A relief defendant cannot avoid an SEC enforcement action simply by asserting he owns the funds. A recipient of "ill-gotten gains," however acquired, must prove he has a legitimate claim to the property both in law and in fact to avoid forfeiture to the SEC. It is insufficient to claim the money is a loan or compensation for services.
What's Mine Is Mine. "Not So Fast," Says SEC
In SEC v. Messina, the SEC initiated an enforcement action against the head of an alleged pyramid scheme, Phil Xu, for defrauding investors of over $65 million. To reduce his assets, Xu made two transfers to his attorney, one for $200,000 purportedly for fees for services, and another for $5 million as an "uncategorized expense." Xu's attorney prepared a loan agreement for the $5 million transfer the following day.
The SEC named the attorney as a relief defendant in the enforcement action. The district court ordered the attorney's assets frozen and authorized expedited discovery. Seeking dismissal, the attorney argued he was not a relief defendant because he had a legitimate claim to the money. With presumptive title, he argued, the district court did not have subject matter jurisdiction over his money.
The district court held a two-day evidentiary hearing with six witnesses and over 150 exhibits. Ultimately, the court found the attorney's testimony not credible and concluded the $5 million "loan" was a sham. Accordingly, the court ordered return of the funds, though permitted the attorney to retain the $200,000 payment for services rendered.
The attorney appealed to the U.S. Court of Appeals for the Ninth Circuit, which identified the requirements a relief defendant must meet to secure dismissal from an enforcement proceeding. The appellate court held that a "relief defendant must assert an interest both recognized in law and valid in fact" to divest a court of jurisdiction, and a district court must resolve factual disputes over the ownership of the property. The appellate court went on to explain that relief defendants are entitled to a "truncated form of process," and the process afforded the relief defendant in this case was "substantial."
"Facts have obviously mattered when applying the legitimate interest standard," notes Joshua D. Jones, cochair of the ABA Section of Litigation's Securities Litigation Committee. With this decision, "the Ninth Circuit added to the 'legitimate interest' analysis to explicitly require that a claim to the monies must have a 'basis in fact,'" adds Jones. Still, even with this new requirement, "the circuits' treatment of relief defendants is relatively homogeneous. The idea that merely saying you own the property because you added value or the money was transferred to you, relatively speaking, has not gotten any traction," observes Vincent P. Schmeltz III, cochair of the Section of Litigation's SEC Enforcement Subcommittee of the Securities Litigation Committee.
For Relief Defendants, One Process Is Not Like the Other
The stakes are high for relief defendants challenging a district court's jurisdiction over their claimed property. If unsuccessful, "relief defendants lose the right to conduct formal discovery prior to the hearing, whether by document exchange, written discovery, or depositions. Accordingly, the record developed is going to be less complete that at summary judgment or trial," observes Jones.
For those representing relief defendants, due process in enforcement proceedings stands in contrast to that afforded in civil or criminal proceedings. "Outside of an enforcement proceeding, a party is required to connect the dots and make more than a tenuous showing that the funds at issues are dirty funds," argues Vincent. "I've been told by a judge off the record that my client was never getting a hearing on whether the funds derived from value added work versus fraud. To say the evidentiary standard is tenuous at best certainly says a lot about being a relief defendant—it doesn't feel like being a defendant in the United States of America," observes Vincent.
Other Section leaders defend the decision. "The court was not running amuck," explains Anthony Bosco, chair of the ABA Business Law Section's White Collar Crime Committee. The appellate court "gave the relief defendant a fair shot at establishing he had a legal right to the funds. There's no authority for the defense's contention that simply claiming an entitlement to the disputed funds divests the district court of jurisdiction. If that were the case, the entire concept of 'relief defendants' would crumble," says Bosco.
Protecting Clients' Financial Transactions
Despite disagreement over Messina's outcome, Section leaders agree that clients involved in financial transactions must be prepared to trace the source funds at issue. "Most relief defendants are hard pressed to show they didn't know the funds were dirty," warns Vincent. "If it feels too good to be true, it likely is. If something feels out of the ordinary, or the compensation is higher than one normally gets in the market, there is going to be a problem.
"To the extent you can negotiate arms-length agreements justifying the compensation or bequest, you will be better prepared when the SEC argues your client knew or show have known the funds were dirty," offers Vincent. But there is no bright line rule about how to avoid a potential forfeiture. "Ultimately, these cases are fact specific and sometimes the facts are so unfavorable that nothing is going to save you," observes Bosco.
Kristen L. Burge is an associate editor of Litigation News.
Keywords: SEC enforcement, relief defendant, Ponzi scheme, financial litigation
- Rory Zamansky, "Countering Attempts of Subject-Matter Jurisdiction Divestment by Relief Defendants," Securities Litigation (May 9, 2017).
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