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Ponzi Schemes and Banks: Positive Trends in Tort Law

Tuesday, September 10, 2013

By Mary Hackett and Nellie Hestin, Reed Smith LLP

The financial crisis brought with it the exposure and collapse of hundreds of Ponzi schemes,1 many of them headline news over the past five years. Scrambling to recover their lost investments, defrauded investors have turned to the courts. And with the shell companies run by the Ponzi scheme perpetrators typically bankrupt, victim-investors have pointed the finger elsewhere: at the banks where the perpetrators held accounts. The logic goes (according to these investors) that whatever tort the Ponzi schemer committed, the bank was liable for aiding and abetting by way of the banking services that it provided. Plaintiffs have also attempted to hold banks liable on other tort-based theories such as negligence, conspiracy, and conversion.

Despite the influx of lawsuits against banks, courts have consistently dismissed the suits for sound legal and policy reasons, and three main themes have emerged. First, banks do not owe a duty to non-customers. Thus, negligence and breach of fiduciary duty claims against banks have failed for want of any duty owed to the investor/non-customer. Second, “red flags”—suspicious, atypical banking activity—do not constitute “actual knowledge,” an element that must be proven for an aiding and abetting claim. Third, providing routine banking services for a client is not enough to constitute “substantial assistance,” another element that must be proven for an aiding and abetting claim.

In short, recognizing the danger of allowing plaintiffs to hold banks liable for the intentional torts of their customers, courts have rightfully imposed a high standard of pleading for allowing these claims to go forward.

I. A Brief Background

In 2009, the recession caused the collapse of nearly four times as many Ponzi schemes as in 2008, beginning with the collapse of Bernie Madoff's $50 billion dollar enterprise.2 With the financial crunch, investors stopped putting in as much money and attempted to withdraw large amounts—two things that a Ponzi scheme, by its very nature, cannot sustain. According to a former Assistant Attorney General for the Department of Justice's criminal division, “the financial meltdown … resulted in the exposure of numerous fraudulent schemes that otherwise might have gone undetected for a longer period of time.”3 Even today, in 2013, in monitoring new filings across the United States, there is a new case filing every day arising out of a Ponzi scheme.

In the wake of the failure of many of these fraudulent scams, the victims began bringing private actions, attempting to hold related entities such as investment firms, accounting firms, insurers, law firms, and banks liable to recover their lost investments. The most active dockets have been in the Second Circuit (with most cases in New York), the Sixth Circuit (with most cases in Michigan and Ohio), the Ninth Circuit (with most cases in California), and the Eleventh Circuit (with most cases in Florida). Some of the most common causes of action include negligence and aiding and abetting of fraud, breach of fiduciary duty, and conversion.

II. The Tort Law Framework

Aiding and abetting is arguably the theory that plaintiffs have leveraged most often to try to hold banks liable for Ponzi scheme losses. In most jurisdictions, the aiding and abetting standard is the same: The plaintiff must allege (1) an underlying violation on the part of the primary wrongdoer; (2) knowledge of the underlying violation by the alleged aider and abettor; and (3) substantial assistance in committing the wrongdoing by the alleged aider and abettor.4 Most courts assessing Ponzi cases have focused on the second and third elements.

Negligence-based claims also are common. Generally, to state a claim for negligence, the plaintiff must establish that (1) the defendant owed the plaintiff a cognizable duty of care; (2) the defendant breached that duty; and (3) the plaintiff suffered resulting damages.5 In the context of Ponzi scheme litigation against banks, the first element of establishing a negligence claim has proven to be the most problematic for plaintiffs.

As another preliminary matter, courts also have been reluctant to expand potential common law liability beyond suits brought by the investors/victims themselves. Indeed, the Court of Appeals for the Second Circuit recently held that such claims—to the extent they have any hope of surviving—cannot be brought against a bank by the bankruptcy trustee for the insolvent Ponzi scheme entity but must be pursued, if at all, directly by aggrieved investors.6 Accordingly, any discussion of potential tort-based liability should now be narrowed to direct claims by defrauded investors.

