You Can't Cheat an Honest Man (38 page)

In
Hirsch
(which was one of many legal spin-offs of the massive Colonial Realty
¹
scheme), the receiver sued Colonial’s accountant—Arthur Andersen—alleging, among other things, violations of the RICO Act. He argued that Colonial participated with Andersen in fraudu

1. For more on Colonial Realty see Chapter 12.

lently issuing memoranda to induce individuals to invest in bogus limited partnerships.

The bulk of the receiver’s complaint alleged a scheme to defraud investors; but the only alleged damage to the Ponzi company was the generation of some unpaid accounting bills. The accused accounting firm argued that the receiver lacked legal standing because the claims “really” belonged to the scheme’s investors and that any claims the companies might make were prohibited by virtue of their own participation in the fraudulent scheme.

The court ruled that the receiver hadn’t alleged any distinct way in which the companies were damaged by the wrongdoing of the CPAs. It dismissed the claims and went on to explain that, because the receiver had alleged that the injury to the companies was coextensive with the injury to the investors, “the trustee has done no more than cast the [companies] as collection agents for the [investors].”

If—as the court suspected—the facts of the complaint suggested that the claims actually belonged to the investors, “a blanket allegation of damage to the debtors will not confer standing on the [receiver].” (The investors had already filed separate lawsuits against the law and accounting firms.)

The appeals court, affirming the lower court ruling, noted that the claim against the accounting firm relied on the distribution of misleading memoranda to investors. So, only the individual limited partners could make the claims against Andersen.

Unfortunately, there are exceptions that confuse matters by suggesting that a receiver
can
sometimes go after professionals on behalf of investors. The 1988 federal appeals court decision
Regan v. Vinick & Young
offered an example. In the case, a Ponzi scheme bought and sold rare coins for its customers—but the principals stole significant assets from the company, which eventually led to its collapse.

A court-appointed trustee sued the company’s accountant and auditor for certifying reports which summarized rare coin transactions. His complaint alleged negligence, breach of contract, negligent misrepresentation, and unfair and deceptive acts or practices. The damages sought included: the cost of the accountant’s services, the misappropriation of assets by the company’s principals, certain sales commissions paid by the company, the costs of its bankruptcy filing and an $11.8 million fine from the FTC.

The accountants argued that the claims filed by the trustee belonged only to investors, a group the trustee did not represent. The court disagreed, ruling:

The trustee steps into the shoes of the [failed company] for the purposes of asserting or maintaining its causes of action, which become property of the estate. [Any] confusion may stem from the trustee’s repeated assertions that the accountant’s wrongdoing caused [investors] to lose money. This emphasis... appears to result from the $11.8 million claim filed on their behalf... and from the concern that the estate may be held jointly and severally liable with the accountant in any eventual actions.

So, these concerns were legitimate. The trustee could go after the accountants. If he won, the money would go into the company’s bankruptcy estate and—all would hope—eventually to the investors.

Lawyers and accountants can’t just take money from Ponzi perps without asking any questions about its origins. As one federal court has written:

The court’s ruling in no way condones the acts of an attorney who blindly handles substantial sums of money for a client with no inquiry into its source if the attorney has reason to suspect the legality of the origins of the funds or if the attorney has reason to suspect his or her client’s right to ownership of those funds. The attorney is clearly subject to disciplinary sanctions according to ABA [guidelines]. Moreover, he or she may be liable under conspiracy or aiding and abetting theories, or even under other theories not pled by plaintiff.

The American Bar Association guidelines were designed to prevent lawyers from playing stupid when advising drug dealers. They apply equally well to lawyers playing stupid when advising Ponzi perps. The civil conspiracy angle mentioned by the court might make sense in some situations. Burned investors stand on stronger legal ground if they allege a conspiracy existed between lawyers or accountants and the Ponzi perps. The problem here: While the
theory
of a conspiracy makes a better argument, it requires a lot more evidence than a negligence claim.

It’s a short step from alleging a civil conspiracy to alleging an organized crime operation under RICO (and RICO’s triple damages). However, the federal courts severely limit RICO’s applicability to lawyers or accountants. In its 1993 decision
Reves v. Ernst & Young
, the Supreme Court explained theRICO restrictions.

The defendants in
Reves
were accountants who drafted misleading financial statements and were subsequently sued for both securities fraud and RICO violations. A jury found that the accountants had engaged in securities fraud; but the U.S. Supreme Court upheld the dismissal of the RICO claim, holding that the mere drafting of statements based on information supplied by the perp did not constitute sufficient participation in the operation or management of the enterprise. So, even if the accountants had engaged in intentional fraud, they could not be held liable under RICO.

In short, the Supreme Court ruled that lawyers or accountants do not incur RICO liability for the traditional functions of providing professional advice and services. It ruled that in order to be liable under RICO, an outside professional must have “participated in the operation or management of the enterprise itself,” and must have played “some part in directing the enterprise’s affairs.”

Some courts have given the matter some leeway. In the 1994 decision
Friedman v. Hartmann
, a federal court in New York ruled:

[I]t will not always be reasonable to expect that when a defrauded plaintiff frames his complaint, he will have available sufficient factual information regarding the inner workings of a RICO enterprise to determine whether an attorney was merely “substantially involved” in the RICO enterprise or participated in the “operation or management” of the enterprise.

But other courts, citing the Reves decision, have dismissed RICO claims without giving plaintiffs an opportunity to conduct discovery.
Establishing Fiduciary Duty—to the Investors

In order to make a claim of professional negligence or breach of fiduciary duty, a burned investor has to show that the lawyer or accountant owed some direct fiduciary duty. This usually isn’t the case, since the professionals are hired by the company—and owe their duty to
it
.

