A Ponzi scheme's legal legacy



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On May 21, when a "test case" of Financial Resources Mortgage Inc.'s massive bankruptcy mess is likely to be settled, the fate of dozens, if not hundreds, of victims of the multimillion-dollar Ponzi scheme will still remain very much up in the air.Ever since the state forced the collapsed Meredith firm and the affiliated CL&M Inc. into Chapter 7 bankruptcy in November 2009, many of the scheme's victims maintain they have been victimized a second time in the bankruptcy process.FRM trustee Steve Notinger of the Nashua-based law firm Donchess & Notinger filed suit against hundreds of those victims, arguing that the mortgages acquired through FRM and in their name -- or in the name of trusts that were supposed to be for their benefit - actually belonged to the bankrupt estate and that any interest that they received was a fraudulent transfer that had to pay back.The victims countered that they were not investing in an overleveraged mortgage company, but were using it as broker to make a loan on a specific property as collateral, and those mortgages belong to them.The Migliaccio case, one of the first adversary cases filed by Notinger in July 2010, raised these issues. And on Feb. 29, 2012, after 139 filings, Judge J. Michael Deasy issued his opinion on the matter.Deasy's 27-page decision seemed to vindicate the secured creditors, yet it was a hollow victory, a theoretical win, and a practical defeat."The bottom line is that there is no change," said Al McIlvene, a lender from Kittery, Maine, who has settled with Notinger but still acts as a spokesman for many of the creditors. "The bankruptcy trustee is still in the catbird seat."Indeed, as if to underline the point, Donchess & Notinger on its own went ahead with an auction of one such contested property in Concord with a $440,000 FRM mortgage. It sold for $15,000.Financial fallout remainsThe judicial and political fallout from the FRM scandal has all been settled.The Ponzi scheme's two principals -- Scott Farah of FRM and Donald Dodge of the CL&M loan servicing company -- have pleaded guilty to running the scheme and are serving out their terms -- 15 years and six years, respectively -- in federal prison. Numerous investigations have been conducted into how state regulators could have let the company continue in operation despite the many red flags that arose over the years.Emerging from the investigations have a number of legislative recommendations, most of which have been ignored, at least so far.Department heads entangled in the regulatory mess have resigned in protest or been forced out. Legal action against the state has gone nowhere, and the media spotlight has moved on.But the financial fallout continues, and the legal bills continue to rise.Donchess & Notinger's legal fees, including some $323,000 held back until the case is closed, amount to more than $1.7 million, and that doesn't include Notinger's commission based on the amount collected.So far, the estate has collected roughly $5.5 million, leaving about $2 million or so to be distributed.Those collections and costs will escalate because a court ruling forced the firm to break up the omnibus adversary case into 150 specific cases. Some 38 of those have closed officially and many more have been settled.Overall, there have been about 150 settlements with about 50 to 100 to go, estimated attorney Jim Donchess, who said that this is a "rough ballpark" figure.Whether the Migliaccio decision has contributed to the acceleration in settlements is a matter of debate, but so is much else about the decision.Philip and Melanie Migliaccio of Washington state were hard money FRM lenders who thought they were making loans on specific properties and projects.They contacted FRM in 2008, received the usual list of loans and ended up funding five of them that year for a total investment of about $450,000 at 13 to 15 percent interest. All of the loans were secured by some sort of collateral, whether it be a duplex in Rochester, N.H., or someone's home in Hilliard, Fla., or a commercial building in Corinth, N.Y.The couple received interest on most of these loans. Some were paid off before FRM went under. But the trustee argued that the collateral belongs to the estate, not to the Migliaccios, and insisted that the couple pay back the interest.The trustee maintained that, although the lenders thought their money was funding a particular mortgage, their funds were actually "commingled" with that of other investors in two CL&M bank accounts. At least some of it went to pay interest to other investors, and to fund a $20 million loan to FRM founder and Ponzi mastermind Scott Farah. The loan was never disclosed to anyone.On this question, Deasy ruled against the trustee.For one, CL&M's operating account was separate from the two accounts set aside for investors. So while the lenders' funds were lumped together, those accounts were really trust accounts, and until the company went under, CL&M faithfully made the payments to the projects that were supposedly tied to those accounts."CL&M did not treat these interest payments as its own money but rather as the money of the Migliaccios," Deasy wrote. "CL&M served as trustee and held legal title to the money subject to a fiduciary duty to use the money for the Migliaccios' benefit."But, added Deasy: "Proof of the intent to create