RECEIVERS: WHY IS EVERYONE UNHAPPY? Wayne Klein Lewis B. Freeman & Partners, Inc. August 15, 2009 Ask: Before last December (when the Madoff scheme blew up), how many knew much about what receivers do?

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.

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. Wallenbrock and its sister company, Citadel, had 60 employees.

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. What do you think the appeals court said?

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.

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?

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? Query: Should Receiver demand that Stu turn property over to Receiver? What should happen to loan by hard-money lender?

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?

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? Factors: Will the price increase or decrease? The future of the real estate market and the general economy. Will there be a cash drain on the home by waiting? Is there a mortgage? What damage to, degredation of, property by leaving it vacant.

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 . . . . Asset freeze: Allen Stanford filed a motion in June saying the criminal case against him should be thrown out if he doesn’t get access to money to pay his lawyers. He said the asset freeze prevents him from mounting a defense to the civil and criminal charges against him. The court denied the motion July 1 because Stanford had not complied with an earlier order to provide an accounting of his personal assets. The Stanford Receiver also is claiming the proceeds of D&O insurance policies, denying Stanford and other officers that have been charged the ability to hire counsel to defend themselves. (www.bloomberg.com/apps/news?pid=2067000&sid=aS_QN89. . .)

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.

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. This includes real estate, cars, jewelry, horses, Faberge egg, Madoff receiver found millions in bank accounts. Receivers need to search for accounts in foreign bank accounts. This includes church tithing, Shebuilds, high school equipment, send coaches to football training camp. Earnest money deposits, investments, overseas investments (advance fee schemes). Elaine Talbot, California airplane hangar, Bank of Commerce payments. Air charter flights to sporting events, missionary contributions, dental work for poor, secret Santa projects. Query: should Receiver ask recipients of these benefits to repay them? Piano, artwork. Will discuss standards later.

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. Claims against law firms might be for: Receiving funds from Ponzi companies, when the funds were used to pay for the defense of the Ponzi operator (Robert Wing has sued several local and national law firms for their receipt of money from VesCor). Receiver for Sunwest Management ($400 million Ponzi scheme that collapsed in May 2009) is accusing Thompson & Knight and Davis Wright Tremaine of playing a key part in assisting the client in running a Ponzi scheme. It is not known whether the Receiver’s decision to sue Davis Wright was affected by the law firm billing the Receiver $250,000 for copying documents the Receiver had requested. Claims against banks include BankEst. Claims against auditors include: Satyam in India. Bank Est - $5 million in assets certified as $120 million. Pharmalat

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.

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).

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. Note that spouses are always women. Ponzi schemes are virtually always run by white males. How many believe Madoff’s wife was innocent?

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? Lie: It is much harder and more expensive to recreate information from the records alone.

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. A. Stanford receiver’s first fee request was $20 million. B. Irving Picard, the Madoff receiver has asked for $15.5 million in fees for the first six months. He says he has recovered over $1 billion and has filed actions to retrieve $13.7 billion. C. The SEC requires that fee application be submitted to them two weeks in advance. D. One solution to concern about fees is to appoint a monitor, as has been done in some recent cases. The downside is that the costs of the monitor also comes from the receivership assets. In March, 21 Standord investors sued the SEC and the U.S. Marshalls’ service claiming the agencies violated investors’ constitutional rights by freezing their Stanford Group accounts when the investors have been accused of no wrongdoing. (www.dandodiary.com/2009/2009/03/articles/securities-litigation/stanford . . .) Investors think the Receiver should give them credit for the account statement balance shown at the time of the Ponzi scheme’s collapse. “Indirect” investors are those who put money in through feeder funds.

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. Stanford has filed an objection to the receiver’s plans to sell some of his assets. The Receiver in a Florida Ponzi scheme had to replaced when it was found that someone else in his law firm represented an affiliate and factoring client of one of the relief defendants. Laura Pendergest-Holt (Stanford CFO) asked the court to dissolve the receiver’s power over her, alleging the receiver violated her constitutional rights in searching her home.

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.” Joe Nocera, Ire at Madoff Swings Toward the Referee, New York Times, July 4, 2009.

Lewis B. Freeman & Partners, Inc. 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. 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