You Can't Cheat an Honest Man (40 page)

While the
Central Bank
decision severely curbed actions against secondary actors, the court admitted that such actors are not “always free from liability under the securities acts.” Specifically, it wrote:

Any person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator....

So, a burned investor has to prove that the bank—or its personnel— were actively involved in promoting the scheme. Of course, the relationship between a Ponzi perp and his bank isn’t always clear. Many perps use unwitting banks—or groups of banks—to create whole systems of bogus transactions intended to hide their tracks. The bank’s liability may
seem
larger here; but it can be even harder to prove.

When Banks Become Promoters

In his 1914 book
Other People’s Money
, which studied the concentration of power among New York investment bankers, future Supreme Court Justice Louis Brandeis wrote:

[T]his enlargement of their legitimate field of operations did not satisfy investment bankers.... They became promoters, or allied themselves with promoters.

The Securities Act of 1933 was influenced by Brandeis’ book. As one congressman put it, “The American investor was relying upon the bankers, since faith in the bankers was virtually the only measuring rod for the investor. How certain bankers and brokers have breached that faith is part of this whole sordid story.”

When this line is crossed—which it still sometimes is—banks can be held liable for Ponzi scheme damages. That’s exactly what happened in the Great Rings Estate Limited Partnership scheme.

Great Rings was a distant relative of the infamous—and much larger— Colonial Realty pyramid scheme that shook Connecticut money circles in the late 1980s. One of Colonial’s most successful salesmen was Kenneth Zak. In early 1988, after studying with master Ponzi perps at Colonial, Zak left to strike out on his own.

What he found was Great Rings, which had been started as a limited partnership among several experienced real estate developers. The stated purpose of Great Rings was to purchase four parcels of unimproved land on Great Rings Road in Newtown, Connecticut, upgrade their zoning, and prepare single-family home sites which would then be resold at a profit.

Zak—who had no experience in developing raw acreage—didn’t care what the stated purpose of the vehicle was. To him, it was a method of raising money. He and the founding general partners agreed on an unusual method of financing. Great Rings would solicit investments in the form of limited partnerships. Investors would borrow the entire purchase price of their shares ($50,000 each) from a bank. Their notes would be directly payable to the bank. The partnership would guarantee a return at 8 percent per annum to the investors, to offset the interest on the notes to the bank.

Zak claimed that, in two years, Great Rings would have sufficient funds to pay off the principal—and still have many of the parcels left to sell. So, the general partners would raise millions and the investors would never pay a dime out of their own pockets.

The scheme, while not inherently unlawful, contained a substantial Ponzi element from the very beginning. The raw acreage could not produce income until it was developed and resold, so the only conceivable source of the 8 percent annual return was money from new investors. This aspect of the enterprise was not mentioned in any of the promotional literature or legal filings produced by Great Rings.

The success of the scheme rested on persuading a bank to go along. Zak approached Connecticut National Bank (CNB). In January 1989, he met twice with Neal Fitzpatrick, then a senior vice-president and regional manager of CNB. The first meeting was at Fitzpatrick’s office, and the second was at a Super Bowl party at Zak’s home.

Fitzpatrick also met with the other general partners of Great Rings. He agreed that, if the general partners would refer potential investors to CNB, the bank would loan money to those investors that it deemed even minimally qualified. “The bank was dying to get money out there working,” recalls one of the general partners. “The minimal qualifications were that the leads could fog a mirror.

Fitzpatrick contacted two other regional managers of CNB— in Hartford and in Waterbury—who also agreed to go along. The bankers reached a detailed agreement with Zak that each investor’s loan was to be in the amount of $50,000 (the purchase price of a Great Rings limited partnership share) with an informal maturity date two years later and with interest set at 1 percent over prime.

The terms were tailored to fit the needs of the Great Rings partners exactly. CNB presented the same terms to every potential investor, with no negotiation on the investor’s part. CNB’s willingness to make these loans was an enormous selling point for Zak.

Great Rings filed the appropriate paperwork to exempt its limited partnership shares from the registration requirements of the Securities Act of 1933. Its argument was that the limited partnerships didn’t qualify as a public offering under Rule 506 of the Act.
Rule 506 exempts transactions involving no more than 35 purchasers of securities. In calculating the number of purchasers under the Rule, “accredited investors” are not counted. An “accredited investor” is a person with a net worth—together with his or her spouse—over $1 million or an income over $200,000 a year in each of the two previous years.

Rule 506 also requires that each purchaser who is not an accredited investor have “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.” Great Rings marketing materials stated:

Units will be sold only to persons that the General Partners reasonably believe to satisfy the definition of an “accredited investor” under...the Securities Act.

So, Great Rings was supposed to be a rich person’s deal.
Sometimes Warnings Tease Greater Interest

The various disclaimers included in the marketing materials acted like catnip to greedy strivers of middle-class means. With the marketing pieces circulating around central Connecticut, many people would know that anyone involved in Great Rings had to be rich by the SEC’s reckoning. So, investing in the deal was something like leasing a Mercedes. It was a sign you had made it.

Of course, Zak didn’t actually follow the disclaimers. He sold Great Rings limited partnership units to accredited and nonaccredited investors alike. And, with CNB rubber-stamping loan applications, a lot of people who wouldn’t normally have $50,000 in cash to invest were able to get involved. As one court later noted:

The evidence is overwhelming that [he] solved this problem by ...wholesale forgery. When an investor signed his subscription agreement, he was told what to fill in and not fill in. It would not be completed in full. [Zak] would then fill in some cooked up figures on the balance sheet so that the investor’s income and net worth would be sufficiently inflated to make him accredited.

The Great Rings promoters focused their efforts in Waterbury on the city’s Republican Party establishment. This was a middle-class crowd...with aspirations for bigger things.