III. Theme I: No Requirement for Banks
To Police Customers
To Protect Non-Customers

As described above, to establish a negligence claim, the plaintiff must demonstrate, inter alia, that the defendant owed a duty as a matter of law.7 To demonstrate that threshold element, however, “the injured party must show that a defendant owed not merely a general duty to society, but a specific duty to him or her, for without a duty running directly to the injured person there can be no liability in damages, however careless the conduct or foreseeable the harm.”8

The general rule in New York (the birthplace of many decisions considering the liability of banks in Ponzi cases) is that “banks do not owe non-customers a duty to protect them from the intentional torts of their customers.”9Similarly, in the Eleventh Circuit, Florida courts have held that a bank owes no duty to a non-customer. “Florida law does not require banking institutions to investigate transactions.”10 Indeed, “a bank has the right to assume that individuals who have the legal authority to handle the entity's accounts do not misuse the entity's funds.”11

In a case in the Eastern District of New York, Agape I, the plaintiffs attempted to use an exception to the general rule, applicable to trust accounts, to impose a duty upon the defendant bank.12 The exception provides that where a bank “has knowledge that funds it holds are being improperly misappropriated by a fiduciary,” the bank must “make reasonable inquiry and endeavor to prevent a diversion” of funds.13 The court rejected the use of this exception, as the accounts at issue were “merely conventional depository accounts” and not trust accounts.14 Because the plaintiffs could not provide any authority “even suggest[ing] that New York law imposes upon banks a duty to protect non-customers from a fraud involving depository accounts,” the court had no basis “to depart from the general rule that banks do not owe non-customers a duty to shield them against intentional torts committed by bank customers.”15

In Lawrence v. Bank of America, one of the leading Ponzi scheme cases out of the Eleventh Circuit, victims of a Ponzi scheme alleged that the bank authorized “numerous deposits, withdrawals, and wire transfers involving large amounts of money,” and that the “transactions were atypical and therefore Bank of America should have known of the Ponzi scheme.”16 The court rejected these arguments, finding that liability was not triggered because “Florida law does not require banking institutions to investigate transactions” and the bank, “in providing only routine banking services[,] was not required to investigate.”17 Likewise, the Southern District of Florida, using Lawrence as guidance, has reiterated that “banks have no duty to investigate even suspicious transactions.”18

Courts thus have been reluctant to stray from the basic rule that banks do not owe a duty to non-customers and are not responsible for the intentional torts of their customers. To be sure, to find otherwise would be to “unreasonably expand a bank's orbit of duty.”19 The case law that has emerged since 2008 has demonstrated the courts' unwillingness to expand that duty.

IV. Theme II: Banks Should Not Be Held
Responsible on Basis of ‘Red Flags’

In addition to consistently finding that banks owe no duty to non-customers, courts have repeatedly held that “red flags” are not sufficient to establish actual knowledge for purposes of an aiding and abetting claim. Rather, the plaintiff must allege “that the defendant had actual knowledge of the wrongful conduct committed, not simply that the defendant should have known of the conduct.”20 Therefore, “statements alleging that a defendant should have known that something was amiss with transactions … are insufficient to support an aiding-and-abetting claim.”21

Nor will allegations that a bank ignored “red flags” or other signs supposedly indicative of fraud establish the requisite actual knowledge.22 Thus, in considering whether the defendant had actual knowledge for purposes of aiding and abetting, a bank's “lapse of wary vigilance, disregard of suspicious circumstances which might have well induced a prudent banker to investigate and other permutations of negligence are not relevant considerations.”23 As such, in many jurisdictions, “courts have routinely held that when a defendant is under no independent duty, even alleged ignorance of obvious warning signs of fraud will not suffice to adequately allege ‘actual knowledge.’”24 A review of cases from several jurisdictions is instructive.

New York

In Agape I, the plaintiffs attempted to allege the knowledge element of aiding and abetting by claiming that Bank of America established an unofficial branch within Agape headquarters and an employee staffed there had access to Agape's business records and contact with the Ponzi scheme perpetrator.25 Plaintiffs also asserted that knowledge could be inferred from the fact that Agape and Bank of America shared proprietary information, including that of customer accounts.26 The court rejected this logic, stating that it did not give rise to the inference that the bank's employee was complicit in the Ponzi scheme.27 The court also noted that while allegations that the bank overlooked red flags did not reflect well on the bank's monitoring system, it did not create an inference of actual knowledge.28

