Judge dismisses 9 counts against bank of abetting fraud

WARSAW — A Michigan judge has dismissed several counts of fraud lodged against a Warsaw financial institution by a bankruptcy trustee tasked with recovering ill-gotten gains from a massive check-kiting scheme.

Judge Scott Dales, of the U.S. Bankruptcy Court in Western Michigan, on Tuesday dismissed nine of the 39 counts against Lake City Bank alleged by the trustee appointed in the bankruptcy of Najeeb Khan. The dismissed counts include allegations of fraudulent transfers as well as aiding and abetting fraud, unjust enrichment and breach of fiduciary duty.

Dales wrote in his opinion that "Lake City Bank's alleged shortcomings in its deposit monitoring are better addressed by a bank regulator, not a bankruptcy judge."

The judge also dismissed bank Director Bradley Toothaker as a defendant in the civil court action, saying that the trustee failed to state a plausible claim for relief.

"It's great news for us; the most egregious of the claims are dismissed," Lake City Bank CEO David Findlay said Wednesday. "It changed the dynamics of the argument. It's positive for us."

Dales allowed claims of a RICO conspiracy to stand, indicating that the complaint against the bank made a plausible case for racketeering, which could potentially go to trial. He wrote that the allegations of a hierarchy with Khan as "the mastermind," who determined the timing of the deposits and withdrawals as well as the duration of the scheme and the "persistent disregard of the countless red flags," allow the court to regard as plausible the existence of a conspiratorial agreement.

"The role of the Lake City Defendants was admittedly more passive and subordinate, with Findlay, for example, allegedly keeping a lookout for the overdraft alerts and when they regularly arrived, using his positional power within Lake City Bank to put the kibosh on the warnings and those raising the alarm," the judge wrote. "The allegations within the (complaint) are consistent with an inference of incompetence, certainly, but also incrimination."

The judge's order gives trustee Mark Iammartino a chance to submit another amended complaint. Dales suggests that the trustee must establish an intent to defraud in the case of certain allegations, but warns that doing so could strengthen the defense against other counts.

"Accordingly, nothing in today's opinion should be read as forecasting success at trial," Dales wrote. "The parties have a long path ahead."

'The real victims'

Iammartino alleges that Khan, the former owner of Elkhart-based Interlogic Outsourcing Inc., couldn't have carried out his fraud without cooperation from Lake City Bank. Iammartino believes the bank is liable because it benefited from the scheme when it collected $13.6 million in negative balance fees from IOI.

Khan filed for bankruptcy after Cleveland-based KeyBank sued him in 2019, saying it could lose hundreds of million of dollars from his years-long fraud. Khan is awaiting sentencing after pleading guilty to federal charges of bank fraud and attempted tax evasion.

He carried out the scheme starting in 2011, using a cycle of check deposits and withdrawals from IOI accounts at Lake City and other banks, according to the trustee's allegations. The amounts eventually reached as high as $100 million.

Khan transferred more than $70 million to his personal accounts in the process, according to Iammartino.

"According to the (second amended complaint), Mr. Khan's audacious multi-year check kiting scheme suddenly collapsed in July 2019, when Lake City Bank, after years of covering IOI's obviously worrisome overdrafts, declined to cover the last one – and the last one was a humdinger," Dales wrote in his 43-page opinion. "With remarkable understatement, the trustee refers to the date that Lake City Bank informed KeyBank it would not cover the last batch of deposits (July 8, 2019) as the 'Disruption Date,' but it is fair to infer that KeyBank, a regional banking giant, regarded the resulting $142 million shortfall as more than merely disruptive."

Lake City Bank moved to dismiss the case, and Findlay said in February that he believes KeyBank was the driving force behind the trustee's efforts. He said KeyBank was among the biggest losers in Khan's eight-year fraud "due to their own errors and omissions and mistakes."

Findlay also claimed Lake City Bank leadership had concerns about Khan, and that they asked him to stop when they discovered his use of negative collected balances. But Findlay said he was unaware something illegal had happened until Khan entered his admission in court.

According to a statement from Lake City Bank on Wednesday, the bank began working with law enforcement to provide evidence of Khan's criminal activity immediately upon terminating the kiting scheme in July 2019. It says its cooperation substantially contributed to Khan's indictment in December 2022.

"Nearly four years after Khan admitted to the kiting scheme, no law enforcement agencies have accused Lake City Bank or its employees of any improprieties related to Khan's scheme," the statement continues. "Further, at no time during the public legal proceedings against him has Kahn (sic) implicated any other people or organizations, including KeyBank, Berkshire Bank or Lake City Bank as coconspirators in committing these crimes."

The statement says the judge's decision significantly narrows the scope of the trustee's "overly broad and legally and factually insufficient" claims, and shows the court acknowledges that the bank will have several strong defenses if the trustee "decides to continue pursuing this meritless case, despite having failed – over three complaints spanning two years – to provide evidence to support its allegations."

Findlay characterized the lawsuit as an attempt to intimidate Lake City Bank into a resolution favorable to KeyBank through "a transparent manipulation of the legal system."

"With two hands legally and procedurally tied behind our back, the bank knocked out the greatest alleged exposure at the very beginning of the judicial process," Findlay said in the statement from the bank. "At this early stage, the trustee benefits from the legal position that requires the court to presume that all allegations as plead are true. Despite this favorable presumption, the court agreed with the bank's argument and dismissed four counts from the complaint that sought recovery of $73 million Khan diverted from IOI accounts."

Lake City Bank President Kristin Pruitt pointed to the payments she said have gone to the trustee's legal counsel.

"This false pursuit of Lake City Bank has been profitable to the trustee, the trustee's legal counsel and other professional service providers, who have collectively been paid more than $16.6 million in fees, with an astounding $12.3 million of these fees going to legal professionals," she claimed in the bank's statement. "The fees continue to rise every single day that these fabricated claims are pursued. This represents real money that could have gone to IOI's clients, who are the real victims of Khan's crimes."

A request for comment was sent to Iammartino and his attorneys.