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RECEIVERS: WHY IS EVERYONE UNHAPPY?

RECEIVERS: WHY IS EVERYONE UNHAPPY?. Wayne Klein Lewis B. Freeman & Partners, Inc. August 15, 2009. Anatomy of a Ponzi :. From 1997 to 2002, J.T. Wallenbrock raised $253 million from investors. Investor funds purchased accounts receivable from a Malaysian latex glove manufacturer.

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RECEIVERS: WHY IS EVERYONE UNHAPPY?

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  1. RECEIVERS: WHY IS EVERYONE UNHAPPY? Wayne Klein Lewis B. Freeman & Partners, Inc. August 15, 2009

  2. Anatomy of a Ponzi: • From 1997 to 2002, J.T. Wallenbrock raised $253 million from investors. • Investor funds purchased accounts receivable from a Malaysian latex glove manufacturer. • Promissory notes said 15% profit in 90 days. • Investors were told there was “no risk”: • 85% of contracted sales price was paid to the manufacturer only when gloves were shipped, • purchasers paid the investors full price for the gloves immediately upon arrival in the U.S.

  3. What was the problem? • There were no latex gloves!!! • The SEC sued and a Receiver was appointed. • The Receiver found: • $113.8 million was paid to investors as returns. • $11.1 million for office expenses and payroll. • $25.5 million in personal and business expenses, including $3 MM in cash, credit card payments. • $99.8 million funded 175 start-up companies. • $3 million in bank at the time of the asset freeze.

  4. Disgorgement ordered: • Defendants consented to an injunction and agreed to pay disgorgement. • Court ordered repayment of full $253 MM. • Defendants appealed, arguing: • No duty to disgorge $36 MM in operating costs. • No duty to repay money loaned to venture capital investments. • Should not have to pay over to investors monies earned from outside business ventures.

  5. Appeals court was unconvinced: • All $253 million was unjust enrichment and must be repaid. • Defendants do not get “an offset for entirely illegitimate expenses incurred to perpetrate an entirely fraudulent operation.” • “[U]njust to permit the defendants to offset . . . the expenses of running the very business they created to defraud those investors . . . .” • A defendant could not offset $1.2 million he lost against disgorgement he owed.

  6. Hypothetical #1: • Investor put $500,000 into Ponzi scheme six years before its collapse. • Investor was paid $100,000 distributions annually. • Most recent account statement from Ponzi operator shows $500,000 principal balance. • After this scheme collapses, how much can the investor claim from the Receiver? • Who will be happy? Who will be unhappy?

  7. Hypothetical #2: • Stu, a personal friend, loans $68,000 to Ponzi operator as scheme is collapsing. • After SEC sues and court freezes assets, fraudster contacts H&H, a company that owes him money. • To satisfy the debt, H&H transfers real property to Stu. • Ponzi operator has Stu borrow $63,000 from a hard-money lender, using property as collateral. • Receiver discovers property transfer. • What should Receiver do? • Who will be happy? Who will be unhappy?

  8. Hypothetical #3: • Receiver analyzes bank records and finds $5,000 paid by fraudster to Mortimer. • Receiver asks why. Mortimer responds: • He is high school teacher who sells his blood to supplement his income. • His LDS bishop visits him, saying he was embarrassed at how he supplements income, gives him $5,000 check from Ponzi company. • Should Receiver demand a return of funds? • Who will be happy? Who will be unhappy?

  9. Hypothetical #4: • Receiver takes inventory of assets, finds lake house under construction in resort area. • Each of two adjacent lots cost $800,000. • $1.6 million has been spent on construction to date; home is 70% completed. • Potential buyer offers $1.4 million for home and both lots. • What factors should the Receiver consider? • Should the Receiver take the offer? • Who will be happy? Who will be unhappy?

  10. Why does the SEC seek Receivers? • Theory: it frees up SEC to bring other cases. • Reality: the theory is true, but, it also results in someone else playing the bad guy. • Receiverships take enormous time and specialized expertise. • Asset freezes give a great advantage to the government: defendants cannot use entity funds to pay their attorneys. • There are risks to the government too . . . .

