Credit Counseling Takes Another Hit

LOS ANGELES — Following Congressional hearings regarding the abuses in the credit counseling industry and the increasing IRS scrutiny, the United States Court of Appeals for the First Circuit has weighed in with strong support for consumers. In a case of first impression nationwide, the First Circuit held that credit repair companies are not automatically excluded from the definition of a “credit repair organization” simply because they are organized as non profit tax exempt entities. Rather, the court held that to be immune from suit under the federal Credit Repair Organization Act (CROA), the defendant must prove that it actually operates in a manner consistent with both of those statuses.

The case involved a class action suit by the Zimmermans, a Virginia couple paid approximately $1,000 in 2002 for a customized debt management program with Cambridge Credit Counseling Corporation, which had advertised that it was America’s premier debt counseling organization. After several months on the Cambridge debt management plan program, the Zimmermans owed more money to creditors and had worse credit scores than before they contacted Cambridge.

Believing that they had been swindled, the plaintiffs sued Cambridge, its owners John and Richard Puccio and several related entities for violations of the CROA. They alleged that Cambridge’s non profit status was a sham and that John and Richard Puccio had, through a complex series of corporate maneuvers, personally made millions off the backs of America’s most vulnerable consumers, i.e. those already severely overburdened by debt that they were willing to do and pay almost anything to avoid bankruptcy. The plaintiffs further alleged that John Puccio already had a history of fraudulent conduct and had been banned for life by the United States Securities and Exchange Commission.

The Zimmermans’ case was thrown out by the district court on the grounds that the CROA excludes from its reach “any nonprofit organization which is exempt from taxation under section 501(c)(3)” and that Cambridge was organized as a Massachusetts non profit company and the IRS had granted Cambridge tax-exempt status. The Zimmermans then appealed.

In the June 1, 2005 opinion, the First Circuit first noted that the CROA’s expressed purpose is to “to protect the public from unfair or deceptive advertising and business practices by credit repair organizations.” The Court then looked closely at the language Congress used for the nonprofit/tax exempt exclusion. It not only held that “non profit” and “exempt from taxation” were separate concepts, but that since tax exempt status determinations by the IRS are exclusively based on material that is provided by the applicant, they are not reliable indicators of how the organization is actually operating and thus cannot be relied upon as precedent for purposes of the CROA. As the Court noted even “the IRS’ subsequent notification that an entity has qualified for tax-exempt status contains a disclaimer stating that the IRS has made its determination based solely on representations provided to it by the party seeking the status.”

From this observation, the Court held that “if a credit repair organization only needed to obtain a section 501(c)(3) designation to qualify for the exception, the exception might well eviscerate the liability-creating provisions” and that “Congress cannot have intended unscrupulous credit repair organizations to have such easy access to CROA immunity.” Further, the Court found that although Congress left the word “nonprofit” undefined in the CROA exclusion, the concept was not difficult and that “nonprofit” status depended primarily on proof that the entity did “not distribute profits to stockholders or others.”

Thus, the Court unanimously concluded, “to be excluded from the CROA … , a credit repair organization must actually operate as a nonprofit organization and be exempt from taxation under section 501(c)(3).”

The First Circuit decision is a landmark opinion in the increasingly regulated area of consumer debt counseling. For not only will credit counseling be required under the new bankruptcy law, but prior to the First Circuit’s opinion, there were conflicting lower court decisions on the effect of an IRS determination of exempt status on whether a credit repair company could be sued under the CROA.

The Zimmermans’ case is not the only class action suit alleging this same type of nonprofit fraud in the credit counseling industry. In another such action, on April 20, 2005, a federal district court froze the assets of Andris Pukke, a convicted felon, who founded Ameridebt, Inc., Debticated Consumer Counseling, Inc. and several other ostensibly “non profit” tax exempt credit counseling entities. That action is entitled Polacsek v. Debticated Consumer Counseling, et al. and is pending in Maryland. Pukke and his company are also being sued by the Federal Trade Commission in the same court and various state Attorney Generals have sued both the Cambridge and Ameridebt organizations.

Finally, the First Circuit opinion would also seem to have wider implications than just application to the CROA and its rationale would include all statutes where either non profit or tax exempt statuses are raised as issues in private litigation. Indeed, it would appear to apply to any instance where the IRS has provided a private letter determination on a particular question that later comes up in litigation. In all of these cases, it seems that the rule will be that while the IRS may continue to treat an entity for tax purposes in one way, federal courts can go the other way based on the organization’s actual operations where the same question is raised in private litigation.

The plaintiffs in both the Zimmerman and Polacsek cases are represented by the Los Angeles office of Morris Polich & Purdy LLP, the Charlottesville, Virginia office of Michie Hamlett Lowry Rasmussen & Tweel PLLC and Charlottesville attorney Gregory Duncan. Massachusetts attorney Steven G. Hennessy also represents plaintiffs in the Zimmerman case.