a trust is not enough however."The Migliaccios have to trace every payment to establish that they have an equitable interest in the money, to show that they have more of a right to it than CL&M or another lender.And since the court can't trace those funds - at least based on the evidence thus far - the Migliaccios don't have a right to the interest or the property.But Deasy's ruling raises some interesting legal questions. If Notinger, as the trustee, is collecting funds on behalf of the beneficiaries of the trust - the secured victims - rather than the estate, then it can't get a commission on those funds.Proposed settlementBoth sides protested the ruling in court, yet both sides claimed a bit of a victory to NHBR."Under the ruling, there was a trust created," Migliaccio attorney Bertrand Zalinsky told NHBR. "It never became property of the debtor.""It holds that in a Ponzi scheme, the funds cannot be traced as a matter of law, so at end of the day they never would have been traced," Donchess explained to NHBR.But in a subsequent filing in March, Zalinsky asked Deasy to reconsider, arguing that he erred in requiring the funds to be traced.Deasy scheduled a hearing on the issue for April 9, but the hearing wasn't held. Instead, both attorneys hammered out a settlement, and presented it to the court on April 5, subject to court approval, which could come at the scheduled May 21 hearing.Under the proposed settlement, Migliaccio appears to come out ahead, keeping three out of the four loans. The trustee only got one, worth $70,000.According to Zalinsky, the pace of settlement has pick up "dramatically" since Deasy's decision in February. But whether that's due to the uncertainty of whether the funds belong to the estate under the decision, or whether it's because of the uncertainty that the debtor would have to be able to trace them if there is a trial, or whether -- as Donchess suggests -- it's just a response to the November filing of 150 individual suits is anybody's guess.The trustee's decision to auction a Concord property with a $440,000 loan on it for $15,000 is a sign that the trustee still thinks the property belongs to the estate, said Susan McIlvene."How could the trustee sell anything with a first mortgage on it without permission?" she asked.Zalinsky, who also represents one of the noteholders on that property, wouldn't comment on the sale because of possible settlement negotiations, but Donchess defended it, saying that it fairly bid at an auction, and nobody wanted to pay anything more for it."It is in terrible shape," Donchess said. "Someone tore the place apart. Wiring was torn out the wall, there are holes in the sheetrock."The borrower on the note was Kevin Guay, a Concord developer embroiled in numerous legal and environmental controversies with state and municipal authorities.There was a $30,000 tax lien on the property, and a mechanic's lien of $25,000, so whoever bought the property would have to shell out $70,000, not to mention the funds to fix it up or tear it down, Donchess said. And the trustee couldn't hang on to it because it would have been sold in a tax sale, "and then the estate might be required to pay the taxes, paying out thousands of dollars on a piece of garbage."The Concord property illustrates the problem of counting these mortgages at face value, Donchess said"Even if it was in perfect shape, the value would never come close to the mortgage," he said.The same could be said of many of the properties that were part of the fraud.Adding to the confusion, not all of the victims sided with the Migliaccios in their contention that the interest they received in the past belong to them.On this point, the bankruptcy trustee has an unlikely ally in Frank Marino, the lender who unsuccessfully sued the state Banking Department for assuring him that there were no problems with FRM the company, even though the department had found hundreds of violations over the years.Marino, a Meredith patent agent, is no fan of the trustee's law firm -- "You don't feel they are on your side. They just give the impression that they don't give a crap about any of us," he told NHBR - but the trustee "could represent the only hope for the unsecured victims."Marino gave Farah two checks totaling $262,000 in the two months before the company shut down."Although it was paid toward particular properties, my bad timing meant that it never actually got legally secured by any deed, mortgage or property. In fact, my money was just split up and sent out to other lenders, like maybe the Migliaccios," he explained in an email.He added, "To the extent the Migliaccios' decision was a victory for them, it was another victimization of us."If the property doesn't belong to the trustee, Marino would be forced to sue Migliaccio and other victims. That "turning of victim against victim" is already ugly enough as it is, he said.He proposed that everybody get together and agree to accept a certain percentage of whatever the trustee could collect. Otherwise, he said, the victims should get their own lawyer to represent their own interest."The ugliest side of all of this -- even uglier to me than what Farah and (former state Banking Commissioner Peter) Hildreth did -- was watching the way some of the victims so selfishly and greedily told the others, "Tough luck -- stay away from my money," said Marino.

 

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