This article is the second in a series, authored by WLJ Banking Law Team members Adrienne Baker and Charles Coleman. Read Part 1 here.
This is how it often plays out in an aiding and abetting claim against a financial institution: The fraudster, let’s call him Madoff, sells high-yield “investments” to individuals and funds. For a few months or years, investors receive the promised return of their principal plus interest. To accomplish this, Madoff uses accounts at several different banks. He deposits investor funds in one or two accounts, then transfers funds to accounts at other banks. Funds are commingled and transferred again, then paid out to investors. In other instances, one bank gets all of the action. Either way, eventually the scheme falls apart and Madoff lands in jail. A federal equity receiver is appointed at the request of the US Securities and Exchange Commission (SEC) to gather Madoff’s assets and pay them over to victims who didn’t recoup their principal (plus some interest, usually). The receiver sues the bank(s) through which investor money passed. The receiver claims the bank(s) had before them all the indicia of fraud, or “red flags,” and did nothing to stop the fraud. The receiver claims use of the bank accounts lent an air of legitimacy to the schemer’s endeavor. By allowing the schemer to use accounts, and by failing to stop the fraud, the bank(s) provided substantial assistance to Madoff. And now, the receiver wants the bank to pay the whole loss arising from the scheme – millions, hundreds of millions, or even billions of dollars.
This is essentially how things played out in the very recent case of Kelly vs. BMO Financial Group. Kelly, a federal equity receiver, was charged with collecting assets to pay to victims of Tom Petters’ fraud. In late 2022, after a trial, the federal jury said BMO Harris must pay more than $563 million to victims. With interest, the financial institution could be liable for nearly $1 billion. For background, BMO Harris acquired M&I Bank, which was alleged to have abetted the fraud of Petters by ignoring red flags that could have stopped the schemes earlier and reduced the loss. Kelly said, “If they had reported this to the feds early on, it would have stopped this Ponzi scheme dead in its tracks.”
Reporting to feds sounds simple enough. If that’s all financial institutions need to do to stay safe from these claims, why are we talking about this? Well, here’s the rub. First, depending on the nature of the relationship, individual banks frequently do not have enough visibility into the fraudster’s activities to make a determination that suspicious activity has occurred. Where a fraudster uses several banks, each bank sees only a small piece of the big picture. And by “sees,” we mean of course that the bank’s BSA/AML monitoring may generate alerts on activity from the accounts. Without such alerts, unless something extraordinary occurs, routine transactions in a fraudster’s account generally will not be on the radar of the bank’s BSA/AML staff. And although it has not been a theme in this litigation against financial institutions yet, this will inevitably evolve into litigation about whether a bank’s BSA/AML monitoring is sufficient and, if not, whether the failure could give rise to a negligence claim against a financial institution. So, issue #1 is that financial institutions are not omnipotent. They process most transactions electronically and rely on electronic BSA/AML software to alert on suspicious activity. Sherlock Holmes is not scouring customer accounts daily.
The second issue is, how do financial institutions “report this to the feds early on,” as receiver Kelly alleged BMO Harris should have done? They file Suspicious Activity Reports (SARs) through FinCEN, of course. In response to a receiver/investor/trustee’s accusation that a financial institution “did nothing,” can the financial institution respond with, “We did our part – we filed a SAR!” Negative, Ghost Rider. The financial institution cannot disclose any information which would indicate whether or not a SAR was filed. In a multi-million or billion dollar case that turns on whether a SAR was filed, and when, and what it said, and what “the feds” did in response, this presents a real problem. This issue is front and center in a pending Ponzi-scheme lawsuit involving a number of banks. At some point, if the parties do not resolve the dispute by agreement, we’ll know what at least one court has to say on the issue.
To add more complication to an already complex topic, these types of claims may not be covered by insurance. Of late, some insurers are denying claims and refusing to provide legal counsel for target banks based on so-called “insolvency” exceptions to policies. Basically, if the loss is alleged to have been occasioned by the insolvency of a bank customer, the claim is not covered. Here, the plaintiffs claim the Ponzi schemes, usually run through sham companies, were always insolvent and never able to pay their debts as they came due. Hence the insurer seizing on an insolvency exception to side-step monumentally expensive legal fees and a potential bank-ending judgment. When banks buy insurance, this probably isn’t the scenario their loss prevention staff think about when reading an insolvency exception.
What are the takeaways from this? First, any bank can be in the cross-hairs in bet-the-company litigation arising from routine-seeming bank account activity, and they may not have insurance to cover the potential loss and costs of defense. This is a real and present risk for all banks. These lawsuits have affected community banks and too-big-to-fail banks, alike. This is something all banks should take seriously. Second, there is no playbook for what to do if your bank becomes embroiled in this kind of situation. Every case is different. The best thing you can do is have good policies and procedures in place, train on them, and enforce them. Third, if you learn a customer stands accused of financial fraud, such as a Ponzi scheme, contact your counsel immediately. This area is extremely complex. There will likely be subpoenas, document productions, and depositions and interviews of bank representatives before any lawsuit is filed. Everything that comes out can be used against the bank later. Your lawyer should be involved from Day One.
The WLJ Banking Law team has defended many banks from claims arising from Ponzi schemes and fraud. Put their extensive experience to work for your financial institution.