Florida

In Groom v. Bank of America, a case arising out of Lou Pearlman's Ponzi scheme, the court found that the plaintiffs could not show that the bank was aware of Pearlman's breach of duty simply because he “deposited vast sums of money” or engaged in other unusual transactions.29 Rather, the court held,“[s]uch red flags do not constitute the conscious awareness of wrongdoing necessary to maintain an aiding and abetting cause of action.”30

Michigan

Likewise, in El Camino Resources, Ltd. v. Huntington National Bank, the court found that the bank, at most, had a strong suspicion of wrongdoing because of atypical account behavior and because the bank knew that one of the Ponzi scheme perpetrators had been sanctioned by the SEC for a securities violation. However, the bank did not know the nature of the shell company's transactions, how it operated, or with whom it did business.31

California

By the same token, in Fowler v. La Salle Bank, the California Court of Appeal noted that although plaintiff detailed the bank's “knowledge of facts that caused it to suspect ‘something fishy’ was going on,” plaintiff did not allege facts showing that the bank actually knew the Ponzi schemer was defrauding plaintiff by selling her unregistered securities.32 As the court succinctly held, “suspicion and surmise do not constitute actual knowledge.”33

Arizona

Finally, the plaintiffs in Stern attempted to allege scienter by claiming that the bank knew of the Ponzi schemers' financial history, including lack of income and debt, and that millions of dollars in deposits and withdrawals were made into and out of their account over five months.34 The court noted that while the plaintiffs' arguments may have suggested that the bank engaged in poor business practices, they did not show that the bank knew that the Ponzi schemers were perpetrating a fraud. In the court's words, “[k]nowledge of suspicious activity is not enough.”35

*****

Despite the trend away from “red flags,” some courts have found that a plaintiff may meet the actual knowledge requirement through allegations of conscious avoidance.36 Conscious avoidance “‘occurs when it can almost be said that a defendant actually knew because he or she suspected a fact and realized its probability, but refrained from confirming it in order later to be able to deny knowledge.’”37 Demonstrating actual knowledge based on conscious avoidance “is a very high bar” and “requires facts supporting an inference that the defendant acted with a culpable state of mind.”38 The court in Agape II noted that “there is no reason to spare a putative aider and abettor who consciously avoids confirming facts that, if known, would demonstrate the fraudulent nature of the endeavor he or she substantially furthers.”39 However, the court cautioned that “this standard does not impose a duty on a bank to take actions they otherwise would not have taken based on a suspicion of fraud.” 40 Instead, conscious avoidance would be found where the defendant avoided taking actions it otherwise would have, “specifically to avoid attributable knowledge of the underlying fraudulent scheme.”41 For that reason, the Agape II court held that where “it was bank policy not to investigate” and the bank did not decline to investigate “specifically to avoid learning of the Agape fraud,” the bank's “decisions not to voluntarily investigate the fraud at any other point, even when faced with ‘red flags' in the account activity, [did] not constitute conscious avoidance.”42

The high degree of scienter required for aiding and abetting liability is well supported by sound policy arguments in many courts' decisions.43 For example, the Western District of Michigan in El Camino observed that:

[I]nsistence on actual knowledge of specific wrongdoing … [stems] from a desire to avoid unjust results. In the commercial context, the close relationship between banks … and their clients makes these entities inviting targets for lawsuits stemming from client wrongdoing. These institutions will always have more information about the client's conduct than the general public, making them vulnerable to the hindsight accusation that they knew of the client's wrongdoing or were wilfully blind. Courts are unwilling to make such institutions the guarantors of their customers' conduct…. The Sixth Circuit in Aetna Casualty recognized that a bank's actual knowledge of a fraudulent scheme is the crucial element that prevents it from suffering automatic liability for the conduct of its customers. Any contrary rule would have a devastating impact on commercial relationships.44

With these policy principles in mind, courts continue to require that a plaintiff show the bank's actual knowledge to sustain an aiding and abetting claim. This high standard rightly aims to prevent banks from becoming their customers' keepers.

V. Theme III: Routine Banking Services
Do Not Constitute Substantial Assistance

The final element of an aiding and abetting claim is substantial assistance. Through Ponzi scheme litigation, the principle has emerged that providing routine banking services to a Ponzi scheme perpetrator does not rise to the level of assistance necessary to establish aiding and abetting liability.

