As a part of its equitable powers, the court in an S.E.C. enforcement action may order a wrongdoer to disgorge all gains from the illegal activity. S.E.C. v. Fischbach Corp., 133 F.3d 170, 175 (2d Cir. 1997); S.E.C. v. First Jersey Securities, Inc., 101 F.3d 1450, 1474 (2d Cir. 1996); S.E.C. v. Certain Unknown Purchasers of Common Stock of & Call Options for Common Stock of Santa Fe Int’l Corp., 817 F.2d 1018, 1020 (2d Cir. 1987);see also S.E.C. v. Lund, 570 F. Supp. 1397, 1404 (C.D. Cal. 1983); S.E.C. v. Ridenour, 913 F.2d 515, 517 (8th Cir. 1990). Disgorgement of “ill-gotten gains” may be ordered against one who has violated federal securities laws, despite the defendant’s own huge loss in the investment scheme. S.E.C. v. J.T. Wallenbrock & Assoc., 440 F.3d 1109, 1117 (9th Cir. 2006). The Second Circuit has affirmed that disgorgement is a remedy available, even in light of the Supreme Court’s holding in Grupo Mexicano de Desarrollo, SA v. Alliance Bond Fund, Inc., 527 U.S. 308 (1999), which provided instruction on the availability of equitable remedies to federal courts. S.E.C. v. Cavanagh, 445 F.3d 105 (2d Cir. 2006)
The purpose of disgorgement is to prevent the wrongdoer from profiting from his illegal acts, not to reimburse those who have been injured by his conduct; and there is no requirement that disgorged funds be used for investor restitution. S.E.C. v. Commonwealth Chemical Securities, Inc., 574 F.2d 90, 102 (2d Cir. 1978) (“. . . the primary purpose of disgorgement is not to compensate investors. . . . it is a method of forcing a defendant to give up the amount by which he was unjustly enriched . . . .”). This principle from Commonwealth was reaffirmed by the Second Circuit in both S.E.C. v. Wang, 944 F.2d 80, 85, 88 (2d Cir. 1991) and Fischbach, 133 F.3d at 175-76 (“The primary purpose of disgorgement orders is to deter violations of the securities laws by depriving violators of their ill-gotten gains. *** ‘The effective enforcement of the federal securities laws requires that the SEC be able to make violations unprofitable.’ ***Although disgorged funds may often go to compensate securities fraud victims for their losses, such compensation is a distinctly secondary goal. ***…and a district court may order disgorgement regardless of whether the disgorged funds will be paid to such investors as restitution.”) (citations omitted). See also S.E.C. v. Huffman, 996 F.2d 800, 802 (5th Cir. 1993) (“. . . disgorgement is not precisely restitution. Disgorgement wrests ill-gotten gains from the hands of a wrongdoer. It is an equitable remedy meant to prevent the wrongdoer from enriching himself by his wrongs. Disgorgement does not aim to compensate the victims of the wrongful acts, as restitution does.”) (citations omitted).
Thus, in certain circumstances, no distribution may be made to victims. For instance, inFishbach, 133 F.3d at 175-176, where it would have been impractical to identify those investors damaged by the fraudulent conduct, the disgorged funds were instead paid to the United States Treasury. Id. See also S.E.C. v. Blavin, 769 F.2d 706, 710, 712-714 (6th Cir. 1985), where disgorged profits in excess of the losses of injured investors would revert to the United States Treasury.
As a “distinctly public-regarding remedy,” designed to deter perpetrators from wrongdoing, it is not necessary that all victims to whom payment may be due be identified, nor is it necessary that the victims that can be identified all be compensated.F.T.C. v. Bronson Partners, LLC, 654 F.3d 359, 373 (2d Cir. 2011) (“While agencies may, as a matter of grace, attempt to return as much of the disgorgement proceeds as possible, the remedy is not, strictly speaking, restitutionary at all, in that the award runs in favor of the Treasury, not of the victims.) However, it is still the policy of the Securities & Exchange Commission to recommend that disgorgements be distributed for the benefit of those injured by the illegal activities. See Fishbach, 133 F.3d at 174.
As to competing jurisdiction over assets between the receivership court and a competing parallel action, see supra 3.01.