More than 40 investors ultimately joined Great Rings, contributing more than $2 million. Monthly payments to cover the interest payments on the CNB loans started in September 1988. They continued for about a year until the fall of 1989. At that point, the money stopped coming—and explanations were in exceedingly short supply. Only one thing was certain: CNB still expected to be paid.

By this time, Zak had left Great Rings. The money that the company had raised was gone. The partnership had acquired two relatively small parcels of land, totaling 10 lots; and even these parcels were eventually foreclosed on by CNB.

The lawsuits started in early 1990. Angry investors sued every person and entity connected to Great Rings—the company itself, Zak, the other general partners and CNB. The bank turned around and sued many of the investors, holding them personally liable for loans taken against the worthless Great Rings partnership units.

One of the most important ruling on these cases was the 1993 Connecticut state court decision
Connecticut National Bank v. Robert A. Giacomi et al
. Clearly astounded by CNB’s actions, the court wrote:

Bankers are regarded in popular folklore as shrewd, tightfisted individuals, unwilling to lend money to anyone unable to prove that he doesn’t need the money in the first place. This case involves bankers of a very different description.... [CNB] made a deal with the promoters of a speculative real estate scheme to give unsecured loans to the investors in that scheme. [R]ather than employing the traditional close scrutiny of a lending bank, it dished out loans to investors it had never seen with a cursory abandon that left the recipients slack-jawed with astonishment.

Of course, there’s no law against loaning money with cursory abandon. But the court was troubled by the shady histories of people like Kenneth Zak. It went on to write:

The promoters here were, essentially, common criminals, who engaged in numerous acts of fraud, forgery, and outright theft of the invested funds. The bank openly allied itself with the promoters and, in effect, became a promoter. ...[T]he general atmosphere of fraud and betrayal in this case [and] the fact that no satisfactory accounting of funds has ever been made...irresistibly lead to the conclusion that the investors’ money was simply stolen.

The court acknowledged that some of the investors had criminal backgrounds themselves—and may have been looking for an easy profit from a sleazy deal. But the argument against CNB—namely, that the bank was a part of the scheme—held up. CNB was in trouble.

The court cited Learned Hand’s statement that, in order to be held as an aider-and-abettor, a person or entity must “associate himself with the venture, participate in it as something that he wishes to bring about, [and] seek by his action to make it succeed.”

CNB associated itself with the venture, participated in it as something it wished to bring about, and sought by its actions to make it succeed. Its involvement was “affirmative, substantial and wrongful.” The court concluded that CNB should not be permitted to recover against the investors. “In a case like this, when the bank went out of its way to act as bait, it cannot complain that the fish were eager to bite.”

When Stockbrokers Push People into Ponzi Schemes

More often than banks, stock brokerages will end up promoting Ponzi schemes. But stock brokerages aren’t always linked so closely with the investments they sell; the key to establishing a brokerage’s liability is proving that it was a “control person.” The 1992 federal appeals court decision
Harrison v. Dean Witter Reynolds
held one brokerage liable on these grounds.

The Ponzi perps in the case had used Dean Witter’s office space, telephone services, and employee trading accounts in order to perpetuate their scheme. The local management failed to enforce Dean Witter’s own rules to prevent such fraudulent practices.
The same appeals court later upheld a jury finding of liability in a related case, based on the brokerage firm’s:

failure to detect and halt its employees’ fraudulent activities, the complete lack of supervision over their abnormal trading activities, and the firm’s refusal to investigate the obvious rule violations committed by its agents.

In that later decision, the court noted the existence of :

[
S]ufficient evidence for a reasonable jury to determine that had Dean Witter not shut its eyes to the various fraud signs available to it, as it did, the whole scheme could have been detected and shut down by Dean Witter far earlier than when it collapsed.

The problem with the investment world is that it mixes conservative vehicles with high-risk ones, often in close quarters. Few brokerage firms investigate all of the investments they sell—and they don’t make false promises about doing so. A New York lawyer who sits on arbitration panels that hear investment disputes lays out the terms:

As long as the stock brokerage isn’t dumping worthless stock that it owns or coercing a person to make an investment he’s said he doesn’t want to, the operating rule is “Buyer beware.” It’s really hard to find a broker liable for a client’s losses. Whether or not they should, the rules assume an investor knows what he’s doing.

As a result, some of the most egregious schemes are able to market themselves through legitimate brokerages.

In April 1989, Thomas Mullens started Omni Capital Group in Boca Raton, Florida. He employed commissioned salespeople, secretaries, and receptionists for the corporate office in Boca Raton and sales offices in New Jersey, California and Ohio.

Omni Capital sold loosely-defined “investment opportunities” in the form of shares, contract rights and participation rights in limited partnerships. Mullens told investors the limited partnerships were formed to buy and sell small, privately held companies for a profit. He published promotional materials claiming he’d sold 22 companies and his investors had averaged 24 percent annual returns.

In reality, Omni Capital was a Ponzi scheme. Mullens and his staff were able to convince about 150 greedy people to invest some $27 million in the scheme between 1988 and 1992. The investors, mostly elderly retirees, were promised annual returns of at least 15 percent on their investments. (But Mullens promised
some
investors returns of up to 15 percent
each quarter
.) “He customized his deals. If he needed money he’d promise you any interest rate,” said Thomas Tew, a Miami lawyer who worked on the case. This is a familiar theme.

To keep investors involved as long as possible, Mullens spent some of the money on false account statements reflecting annual rates of return of 20 percent to 30 percent. As with the typical Ponzi scheme, he used some of the contributions from later investors to pay off returns promised to earlier investors, thus convincing at least some people that Omni Capital was a successful enterprise.