RECEIVERS: WHY IS RECEIVERS: WHY IS EVERYONE UNHAPPY?EVERYONE UNHAPPY?

Wayne Klein

Lewis B. Freeman & Partners, Inc.

August 15, 2009

Anatomy of a Ponzi: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.

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What was the problem?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.

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Disgorgement ordered: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.

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Appeals court was Appeals court was unconvinced: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.

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Hypothetical #1: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?

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Hypothetical #2: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?7

Hypothetical #3: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?

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Hypothetical #4: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?9

Why does the SEC seek Why does the SEC seek Receivers?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 . . . .10

Who controls the Receiver?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.

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Types of claims made by Types of claims made by Receivers:Receivers:1. Assets of Ponzi operator and family.2. Balances in bank, brokerage

accounts.3. Charitable contributions.4. Investments, joint ventures.5. Payments made for debts of others.6. Payments made for benefits of others.7. Unconsummated transactions.8. Overpaid investors.

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Other targets of Other targets of Receivers: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.

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The Receiver’s arsenal: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.

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Good faith defense: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).

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Who can Receivers trust?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.

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Learning the truth: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?

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Complaints about Complaints about Receivers: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.

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More complaints: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.

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Targets of investor anger: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.”

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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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