This guideline stems back at least to a 1930s decision written by federal judge (and later U.S. Supreme Court Justice) Benjamin Cardozo which held that an accounting firm owes a duty of due care only to those in “privity of contract” with it or to “those whose use of its services was the end and aim of the transaction.”

This is still generally the law on the duty. However, the duty of accountants in some states has been expanded to include reasonably foreseeable reliance provided it lies “within the contemplation of the parties to the accounting retainer.” The 1985 New York Court of Appeals decision
Credit Alliance v. Arthur Andersen & Co
. also created a test which can expand Cardozo’s limits. The court ruled:

Before accountants may be held liable in negligence to noncontractual parties who rely to their detriment on inaccurate financial reports, certain prerequisites must be satisfied:

1) the accountants must have been aware that the financial reports were to be used for a particular purpose or purposes;

2) in the furtherance of which a known party or parties was intended to rely; and

3) there must have been some conduct on the part of the accountants linking them to that party or parties....

This so-called “Credit Alliance test” usually requires some evidence of a “nexus between the [professionals] and the third parties to verify the [professionals’] knowledge of the third party’s reliance.”

The 1988 New York case
Crossland Savings v. Rockwood Insurance Co.
involved a bank that loaned money to a crook in large part because the crook’s lawyer wrote several opinion letters attesting— wrongly—to the crook’s financial viability.

After the scheme collapsed, the bank sued the lawyer’s professional liability insurance company. The insurance company didn’t want to pay; it argued that the circumstances didn’t meet the Credit Alliance test. The court agreed with the bank: “When a lawyer at the direction of her client prepares an opinion letter which is addressed to the third party [namely, the bank] or which expressly invites the third party’s reliance, she engages in a form of limited representation.”

Under such circumstances, the “opinion letters do not constitute advice to a client, but rather were written at the client’s express request for use by third parties.”

Misrepresentations and Omissions

Under Securities and Exchange Act Rule 10b-5, burned investors can go after lawyers and accountants, alleging liability for either “material misrepresentations” or “omitting to state a material fact necessary to render the statements made not misleading.”

The first of these charges, misrepresentation, is easy to articulate in legal theory but difficult to prove. A burned investor has to establish that the lawyer or accountant affirmatively stated something untrue about the scheme or its perps. Most professionals—even determinedly crooked ones—can manipulate language enough to avoid this direct connection.

This is why the prospectuses for Ponzi investments will often include critical boilerplate language stating that the securities are not traded on any securities exchange, not approved by the SEC or both.

If the burned investor can establish that the lawyer or accountant has affirmatively made false statements, the investor “must demonstrate that he or she relied on the misrepresentation when entering the transaction that caused him or her economic harm.”
A charge of aiding and abetting liability against a lawyer under Rule 10(b) is especially tough to prove if there was no fiduciary relationship between the lawyer and the investor. In such a situation, the investor has to argue that the lawyer display an “actual intent to aid in [the] primary fraud” instead of mere “recklessness.”

The 1988 federal appeals court decision
First Interstate Bank v. Chapman & Cutler
dealt with a case in which the defendant—a law firm—had allegedly made misstatements in connection with an initial bond offering to finance a nursing home. In a “classic Ponzi scheme,” the proceeds of subsequent bond offerings were used to repay the initial offering.

First Interstate Bank, representing a group of burned investors, argued that “the subsequent bond issues were the inevitable result of the defendants’ need to acquire funds to avoid defaulting on the [initial] issue.” It also argued that but for the law firm’s misleading statements, it would have avoided the investment. These arguments worked at trial but were eventually reversed.

The appeals court dismissed the bank’s charges and ruled that “something more than but-for causation is required.” It concluded that while the issuance of the bonds might have been foreseeable, the misuse of the bond proceeds “constitute[d] a superseding event” and, therefore, the attorneys were not liable.

The second charge, omission, is more difficult to articulate. To begin, a burned investor has to show that the lawyer or accountant had a specific fiduciary duty or “other relation of trust” to the investors. (This usually isn’t the case, any duty they have usually goes to the company that is paying their bills.)

As the U.S. Supreme Court explicitly stated in its
Central Bank
decision, “[w]hen an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak.”

There’s a slight benefit to this more difficult standard. If a burned investor can establish that a lawyer or accountant has made a material omission, positive proof of reliance is not necessary if the investor can show that (1) the withheld facts were material, and (2) defendant had a duty to disclose the facts. The two charges are often so closely linked that both—or either—can be made by a burned investor. For that reason, many make both claims. The courts are left to sort through somewhat confusing law and absolutely confusing facts.

As one court noted: “Like standing dominoes, however, one misrepresentation in a financial statement can cause subsequent statements to fall into inaccuracy and distortion when considered by themselves or compared with previous statements.”

In the end, the courts themselves aren’t clear about the distinctions between
misrepresentations
and
omissions
. In the federal appeals court decision
Little v. First-California Company
, the court stated:

The categories of “omission” and “misrepresentation” are not mutually exclusive. All misrepresentations are also non-disclosures, at least to the extent that there is failure to disclose which facts in the representation are not true. Thus, the failure to report an expense item on an income statement, when such a failure is material, ...can be characterized as (a) an omission of a material expense item, (b) a misrepresentation of income, or (c) both.

One of the issues that kept the Home-Stake Mining Ponzi scheme in the courts for more than 20 years was whether its lawyers could be held liable. Even the question was complicated. One of the appeals courts asked whether the lawyers:

aided and abetted the fraudulent conduct...in the preparation of registration statements...either with actual knowledge as attorneys of the misrepresentations and the omission of material facts set forth in the registration statements and prospectuses in which their names appeared, with their consent, or, in the alternative, under circumstances where in the due exercise of their professional responsibilities these attorneys should have known of such....