You Can't Cheat an Honest Man - James Walsh [106]
Using the NFP Structure to Build a Ponzi Scheme
An even more creative approach is to set up an NFP as a vehicle for Ponzi fraud. A perp who starts a “nonprofit” can take advantage of the presumption of goodwill that many people feel toward the things. And, in some cases, it’s not only people who make the mistaken presumption...it’s sometimes banks or governments that do.
Lee Sutliffe exploited this goodwill with a Missouri-based NFP called First Humanics Corporation (FHC). FHC turned out to be a Ponzi scheme—and serves as a good illustration of the mechanics of an NFP fraud.
The company was incorporated in the 1970s as Faith Evangelistic Mission Corporation, a tax-exempt NFP which was intended to own and operate church-affiliated nursing homes in the Midwest. In July 1984, Sutliffe gained control of the company and changed its name to First Humanics. He used FHC’s tax-exempt status to issue so-called “Section 103 bonds.”
The interest paid by these bonds is often high and always exempt from federal income tax. The bonds, which aren’t registered or rated like corporate bonds, are usually issued by local governments; but NFPs that provide public services can issue them, too.
Between 1984 and 1987, FHC acquired 21 nursing homes and paid for the purchases by issuing a total of over $80 million in Section 103 bonds. Sutliffe—a Kansas City financier with a long history of troubled bond deals—treated the municipal bond market as his sucker investor, selling it round after round of new bonds pledged against the same 21 nursing homes. “He knew underwriters all over the county and bond lawyers,” said one former business associate. “He was familiar with the bond industry.”
Sutliffe shrouded his questionable deals in a cloak of legitimacy by hiring top-flight accounting firms to give advice. From 1984 until 1986, Deloitte & Touche provided financial forecasts and feasibility studies in connection with FHC’s bond issues. But, as the scheme grew, a new accounting firm was brought in. Starting in 1986, Price Waterhouse advised FHC with its bond issues.
An important note: Neither Deloitte & Touche nor Price Waterhouse audited FHC’s finances. They were merely brought in to do consulting work—and lend their names.
In 1987, FHC ran into problems. The Illinois Department of Public Health reported substandard conditions at some of its nursing homes. Among other things, state inspectors found untended elderly patients tied to wheelchairs for hours at a time. Daily food budgets at some of the homes had been cut to as little as $2.15 per day per patient.
In the next 18 months, FHC’s nursing homes saw an exodus of residents. While this was happening, the company moved deeper into its Ponzi scheme. It raided the proceeds from each of several new bond offerings to pay the holders of previously issued bonds. This kept existing, troubled nursing homes from financial failure.
But the scheme couldn’t last forever. In the fall of 1989, the company defaulted on the bonds connected with one of its nursing homes. Sutliffe insisted that the default was a technicality: “The bank just screwed up and paid more money to the nursing home instead of covering the bond debt service first.”
Within a few weeks, though, anxious bondholders had forced FHC to file a petition for relief under Chapter 11 of the Bankruptcy Code. After the filing, Sutliffe’s story changed. He blamed the bankruptcy on inconsistent Medicaid and Medicare reimbursements that forced the outside management company FHC had contracted to run the nursing homes to shift funds from financially healthy locations to those suffering cash flow problems.
The bondholders didn’t agree. In court papers, they claimed that FHC “was ever