Banking & Financial Services Update - Vol. 13, Summer 2012


In this issue:


(full article published by Bloomberg BNA, BNA’s Banking Report, 98 BBR 881 (May 15, 2012), available here). 
Victims of Ponzi schemes are increasingly seeking to recover their losses from the financial institutions used by Ponzi scheme perpetrators to hold victims' funds before misappropriating them. Whether the theory is that the financial institution had actual knowledge and aided and abetted the scheme or that it was negligent because it failed where harm was reasonably foreseeable to identify and report suspicious Ponzi-like activity, financial institutions have options in defending against and minimizing the risk of liability for such claims.
The Contours of Financial Institution’s Liability for Actions of Depository Fiduciaries
Absent extraordinary facts, courts generally hold that financial institutions owe no duty to protect third parties from the unlawful acts of bank customers. The prevailing wisdom concludes that individuals who retain fiduciaries stand in the best position to investigate thoroughly the would-be fiduciary’s background, and monitor his or her performance on an ongoing basis. To conclude otherwise would effectively require individual institutions to monitor thousands of accounts (or more, depending on the institution’s size) at considerable expense.  
Negligence claims, however, hold a special definition for “duty” that has caught the attention of Ponzi scheme victims seeking to lay blame on a financial institution. To prevail on a negligence claim, a plaintiff must plead and establish (1) duty, (2) breach, (3) causation, and (4) damages. As a general legal principle under a negligence analysis, a duty arises where the nature and scope of harm to another is readily foreseeable.  
Many Ponzi scheme plaintiffs have endeavored to fulfill the obligation to prove a “foreseeable harm” by demonstrating the existence of facts which, they contend, provide notice to financial institution of ongoing fraudulent activity. This, in theory, creates a legal responsibility (or duty) on banks to monitor accounts for activity which may negatively impact individual non-customers.    
Potential Strategies to Employ When Defending Suits by Ponzi Scheme Victims  
As many financial institutions know (often from firsthand experience), litigation represents a costly and time-consuming endeavor. Financial institutions facing claims from Ponzi scheme victims need to understand and implement strategies calculated not only to defeat such claims, but to do so as expeditiously as possible. As described in more detail in the full version of this article (found here), there are three broad tactics of defense:
  1. Take full advantage of the recently-heightened standard for evaluating the sufficiency of a complaint.
  2. Assert contributory and comparative negligence defenses.
  3. Make full use of any criminal prosecution of the Ponzi scheme perpetrator.
Proposed Preventative Measures 
While there is no panacea for suits by Ponzi scheme victims, financial institutions are not helpless to prevent against such claims. Better understanding the nature of the risk presented is an important first step. The effectiveness of that comprehension can be compounded by implementation of some basic strategies calculated to reduce the potential for such claims. Those include:
  1. Reviewing the bank’s new account information forms to confirm that they elicit sufficient information such that the fiduciary nature of the account is clear (so as to better identify those accounts which may require additional attention);

  2. Enhancing disclaimer language in the bank’s new account information forms requiring fiduciary depositors to acknowledge that the bank has no responsibility to the fiduciary or its beneficiaries to inquire into or otherwise monitor the fiduciary’s activities on behalf of the account;

  3. Considering other mechanisms for the bank to disclaim liability for the actions of fiduciaries, e.g., adding a section on the bank’s website explaining what steps a reasonable beneficiary should take to prevent or detect being victimized by a Ponzi schemer.

