Several months ago, news broke that a significant EB-5 investor project to develop a ski resort in Vermont had been revealed as a hopelessly insolvent Ponzi scheme. Worse, many international investors – who had participated in the EB-5 program in order to obtain U.S. citizenship – learned for the first time that not only was their investment gone, but they would be unable to qualify for citizenship. A bad investment has cost them not only their hard-earned capital but their access to a better, more secure life in the United States.
Amidst the fallout over the busted project is a class action lawsuit brought against Raymond James Financial Inc. and its affiliates filed last month in the U.S. District Court for the Southern District of Florida. A companion state case filed in Miami-Dade county reminds us of the potential exposure that financial institutions face under the Uniform Fraudulent Transfer Act. As a case of first impression in the State of Florida, the issue raised is likely to make a lasting impact on the way banks and other financial institutions regulate the activities of their employees when providing services to family members.
Facts
Several years ago, politicians in Vermont (including Presidential candidate Bernie Sanders and Vermont’s other senator, Pat Leahy) partnered with the federal government to promote a real estate development project that would bring a high end ski resort to the northeastern corner of that state. More than $350 million was raised from foreign investors as part of an EB-5 program to develop the Jay Peak Ski Resort. Under the EB-5 program, foreigners investing $500,000 to $1 million could obtain U.S. citizenship in as little as two years, all the while earning upwards of 6% on their investment.
Fast forward to today, and the SEC alleges that over $200 million was lost when the investment project turned out to be not much more than a Ponzi scheme. The SEC’s director for enforcement charged that the promoters of Jay Peak, Ariel Quiros and William Stenger, perpetrated a fraud that “ran the gamut from false statements to deceptive financial transactions to outright theft.” The SEC froze the assets of the promoters as well as the investment project. As for the foreign investors’ money, according to the SEC, “[T]he defendants diverted millions of EB-5 investor dollars to their own pockets, leaving little money for construction of the research facility investors were told would be built and thereby putting the investors’ funds and their immigration petitions in jeopardy.”
Potential Exposure to Fraudulent Transfer Liability
According to the state court complaint, some of the EB-5 investor funds transited through brokerage accounts maintained by Raymond James on behalf of Quiros and Stenger. From there, funds were disbursed as instructed by Quiros and Stenger. Also, Quiros and Stenger acquired margin loans against investments purchased with some of the investor funds, according to the plaintiff.
Normally, a financial institution handling funds raised in a Ponzi scheme enjoys an exemption from fraudulent transfer liability on the basis that it is a mere conduit lacking knowledge of the wrongful motives of its account holder. This doctrine applies in particular in the bankruptcy context, where § 550(a)(1) of the Bankruptcy Act makes the “initial transferee” liable on a fraudulent transfer; banks and brokerage firms would almost always be the “initial transferee” absent the mere conduit and control test. This judicially-crafted exception to § 550(a) acknowledges the legal duty many custodians have in respect of funds held in an account and subject to disbursement at a client’s request. As the Eleventh Circuit noted in In re Harwell, the rationale for this exception is premised on equity:
Equitable considerations play a major role in the mere conduit or control test because it would be inequitable to hold an initial recipient of the debtor’s fraudulently-transferred funds liable where that recipient could not ascertain the transferor debtor’s solvency, lacked any control over the funds, or lacked knowledge of the source of the funds.
In re Harwell, 628 F.3d 1312 (11th Cir. 2010). Because the exception is based in equity, the Eleventh Circuit further explained that conditions attach to being able to claim the exception to “initial transferee” status. In particular, financial institutions relying on the mere conduit exception must establish that:
- They did not have control over the assets received, i.e., that they merely served as a conduit for the assets that were under the actual control of the debtor-transferor; and
- They acted in good faith and as an innocent participant in the fraudulent transfer.