Substantial assistance means “something more than merely providing routine professional services that aid the tortfeasor in remaining in business, but do not proximately cause the plaintiffs' harm.”45 Therefore, substantial assistance is generally found where “(1) a defendant affirmatively assists, helps conceal, or by virtue of failing to act when required to do so enables the fraud to proceed; and (2) the actions of the aider/abettor proximately caused the harm on which the primary liability is predicated.”46 As a practical matter, “courts generally hold that a bank does not aid and abet its customer's wrongdoing merely by providing routine banking services to its customer.”47

Providing ordinary banking services may satisfy the substantial assistance element of an aiding and abetting claim “only if the bank actually knew those transactions were assisting the customer in committing a specific tort.”48 Consequently, “the mere maintenance of a bank account and the receipt or transfer of funds,” without more, do not equate to substantial assistance.49

Similarly, a failure to act “constitutes substantial assistance only when the defendant had an independent duty directly to the plaintiff. A failure to investigate, i.e., constructive knowledge, is not enough to support a claim for aiding and abetting a fiduciary absent the existence of a fiduciary duty running from defendant to plaintiff.”50 In Groom, the plaintiffs contended that the defendant banks “failed to adhere to the customary and accepted standard of care and failed to monitor incoming deposits and wires and other monies entrusted to them.”51However, the court reiterated that the allegation of a failure to act, absent a duty, is not substantial assistance.52

Likewise in Agape II, the court noted that “the caselaw is clear that opening accounts and approving transfers, even where there is a suspicion of fraudulent activity, does not amount to substantial assistance.”53Additionally, the bank had no affirmative duty to discover the perpetrator's fraud.54 Therefore, the court dismissed claims of aiding and abetting fraud and breach of fiduciary duty.

Furthermore, “but-for causation” has been “universally rejected” by courts, as they have required the defendant's acts of substantial assistance to be the proximate cause of the plaintiff's harm.55 In El Camino, the plaintiffs posited that the bank was liable if it helped to “perpetuate the enterprise.”56 The court rejected this theory, aptly noting that:

One might as easily hold the grocer liable for aiding and abetting Al Capone, on a showing that the grocer suspected Capone was a hoodlum but sold him food anyway, allowing him to live another day to commit his crimes.57

Therefore, the plaintiffs' allegations that the bank kept the sham company alive during the time of its fraudulent activity were not enough.58

Finally, in Stern, with regard to substantial assistance, the court stated that processing day-to-day banking transactions does not constitute substantial assistance unless the bank has an “extraordinary economic motivation to aid in the fraud.”59 The plaintiffs alleged no such motivation, and therefore, the bank's motion to dismiss was granted.

The reasoning borne from this line of case law shows the courts' recognition of the potentially untethered liability that could result if “but for” causation were an appropriate method of showing substantial assistance. Further, time and again, courts have demonstrated their reluctance to hold banks liable for their customers' conduct when the bank merely provided routine banking services, without some extra “plus” factor.

VI. Conclusion

As the case law that has developed since 2008 shows, courts have been unwilling to hold banks liable for the intentional torts of their customers unless plaintiffs meet a high pleading standard. Based on previously established common law legal principles and sound policy rationales, courts have reiterated that banks owe no duty to non-customers and have required plaintiffs to adequately allege actual knowledge and substantial assistance for aiding and abetting claims. And as the Second Circuit Court of Appeals' recent decision in the Madoff bankruptcy indicates, courts are increasingly narrowing the avenues to bank-borne liability. With each decision, and particularly those in the Second, Sixth, Ninth, and Eleventh Circuits, courts consistently impose strict requirements for allowing Ponzi scheme liability cases to go forward, and it appears that this trend will continue.

Mary Hackett is a partner with Reed Smith LLP where she represents financial services companies in a wide range of litigation matters in many areas including consumer finance, corporate banking and wealth management. She has represented financial services entities in more than 50 class actions in courts across the United States.

Nellie Hestin is an associate at Reed Smith LLP where she represents financial industry clients in all stages of litigation and alternative dispute resolution. Her practice has a particular emphasis on class action defense, and she has experience defending banks in numerous cases involving Ponzi schemes.

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