  4. Augmenting the bank’s BSA compliance efforts to include a component directing the BSA officer evaluating suspicious activity to determine whether the accounts in which suspicious activity appears are fiduciary in nature; and

  5. Renewing efforts to educate bank employees of the need to report concerns about potential impropriety in fiduciary accounts, even if the harm is threatened to parties other than the financial institution.
So long as the financial institutions remain the sole source of financial recovery when the dust of a Ponzi scheme clears, the battle over the scope of bank liability for negligence claims by victims of such schemes will wage on. These and other preventative measures will serve financial institutions well in those efforts, as well litigation strategies calculated to bring a quick and decisive end to such challenges. Forewarned is forearmed.  
Almost exactly one year after the Supreme Court, in AT&T Mobility v. Concepcion, 563 U.S. ____ (2011), held that the Federal Arbitration Act (“FAA”) green-lighted the validity of mandatory arbitration provisions that bar the arbitration of claims brought on a class-wide basis, the Consumer Finance Protection Bureau (“CFPB”) initiated its study of arbitration agreements.  
Section 1028(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) requires the CFPB to study the use of pre-dispute arbitration agreements in connection with the provision of consumer financial products or services. On April 24, 2012, the CFPB issued a Notice and Request for Information (the “Request”) seeking public comment on the appropriate scope of its study and the methods and sources of data it should use.  
Although Section 1028(b) explicitly allows the CFPB, consistent with its study, to prohibit or limit the use of pre-dispute arbitration agreements in consumer financial contracts when it “is in the public interest and for the protection of consumers,” the CFPB’s Request specifically states that it is not seeking comment as to how the CFPB should exercise that rulemaking authority at this time.  
Hostility to arbitration agreements is nothing new. It motivated Congress’s 1925 enactment of the FAA, which, according to the Supreme Court in Moses H. Cone Memorial Hospital v. Mercury Construction Corporation, 460 U.S. 1 (1983), reflects a “liberal federal policy favoring arbitration.”         
It is too early to tell what, if anything, the CFPB will do about pre-dispute arbitration provisions. But given many courts’ hostility to arbitration, checked only by the FAA, and the CFPB’s power to curtail the use of arbitration provisions in consumer financial contracts when it is “in the public interest and for the protection of consumers,” the odds probably favor some action by the CFPB. If it does act, then federal policy respecting arbitration will no longer be unambiguously favorable.   
Would banning or limiting the use of pre-dispute arbitration agreements in consumer financial contracts “protect” consumers? Perhaps. But it could also encourage financial product and service providers to shorten the menu of products and services offered to them.  
Does the agent bank in a loan syndicate have the unilateral right to settle a claim against the agent and force the members of the syndicate to pay for the settlement? That issue was addressed recently in an arbitration in which Waller represented five banks.
The bank syndicate was formed to fund a credit facility for a large chain of camera stores. After the borrower was liquidated in bankruptcy, one of its other creditors sued the syndicate’s agent bank, claiming that the agent and participant banks violated an inter-creditor agreement. After defending the litigation for several years, the agent suddenly decided to settle the creditor’s claims. Rather than obtaining approval from the participating banks, the agent informed the syndicate members that it had the unilateral right to settle the case. Over objections from some participating banks, the agent entered into an eight-figure settlement. The agent demanded payment from the other syndicate banks pursuant to an indemnity provision in the syndicate’s credit agreement.
Five of the banks refused to pay and employed Waller to defend the agent’s claims. After a lengthy evidentiary hearing in Atlanta, Georgia under the rules of the American Arbitration Association, the arbitration panel ruled in favor of Waller’s clients. The panel held that the agent bank acted unreasonably in settling the case and that the five banks were not required to pay any portion of the agent’s settlement.
Two main lessons came out of the arbitration result. First, agent banks act as representatives for members of a lending syndicate. They should always seek approval from the syndicate members before taking important actions, especially those that will obligate the syndicate members to spend their own funds. Second, before settling a claim that is covered by an indemnity agreement, the beneficiary of indemnity should always present the settlement offer to the indemnifying parties for their approval. As the agent bank discovered in this arbitration, it is better to be safe than sorry.

Corporate and Commercial Transactions:
Marlee Mitchell (615 850 8943)
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Larry B. Childs (205 214 6380)
Regulatory Issues:
Marlee Mitchell (615 850 8943)
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