On December 1, 2011, a 12-person federal jury in Minnesota found TD Bank, N.A., liable to American Bank of St. Paul and 25 participant banks for aiding and abetting fraud by imprisoned Florida Ponzi-schemer Louis J. Pearlman and conspiring with Pearlman to commit that fraud. (Captioned American Bank of St. Paul v. TD Bank, N.A., Civil No. 09-2240 (ADM/TNL).) The jury awarded American Bank and the participants nearly $13.6 million in damages.
Pearlman’s bank fraud and TD Bank’s complicity in it.
The claims against TD Bank arose out of a $28.5 million participation loan made to Pearlman in March 2006. At the time, Pearlman was believed to be a successful businessman, best known for promoting the boy bands *NSYNC and Backstreet Boys and producing “Making the Band,” the first network television reality show.
Pearlman represented that the $28.5 million loan would fund a music television show and refinance approximately $11 million in loans extended by Mercantile Bank, a Florida bank purchased by TD Bank in 2010. When total commitments came up short, and at the request of Pearlman’s agent, Mercantile Bank agreed to provide the last $1.9 million in funding to allow the loan to close.
At closing, Mercantile Bank received more than $9 million of the loan proceeds from the participation loan. Its participation interest was paid off in April 2006, after additional banks agreed to join the loan. Of the numerous banks Pearlman pleaded guilty to defrauding, Mercantile Bank was the only bank that did not lose money in his fraud.
Mercantile Bank avoided losing money to Pearlman’s fraud because it uncovered that fraud in August 2005. Following investigations into Pearlman, Trans Continental Airlines (TCA)—the entity that guaranteed Pearlman’s loans—and their accountants, Mercantile Bank discovered that Pearlman’s loans were based on bogus financials and tax returns created by fictitious accountants. Mercantile Bank also learned that TCA was not a real airline and that it owned no airplanes.
Mercantile Bank also knew that the same fictitious financials, bogus accountants, and false representations were being used by Pearlman to convince banks to underwrite the new $28.5 million loan. Mercantile Bank’s agreement to provide the final funding to close the $28.5 million loan formed the basis for its conspiracy and substantial assistance to Pearlman in committing and expanding his fraud seven months after the fraud was first uncovered.
After uncovering Pearlman’s fraud, Mercantile Bank engaged in a pattern of dishonesty, concealment, and active assistance of Pearlman’s fraud. For example, Mercantile Bank withheld key facts about Pearlman, TCA, and their accountants from holding company officers who could have stopped the fraud altogether. Although it knew Pearlman’s financial information was fraudulent, Mercantile Bank relied on that information in approving forbearance agreements and its loan participation, without qualification.
Mercantile Bank repeatedly deviated from its loan policies following its discovery of Pearlman’s fraud. It maintained a “performing” risk rating on Pearlman’s largest loan, even though the loan was in default. Contrary to its loan approval document, Mercantile Bank’s participation in the $28.5 million loan did not meet underwriting standards. And, most problematically for Mercantile Bank, without its participation in the loan it knew to be fraudulent, the loan would not have closed.
Lessons Learned from TD Bank’s misconduct
The facts underlying Mercantile Bank’s conspiracy with Pearlman and substantial assistance of his fraud provide practical lessons applicable to lending decisions banks make on a daily basis.
First, material facts underlying any lending decision should be disclosed to decision makers. Whether formally or informally, approving officers must have knowledge of all facts relevant to each lending decision. Testimony from the chief credit officer for Mercantile Bank’s holding company showing that he lacked basic knowledge of Pearlman’s fraud highlighted Mercantile Bank’s wrongdoing.
Second, foster an open environment. Employees should be encouraged to disclose material information to superiors, even if that information is inconsistent with prior lending decisions. Mercantile Bank lacked such an environment. Instead, officers and employees sought to avoid recrimination and were unable or unwilling to backtrack when called upon by Pearlman to further his fraud.
Third, because approving officers often are not involved in day-to-day communications about borrowers, important communications should be promptly documented in the loan file. To facilitate disclosure, guidance should be provided concerning the documents or notes to be maintained in loan files. Mercantile Bank lacked such guidance. For example, neither the investigative report outlining Pearlman’s fraud nor any reference to that report were maintained in Pearlman’s loan file. The absence of this important information from the loan file showed that the investigative report had been concealed from certain approving officers.
Fourth, the lending approval process should be transparent. In addition to disclosing relevant information to decision-makers, material loan policy exceptions should be disclosed in loan approval documents. Mercantile Bank’s intentional suppression of policy exceptions assisted Pearlman in committing his fraud. While Mercantile Bank’s violations were intentional, inadvertent policy violations also should be avoided. Loan policies therefore should conform to everyday lending practices. Consider modifying policies that do not conform to daily lending realities.
Fifth, if fraud is suspected, obtain answers to any “red flags.” Under certain circumstances, knowingly assisting a borrower in refinancing a fraudulent loan can subject a bank to civil liability. More commonly, unresolved “red flags” can subject a bank to liability in bankruptcy. In short, remaining ignorant in the face of signs of borrower fraud, misconduct, or insolvency will not shield a bank from liability and can create exposure that would not otherwise exist. Notably, in addition to liability in Minnesota, Mercantile Bank faces a multi-million dollar trustee clawback action arising out of its knowledge of Pearlman’s fraud.
Finally, ask your attorney about potential liability issues when faced with possible borrower misconduct or insolvency. Even if the scope of retention is narrow, determine whether broader rights or liabilities may be implicated that either improve the chances of recovery from the borrower or reduce risk of civil liability.
Mercantile Bank clearly failed to engage in proactive discussions with counsel about potential liability arising from its discovery of Pearlman’s fraud. Mercantile Bank never asked its lawyer whether its conduct could create third party liability or otherwise expand the bank’s Pearlman-related exposure. Additionally, by failing to examine broader liabilities, testimony intended to defend the allegations that Mercantile Bank knew about Pearlman’s fraud in the Minnesota litigation significantly increased the likelihood of liability to the bankruptcy trustee in Florida.
The facts underlying Mercantile Bank’s relationship with Pearlman and its participation in the $28.5 million loan are extraordinary because they involve the use of fictitious accountants and wholly fabricated financial information. However, they highlight the importance of transparency in the loan approval process, the significance of fully investigating unusual and important issues arising in the underwriting process. They also demonstrate the importance of examining every potential avenue of recovery and potential liability associated with lending decisions and practices that banks face on a daily basis.