Bankruptcy Litigation Committee

ABI Committee News


Defrauded Parties' Recovery of Funds from Innocent Third Parties: The Relief Defendant

This country has recently been inundated with tales of investment fraud. On July 13, 2009, Marc Dreier was sentenced to 20 years for a conviction arising from securities fraud. On June 30, 2009, Bernard Madoff was sentenced to 150 years in prison for his involvement in a Ponzi scheme that cost investors billions. Sir Paul Allen Stanford was charged by the Securities Exchange Commission (SEC) for fraud and multiple securities law violations on Feb. 17, 2009. Often, the property traceable to profits derived from such scams is funneled to “innocent” third parties, such as a spouse or other relative. This article discusses the common-law equitable concept of the “relief defendant” and how it may be used in bankruptcy court to recover property obtained through fraud and funneled to supposedly innocent third parties.

Origin of the “Relief Defendant”
There is no mention of the term “relief defendant” in the Federal Rules of Civil Procedure (FRCP); however, courts use the term interchangeably with “nominal defendant,” which is referenced in the FRCP. SEC v. Bentley, No. 01-5366, 2002 U.S. Dist. LEXIS 5769, at *2 (E.D. Pa. April 4, 2002); SEC v. Cavanagh, 155 F.3d 129, 136 (2d Cir. 1998); Bentley, 2002 U.S. Dist. LEXIS 5769, at *2. The nominal defendant “is typically a custodian, depositary, trustee or similar agent who ‘has no legitimate claim to the disputed property’ and ‘is not a real party in interest.’” Bentley, 2002 U.S. Dist. LEXIS 5769, at *2-3 (quoting SEC v. Colello, 139 F.3d 674, 676 (9th Cir. 1998)). See also SEC v. Cherif, 933 F.2d 403, 414 n.13 (7th Cir. 1991) (describing nominal defendant as someone who “has no interest in the property that is the subject of the litigation”).

A variety of individuals have been named as nominal defendants. In Cavanagh, the culpable defendant’s wife was joined as a nominal defendant, although she did not know that her husband deposited the proceeds of the fraudulent sale of stock into her bank account. Cavanagh, 155 F.3d at 137 (reasoning that “[a]llowing her to...claim valid ownership of those proceeds would allow almost any defendant to circumvent the SEC’s power to recapture fraud proceeds, by the simple procedure of giving [ill-gotten property] to friends and relatives, without even their knowledge”). See also SEC v. Antar, 44 Fed. Appx. 548, 550 (3d Cir. 2002) (children and other relatives of main defendant named as relief defendants); SEC v. Infinity Group Co., 212 F.3d 180, 185 (3d Cir. 2000); SEC v. Breed, No. 01CIV.7798 (CSH), 2003 WL 118494, at **1,3 (S.D.N.Y. Jan. 13, 2003) (allowing leave to amend complaint to add, as relief defendants, defendant’s mother, brother and then girlfriend (now wife) in whose accounts defendant illegally tipped or directed illegal trading); SEC v. Antar, 831 F.Supp. 380, 401-02 (D. N.J. 1993) (naming wife and children of defendant as nominal defendants after concluding that culpable defendant exercised “absolute control” over trust accounts that were in names of culpable defendant’s wife and children and contained funds “directly traceable to” fraud).

“No Legitimate Claim” Requirement
Generally, a court “may order equitable relief against a person who is not accused of wrongdoing...where that person: (1) has received ill-gotten funds and (2) does not have a legitimate claim to those funds.” Cavanagh, 155 F.3d at 136. See also George, 426 F.3d at 791, 798 (disgorging property from relief defendants who were overpaid investors in fraudulent investment scheme and spouse of one defrauder who received 2.6 carat diamond engagement ring, $18,800 to lease automobiles and $14,419 for unspecified purposes); Springer v. The Infinity Group Co., 189 F.3d 478 (10th Cir. 1999) (unpublished opinion); SEC v. Colello, 139 F.3d 674, 677 (9th Cir. 1998) (rejecting nominal defendant’s claim that his receipt of ill-gotten funds was for payment for his services to defendant company in light of fact that he never disclosed purposes of payments and he pleaded Fifth Amendment when asked about his ownership claim).

Consideration, such as services given in return for receipt of funds, is deemed sufficient to prove a legitimate claim to property. See SEC v. Better Life Club of Am. Inc., 995 F.Supp. 167, 180-84 (D. D.C. 1998). However, at least one court has concluded:

[R]eceipt of funds as payment for services rendered to an employer constitutes one type of ownership interest that would preclude proceeding against the holder of the funds as a nominal defendant. However, a claimed ownership interest must not only be recognized in law; it must also be valid in fact. Otherwise, individuals and institutions holding funds on behalf of wrongdoers would be able to avoid disgorgement (and keep the funds for themselves) simply by stating a claim of ownership, however specious.
Kimberlynn Creek Ranch, 276 F.3d at 192.

However, consideration must be bargained-for to be valid. See Hodgkins v. New England Tel. Co., 82 F.3d 1226, 1231 (1st Cir. 1996). A payment received as compensation for services rendered in the past is not consideration when the recipient of the payment rendered the past services without entering an agreement concerning the services and payment. See id. Moreover, if the relief defendant cannot show that a specific amount of compensation was agreed upon before the receipt of the funds, then the contract for services fails due to the lack of an essential term. See Zaitsev v. Salomon Bros. Inc., 60 F.3d 1001, 1004 (2d Cir. 1995) (concluding that compensation amount is essential term of contract for employment).