The problem for Raymond James is that the broker responsible for the account relationship, Joel Burstein, is the son-in-law of one of the accused Ponzi schemers, Ariel Quiros. Burstein allegedly permitted funds collected in the Raymond James accounts to be misused, even though Burstein and Raymond James should have known that the funds were EB-5 investor money earmarked for the development project.
One area of scrutiny concerns a margin facility that Burstein helped set up for his father-in-law, Quiros, to purchase the resort from Mont Saint Saveur International (MSSI). MSSI had started the EB-5 program at Jay Peak and had collected substantial funds from immigrant investors. The plaintiff charges that Quiros induced MSSI to transfer investors funds to Raymond James, which were then used as collateral for the margin loan advanced to Quiros to purchase the resort from MSSI. The plaintiff claims that Raymond James knew the MSSI funds were investor funds that could not be used by Quiros for the purchase of the resort.
Analysis
Banks and brokerage firms always find themselves named as defendants in litigation when a Ponzi scheme unravels. The universal charge is always that the bank knew investor money was flowing into an account for a designated purpose, and that the bank should have stopped outbound transfers made for any other purpose. Plaintiffs always cite the fees made by the bank as sufficient incentive to turn a blind eye while the Ponzi schemer goes to work. Banks always defend themselves on the basis that they cannot control the funds of their clients when there is no basis to know that the client is perpetrating a fraud.
What makes the case with Raymond James unusual is the connection between the relationship manager, Burstein, and one of the two alleged architects of the Ponzi scheme, Quiros. It is logical for the plaintiff to assert a lack of good faith by insinuating an improper relationship between the broker and the client on the basis of family. Whether the evidence supports this claim is yet to be determined. Nevertheless, this points up a red flag for financial institutions: The inherent conflict of interest when an employee of the institution holds sway over the account relationship of a family member.
It should be noted that the “mere conduit” exception only applies in bankruptcy proceedings. The plaintiff’s action in this case has been filed against Raymond James in Florida state court, implicating Florida’s version of the Uniform Fraudulent Transfer Act. Assuming a fraudulent transfer under Florida Statutes §§ 726.105 (present and future creditors) or 726.106 (present creditors), the plaintiff would be entitled to avoidance of the transfer under Florida Statutes § 726.108(1)(a) (including a judgment against Raymond James pursuant to Florida Statutes § 726.109(2)), subject to any defenses Raymond James might make under Florida Statutes § 726.109.
What are the defenses Raymond James can rely on? Banks and financial institutions normally take the position that funds held on account for the client are not assets of the institution, such that the institution itself is literally not a “debtor” or “transferee.” This is essentially the same argument as the “mere conduit” exception raised in bankruptcy proceedings. This then leaves the creditor trying to claw back bank fees and other charges from the financial institution. However, the Uniform Fraudulent Transfer Act provides an exception where the transferee receives the asset in good faith and for a reasonably equivalent value. Specifically, Florida Statutes § 726.109(1) provides a blanket defense for any transferee who took the asset “in good faith and for reasonably equivalent value,” and for any subsequent transferee of that initial transferee.
The foregoing suggest that Raymond James’ exposure should at most consist of the fees that it earned over the course of its relationship with the alleged Ponzi schemers. Even then, Raymond James should be able to argue that it provided “reasonably equivalent value” by rendering services for Quiros and Stenger. Some lawyers contend that “value” given by a service provider is worthless when the services permit a Ponzi scheme to perpetuate, but this argument was roundly dismissed by the Texas Supreme Court – with able assistance from members of our team – earlier this year. As long as Raymond James charged market rates for its services to Quiros and Stenger, “value” should exist.
Thus, everything comes down to the “good faith” argument: Both in the Florida state law context and also in any potential bankruptcy proceeding. Lack of good faith may entail liability for Raymond James on the fees it received from the relationship under the UFTA and, more importantly, may leave Raymond James exposed for investor funds that transited the accounts under § 550(a) of the Bankruptcy Code. Again, this highlights the importance for financial institutions of maintaining a policy that prevents staff from directing services for family members.