Originally published January 2010
Earlier this month in Marion v. TDI, Inc., the Court of Appeals for the Third Circuit overturned a $32.7 million jury verdict against defendants accused of deepening the insolvency of Bentley Financial Services ("BFS") by giving it access to more cash and investors. The suit was brought by the receiver for BFS, a Pennsylvania corporation, after BFS's chief officer used the corporation to run a Ponzi scheme for five years, defrauding more than 200 investors and causing $375 million in losses. The receiver claimed that the defendants, together with BFS's chief officer, had harmed the corporation by saddling it with additional liability to victims of the scheme.
Robert Bentley formed BFS in 1986 to broker bank-issued certificates of deposit (CDs). Bentley also later formed Entrust Group, a Pennsylvania sole proprietorship to act as custodian on BFS-brokered transactions. As the Third Circuit explained in its opinion, "[i]n the CD-selling industry, the broker is responsible for connecting CDs available for purchase from banks with particular investors. The custodian then collects the money from each investor, wires it to the issuing bank and holds onto the CD, while issuing a 'safekeeping receipt' to the investor indicating that it has title to the CD held by the custodian." The CD seller's profit comes from the difference between the terms of the CD purchased from the bank and the terms on which the CD is sold to the investor. A CD seller also can profit by mismatching maturity dates — for example, by locking in an interest rate for a long-term CD, but then selling it as a series of short-term CDs in the hope of profiting on the difference in the interest rate between the rate for the short-term CDs and the long-term rate the broker locked in. This is a legal, but risky, practice as long as the mismatch is disclosed to the investor (including the fact that the investor may not be able to reclaim its principal at the maturity date stated in the investment contract).
The Ponzi scheme began in 1996, when Bentley's bank learned that he had forged his accountant's signature in a letter certifying collateral that secured a $2 million credit line for cash flow management. The bank called the balance on the credit line, thus threatening Bentley's business. To repay the loan, Bentley created and sold fictitious CDs — a scheme he was able to perpetuate because he was his own custodian and issued bogus safekeeping receipts. Bentley also failed to disclose his practice of mismatching so that investors who purchased mismatched short-term CDs did not know that they were actually purchasing interests in long-term CDs. As a result, if an investor wanted its principal back at the end of the stated maturity date, Bentley was unable to force the investor to stay with the long-term CD without revealing its true nature. As typical of most Ponzi schemes, Bentley would have to quickly generate the cash necessary to return the principal by selling another mismatched short-term CD to a new investor at a higher rate of interest.
The scheme was discovered in September 2001, shortly after a Texas bank that had purchased fake CDs from Bentley tried to confirm its ownership. Bentley ultimately pled guilty to one count of mail fraud and one other charge unrelated to the issues in the Third Circuit's opinion. He was sentenced to 55 months' imprisonment and ordered to pay $38 million in restitution.
In November 2001, the District Court for the Eastern District of Pennsylvania appointed David H. Marion as receiver for Bentley, BFS and Entrust pursuant to 28 U.S.C. § 754, giving him complete jurisdiction and control over the Bentley entities' property. In August 2002, Marion brought an action on behalf of BFS against Ted Benghiat, Joseph Marzouca and Peninsula Bank, among others, which was characterized as one "to recover damages from defendants for injuries, losses, obligations and liabilities suffered by and imposed upon [BFS] as a result of, inter alia, a fraudulent scheme orchestrated by [Bentley] and others (including the defendants)." Benghiat owned two Florida firms — SFG Financial, Inc., a CD broker with whom BFS frequently served as co-broker, and Southeastern Securities, Inc. ("SSI"), a securities firm. Marzouca was Vice-President of Peninsula Bank, a Florida bank that had an ongoing relationship with SFG as a warehouser of its CDs, and that later served as a custodian on a number of BFS's sales.
