RELIEF DEFENDANTS MAY BE ABLE TO KEEP ASSETS FROM FRAUDSTER

The Second Circuit Court of Appeals vacated a preliminary injunction secured by the SEC and the CFTC freezing the assets a spouse received in a divorce settlement from her former husband who ran a massive Ponzi scheme. The court held that the agencies are only entitled to obtain disgorgement of ill-gotten funds to the extent a relief defendant “lacks a legitimate claim to them.” CFTC v. Walsh, Nos. 09-3742, 09-3787 (2^nd Cir. Decided Sept. 15, 2011).

Relief defendant Janet Schaberg (named in the action as Janet Walsh) was married to Stephen Walsh for two decades. By the time of their separation in 2004 Mr. Walsh had amassed a substantial fortune. Under the terms of the final 2006 divorce settlement Mr. Walsh paid his former spouse $12.5 million in biannual installments through 2020. She also obtained nearly $5 million held in several checking accounts during the marriage as well as their home in Port Washington, New York and other real estate.

In 2009 the SEC and the CFTC accused Mr. Walsh of operating a Ponzi scheme. He and his partner supposedly fleeced investors out of $554 million. Investor funds which were suppose to be put in a vehicle to trade in equity index arbitrage were in fact used for the personal expenses of Mr. Walsh. Both agencies filed enforcement actions and requested a preliminary injunction freezing assets including those held by Ms. Schaberg. The district court granted the motions of the SEC and CFTC.

Critical to a resolution of this case is the question of whether Ms. Schaberg has a legitimate claim to the assets. To resolve this issue the court certified two questions to the New York Court of Appeals for resolution, rejecting the contention of each agency that it is one of federal law. Question one focused on whether “marital property can include the proceeds of a fraud.” The second, which the New York court recast, is whether a spouse paid fair consideration if all or part of the marital estate consists of the proceeds of a fraud. The answer to the first question is yes while the response to the second is no. The response to the second question is qualified however. The court stated that a spouse cannot be viewed as having paid fair value for the assets received by relinquishing a claim to a bigger share of the fraudulently obtained assets where the marital estate is primarily or all the proceeds of a fraud. Fair consideration giving the spouse a legitimate claim to assets can be given the court held by relinquishing rights such as maintenance, inheritance and child custody.

In this case the preliminary injunction was predicated on the notion that Ms. Schaberg had no legitimate claim to the assets because the estate was largely if not wholly the fruits of the Ponzi scheme. However, under New York law it is clear from the ruling of the Court of Appeals that a “divorce decree may cleanse such a taint [from a Ponzi scheme] where the innocent spouse acts in good faith and gives fair consideration.”

In reaching its conclusion that the preliminary injunction had to be vacated the court rejected arguments by the SEC and CFTC that the ruling could be affirmed on the basis that under the facts here valid consideration was not paid. First, the Court of Appeals held that there could be fair consideration under New York law. Second, at least some part of the funds spent on the residence in Port Washington, appear to have come from untainted sources. Third, Ms. Schaberg relinquished rights to maintenance and inheritance which might not have been worth much at the time, but at some point they may have value. Finally, it is possible that fair value may have been given for at least some of the assets. Accordingly, the case had to be remanded to the district court for further proceedings.

Program: ABA Seminar: Is the DOJ and SEC War On Insider Trading Rewriting the Rules? ABA program, live in New York City, webcast nationally. Friday September 23, 2011 from 12 – 1:30 p.m. at Dorsey & Whitney, 51 West 52 St. New York, New York 10019.
Co-Chairs: Thomas O. Gorman, Dorsey & Whitney LLP and Frank C. Razzano, Pepper Hamilton LLP.
Panelists: Christopher L. Garcia, Chief, Securities and Commodities fraud Task Force, Assistant U.S. Attorney, Southern District of New York; Daniel Hawke, Chief, Market Abuse Unit, Securities and Exchange Commission; Stuart Kaswell, Executive Vice President & Managing Director, General Counsel, Managed Funds Association; Tammy Eisenberg, Chief Compliance Officer, General Counsel and Senior Vice President, DIAM U.S.A., Inc.