customers” policy but the employees should be trained in it. These policies help the bank understand the potential customer, his or her business, and the types of transactions associated with it. In so doing, the bank will be able to create a good customer transaction profile.

Procedure should be followed, with few exceptions. All bank employees, from retail to executive management should follow bank procedure as to their customers. The customers or their requests may appear to be legitimate, but appearances can be deceiving. Any history of exceptions or special treatment for an operator of a Ponzi scheme could be a death nail to a bank trying to defend itself from the victims.

If bank management becomes aware of or suspects potential fraud, then additional steps should be taken. First, the Bank should consider filing a Suspicious Activity Report as to its suspicions. Furthermore, the bank may wish to take steps to terminate its relationship with the customer. Regardless of the veracity that by allowing the relationship to continue you are in some way assisting in the scam, the bank is definitely putting its reputation at stake by keeping the customer. By terminating the relationship, the reputational risk to the bank is minimized and a culture of compliance and risk control is enhanced

Finally is the bank’s culture. It must be one of vigilance, control of risk, protecting the bank and its reputation, and recognizing that not every customer is one that the bank should want. Just ask all these banks that are writing checks for the misdeeds of their customers.

In conclusion, my Willie Sutton paraphrase is true but incomplete. You may not be sued only because you have money, but it could be you have liability too.
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