  11. Who controls the Receiver? • Once appointed, the Receiver is answerable only to the court. • Receivers are granted enormous discretion. • Stanford case exposes potential conflicts: • Innocent investors hold proceeds from CD purchases in domestic brokerage accounts. • Court order freezes investor access to accounts. • Receiver sues investors, seeking these funds. • SEC files emergency motion to reclaim exclusive authority to pursue claims against investors.

  12. Types of claims made by Receivers: • Assets of Ponzi operator and family. • Balances in bank, brokerage accounts. • Charitable contributions. • Investments, joint ventures. • Payments made for debts of others. • Payments made for benefits of others. • Unconsummated transactions. • Overpaid investors.

  13. Other targets of Receivers: • Receivers bring claims against others who assisted – or just ignored – the fraud. • These include “gatekeepers” such as: • Law firms • Banks • Accounting/auditing firms • Officers and directors • Receivers may fight among themselves: • Liquidators from Antigua were awarded control of $196 million in Stanford assets in the U.K.

  14. The Receiver’s arsenal: • Receiver is often exempt from “unclean hands” defense. • Fraudulent conveyance laws: • Can recover funds paid by an insolvent entity. • Actual fraud vs. constructive fraud. • If actual fraud, all payments must be returned. • If constructive fraud, only net profits come back. • “Badges of fraud” can help prove fraud: • Diverted funds, false statements, no profits.

  15. Good faith defense: • Good faith defense is an affirmative defense. • It is a high standard: the investor had no knowledge of problems or suspicions about viability of the enterprise. • Good faith only protects principal. • Any “net” payments go back to the receiver for distribution to investors – pro rata. • For an excellent discussion of these issues, see: Donnell v. Kowell, 533 F.3d 762 (9th Cir. 2008).

  16. Who can Receivers trust? • Madoff’s wife was accountant for Madoff, but claims she was innocent and had separate wealth for Manhattan apartment. • Some Ponzi operators claim they have assets overseas and offer to go get them. • Spouse could not explain why she signed note and personal guarantee for 40% loan. • Investors provide evidence of investments made, but understate size of withdrawals.

  17. Learning the truth: • Ponzi operators lie. • Fraudster had inadequate or no records. • False records: • Fictitious account statements • Palmer financial statements on computer • Tax returns on computer showed $1 million payment of estimated taxes. • Possible solution: limited immunity by prosecutor for assistance to Receiver?

  18. Complaints about Receivers: • Size of fees. • They seek “clawbacks” from investors. • Refuse to permit investor withdrawals. • Not honoring balances on account statements. • No recovery for “indirect” investors. • Should not target attorneys, banks, or CPAs. • Cooperation with the Receiver will result in the SEC learning information. • No ongoing living allowance.

  19. More complaints: • Deny funds for criminal, civil defense. • Receiver is perpetuating improper actions by the SEC in stopping a legitimate business enterprise and destroying its value. • Should not sell assets before case has been proven against the Ponzi operator. • Conflicts of interest. • Receiver is too aggressive. • Receiver is not sufficiently aggressive.

  20. Targets of investor anger: • A New York Times reporter offered up this defense of the Madoff receiver: • “But the essential unfairness is Mr. Madoff’s fault, not Mr. Picard’s. He has been left with a series of unpalatable choices . . . .” • “Every time he decides not to claw back money from that cancer patient who cannot afford treatment, he is depriving some other Madoff investor of money that belongs to him.” • “No matter what he does, someone gets hurt.”

  21. Contact Information: Wayne Klein Lewis B. Freeman & Partners, Inc. _____ 3225 Aviation Avenue, Suite 501 Miami, FL 33133 (305) 443-6622 www.lbfglobal.com _____ 299 South Main, Suite 1300 Salt Lake City, UT 84111 (801) 534-4455 (801) 824-9616 (cell) wklein@lbfglobal.com • LBF is a forensic accounting and litigation consulting firm that: • Has principals that act as receivers and trustees, • Performs forensic accounting, • Conducts due diligence, internal investigations, • Provides professional advising on internal controls, SOX compliance, • Manages restructurings and business workouts, • Provides specialized subject-matter expertise in securities, commodities, banking, hotel, and real estate, and • Serves as expert witness.

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