Marion's action focused on two ways in which Benghiat and Marzouca had allegedly facilitated Bentley's scheme. First, Marion alleged that Benghiat and Marzouca had aided and abetted, and/or conspired in, the fraud Bentley perpetrated on BFS by repeatedly helping Bentley obtain the capital he needed to prevent the scheme from unraveling. (This theory often is referred to as "deepening insolvency," although Marion's claims sounded in fraud.) Marion focused on three separate occasions in which Benghiat and Marzouca helped Bentley obtain cash by engineering a "warehousing" transaction between Bentley and Peninsula Bank in which the Bank agreed to temporarily purchase CDs on terms very favorable to Benghiat and Marzouca. Second, Marion alleged (with respect to Benghiat only) that Benghiat's firm had failed to adequately supervise Bentley's CD-selling operation during an 18-month period in which BFS had brokered securities for Benghiat's firm, SSI. During that period, SSI had supervised BFS's brokering of securities, but not his CD-selling operation, because SSI maintained that the CDs did not qualify as securities.
The case was tried to a jury over 11 days in June 2006. The jury found for Marion on his claims that the defendants aided and abetted, and conspired in, Bentley's fraud, and (in Benghiat's case) failed to supervise him in the face of a duty to do so. The jury assigned damages in the amount of $13,109,732 to Marzouca and $19,664,598 to Benghiat, for a total award of $32,774,330. The defendants' post-trial motions were denied. In their appeal, Benghiat and Marzouca challenged, among other things, whether the evidence was sufficient to support the verdict.
The Third Circuit reversed the District Court's denial of the post-trial motions. According to the Court, neither defendant could be liable to Marion acting as BFS's receiver on the facts presented to the jury. The Court assumed that the jury's verdict rested on a finding that Benghiat and Marzouca helped Bentley bring cash into his operation knowing that the money would be used to keep the scheme alive. But any such acts could not serve as the basis for the defendants' liability to BFS: there was no causal link between the defendants' actions and BFS's harm because Bentley's use of the cash received from the defendants caused the harm — not the defendants' cash infusion itself.
The Court further assumed that the jury's verdict rested on a finding that Benghiat failed to adequately supervise Bentley's CD-brokerage operation. This theory also was defective because the relevant breach of duty would have been to the investors and not BFS.
The lesson of Marion v. TDI, Inc. is that plaintiffs must prove a causal link between the alleged harm and the defendants who allegedly deepened the insolvency, as well as a breach of duty — not to the ultimate victims of the Ponzi scheme, but, as in this case, to the corporation through which the scheme is run. The Third Circuit distinguished the case before it from previous cases in which, unlike here, the defendants did not merely provide funds with the knowledge that the corporation might use them unwisely, but rather actively participated in the alleged fraudulent scheme. See, e.g., Thabault v. Chait, 541 F.3d 512 (3d Cir. 2008); Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001). Thus, absent a causal link between the assistance provided by the defendants and the fraud carried out by the corporation's principals, a corporation cannot establish liability for deepening insolvency.
Moreover, nothing in Marion has altered the Third Circuit's holding in In re CitX Corp., 448 F.3d 672, 677-78 (3d Cir. 2006). The plaintiff in CitX also alleged that the defendant's conduct had allowed the corporation to hide its true financial condition from investors, thus enabling the corporation to raise more money and eventually go even deeper into debt. The Third Circuit affirmed the trial court's grant of summary judgment in favor of the defendant-accountants on the plaintiff's accounting malpractice claim, holding that deepening insolvency is not a measure of damages for an independent tort. Because the holding in CitX remains good law, defendants in these types of cases in federal court1 should continue to press the argument that "deepening insolvency" is not a valid measure of damages for torts such as conspiracy and aiding and abetting even if, as apparently was the case in Marion, the plaintiff does not characterize the relief sought as "deepening insolvency" damages.
Footnote
1. Pennsylvania state courts, by contrast, recognize deepening insolvency as a measure of damages. Ario v. Deloitte & Touche LLP, 2008 Pa. Commw. LEXIS 437 (Pa. Commw. Ct. June 13, 2008).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