In SEC v. Infinity, the wife of the securities law violator, one of the named relief defendants, contended that in her capacity as trustee of certain trusts, she provided administrative and clerical services to the defendant corporation, which served as consideration for the funds received. 993 F.Supp. 324, 331 (E.D. Pa. 1998). The court rejected the wife’s claim because she produced no physical evidence or testimony to support her contention. Id. The court reasoned that “[i]t would be contrary to to allow [the wife] to launder the proceeds of a...fraud by billing bilked investors for services rendered in furtherance of that fraud. Illegal consideration is invalid consideration and thus cannot shield ill-gotten gains from disgorgement.” Id.

Obtaining Jurisdiction over Relief Defendants 
Only personal and not subject-matter jurisdiction need be established over the relief defendant. See SEC v. Carrilo, 115 F.3d 1540 (11th Cir. 1997). Since there is “no claim against a nominal or relief defendant, it is unnecessary to obtain subject matter jurisdiction over him once jurisdiction over the defendant is established.” CFTC v. IBS Inc., 113 F.Supp.2d 830, 851-55 (W.D.N.C. 2000).

Equitable Theories of Recovery
Even though relief defendants may not have directly engaged in any illegal activity, courts disgorge property obtained as a result of the primary defendant’s wrongdoing in order to deter others from engaging in illegal conduct. Think Achievement Corp., 144 F.Supp.2d at 1020. “As between the [relief] defendant...and the victims of fraud, equity dictates that the rights of the victims should control.” Id. Disgorgement is obtained through use of the equitable theories of constructive trust and unjust enrichment. Id.

State law governs use of the constructive trust remedy. Id. at 1021 n. 3 (“Constructive trust is a creature of state law”). The requirements for imposition of a constructive trust vary by jurisdiction. For instance, the district court in the District of Columbia requires that the moving party establish (1) a wrongful act, (2) specific property traceable to the wrongful behavior and (3) explanation of why the party holding the property cannot in good conscience keep it. Capital City Mortgage Corp., 321 F.Supp.2d at 19 (D. D.C. 2004) (holding that constructive trust should be imposed on funds passing to beneficiaries of deceased wrongdoer’s estate). As stated by Judge Cardozo, “[a] constructive trust is the formula through which the conscience of equity finds expression.” When a constructive trust is imposed, the court “has jurisdiction to reach the property either in the hands of the original wrongdoer, or in the hands of any subsequent holder, until a purchaser of it in good faith and without notice acquires a higher right and takes the property relieved from the trust.” Harris Trust & Sav. Bank v. Salomon Smith Barney, 530 U.S. 238, 251 (2000).

The doctrine of unjust enrichment is a second theory used to recover property from relief defendants. Antar, 831 F.Supp. at 402. To recover under this doctrine, a plaintiff must establish that the relief defendant was enriched and that “the circumstances dictate that, in equity and good conscience, the [relief] defendant should be required to turn over its money to the plaintiff.” Id. (quoting Universal City Studios Inc. v. Nintendo Co., 797 F.2d 70, 79 (2d Cir. 1986)). When a court finds that a relief defendant has benefitted at the expense of defrauded parties (unjustly enriched), the court will impose a constructive trust, as discussed above, to disgorge the relief defendant of the ill-gotten gains. Think Achievement Corp., 144 F.Supp.2d at 1021-22 (ordering that constructive trust be imposed on all assets, including profits invested in mutual fund accounts, that were controlled by relief defendant and derived from primary defendant’s fraudulent scheme).

The Bankrupt Relief Defendant or Bankrupt Defrauded Investor
A bankruptcy court is a court of equity. See 11 U.S.C. §105(a) (“The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Code]. No provision of the [Code] shall be construed to preclude the court from...taking any prevent an abuse of process.”); Colello, 139 F.3d at 676 (noting that no precedent existed, yet “ample authority support[ed] the proposition that the broad equitable powers of the federal courts can be employed to recover ill-gotten gains for the benefit of victims of wrongdoing, whether held by the original wrongdoer or by one who has received the proceeds after the wrong”).

Accordingly, a bankruptcy court is not foreclosed from allowing parties to use the concept of a relief defendant as an alternative tool to aid in recovery in bankruptcy court and may be used in some form or fashion in bankruptcy proceedings to recover property on behalf of a defrauded debtor pursuant to §§105 (equitable powers of bankruptcy court), 541 (property of estate) and 542 (turnover) of the Bankruptcy Code, and Bankruptcy Rule 7001. For example, if a defrauded investor files for bankruptcy protection, the bankrupt investor may initiate an adversary proceeding—grounded in fraud, among other things—against the main perpetrator of fraud and name the innocent third party as a relief defendant in the action. The defrauded investor would allege that the property she is seeking to recover is rightfully property of the bankruptcy estate, that the defendant and relief defendant only hold the property in constructive trust for the debtor, and that the proper remedy is turnover pursuant to §542. A fraudulent-transfer theory of recovery may also be available in such a scenario. Defrauded investors could also use the relief-defendant concept to seek recovery of property transferred to “innocent” bankrupt entities or individuals to whom ill-gotten property was transferred.

Recovering property from “innocent” third parties (relief defendants) is commonplace in civil securities law enforcement actions. It appears that the concept of relief defendant has not yet been used as a tool to aid defrauded investors in recovery of property in bankruptcy court. However, a bankruptcy court, as a court of equity, is not precluded from allowing the use of this equitable concept. As more massive schemes of fraud are uncovered, defrauded investors will be required to “think outside the box” to ensure maximum recovery of their investment.