Any plan of distribution may be adopted that is reasonable. Wang, 944 F.2d at 83-84.See also Quilling v. Trade Partners, Inc., 572 F.3d 293, 298-301 (6th Cir. 2009) (“In a receivership proceeding, the district court has ‘broad powers and wide discretion’ in crafting relief…Thus, a district court’s decision relating to the choice of a distribution plan for the receivership is reviewed for abuse of discretion.***Ultimately, the district court has wide discretion in distributing receivership assets’); S.E.C. v. Basic Energy & Affiliated Res., Inc.(“BEAR”), 273 F.3d 657, 668, 670-71 (6th Cir. 2001) (“Similarly, in the present case the district court carefully considered the escrow investors’ arguments, the position of the other BEAR investors, and the facts of the case, and accordingly fashioned a distribution plan that was fair and equitable. Thus, we cannot conclude that the district court has abused its discretion.”); S.E.C. v. Forex Asset Mgmt. LLC, 242 F.3d 325, 331 (5th Cir. 2001) (“ . . . [i]n shaping equity decrees the trial court is vested with broad discretionary power . . . .”); S.E.C. v. Elliott, 953 F.2d 1560, 1566-67 (11th Cir. 1992) (“The district court has broad powers and wide discretion to determine relief in an equity receivership.”); S.E.C. v. Hardy, 803 F.2d 1034, 1037-39 (9th Cir. 1986) (“[I]t is a recognized principle of law that the district court has broad power and wide discretion to determine the appropriate relief in an equity receivership.”); Lund, 570 F. Supp. at 1404 (“The receiver or trustee, in addition to handling other duties if necessary, is given the task of locating those members of the public who were injured by the illegal activity and to pay each injured party an amount determined by the trustee to be fair and equitable.”) See also Norwest Bank Wisconsin, N.A. v. Malachi Corp., 245 F. App’x 488 (6th Cir. 2007).
As the receiver is operating in equity, tracing principles need not apply in determining a distribution plan. Commodity Futures Trading Comm’n v. Eustace, CIV.A. 05-2973, 2008 WL 471574 (E.D. Pa. Feb. 19, 2008) (citing Cunningham v. Brown, 265 U.S. 1, 13, 44 S.Ct. 424, 68 L.Ed. 873 (1924). Generally, the receivership court, sitting in equity, will favor plans that distribute assets to the investor victims, on an equal pro rata basis, on the theory that each was a victim of the scheme. See Commodity Futures Trading Comm’n v. Wilson, 11-CV-1651-GPC-BLM, 2013 WL 3776902 (S.D. Cal. July 17, 2013) (citing United States v. Real Property Located at 13328 and 13324 State Highway 75 North, 89 F.3d 551, 553 (9th Cir.1996)).
In United States v. Durham, 86 F.3d 70 (5th Cir. 1996), the defendants defrauded thirteen (13) consumers of $806,750 through an advance fee loan business whereby consumers were told their investment would be used to originate loans. Id. at 71. When the defendants were finally arrested, only $83,495.52 of assets remained in a single bank account. Id. at 71-72. All but $8,803.99 in the account could be traced to seven claimants, four of which filed claims. Id. at 72. Over the objection of the four claimants, “the district court elected in the interest of equity, to distribute the $83,000 pro rata rather than giving the bulk of it to [the claimants] whose funds had been traced.” Id. In upholding the decision of the district court, the United States Court of Appeals for the Fifth Circuit quoted the district court:
In determining a plan for distribution, the Court must act to determine the most equitable result. In the instant action, all claimants stand equal in terms of being victimized by the defendant defrauders. The ability to trace the seized funds to Claremont and Northernaire is the result of the merely fortuitous fact that the defrauders spent the money of the other victims first. Allowing Claremont and Northernaire to recover from the funds seized to the exclusion of the other victims under the tracing principle would be to elevate the position of those two victims on the basis of the actions of the defrauders. The Court sees no justification in equity for this result.
Id. (footnote omitted); see also Forex Asset Mgmt., 242 F.3d at 331.
In upholding a plan of distribution that provided for pro rata distribution rather than a tracing approach, the Sixth Circuit held that “‘equality is equity’ as among ‘equally innocent victims,”’ further noting that “[t]he district court’s approach of pooling the receivership assets and distributing then on a pro rate basis is well supported….” Trade Partners, 572 F.3d at 298, 301 (citing Basic Energy, 273 F.3d 657, S.E.C. v. Credit Bancorp, Ltd., 290 F.3d 80, 88 (2d Cir. 2002), Forex, 242 F.3d 325, and Elliott, 953 F.2d 1560). In dicta, the Court indicated that even “ownership” of an asset would not necessarily defeat pooling rather than tracing, but would simply be one item for the district court to consider. Id., 300, n.1.
There are various methods used in pro rata distributions; the method chosen may result in differing treatment of claimants. In certain circumstances a distribution plan may provide for reimbursement to certain claimants, while excluding others. Levine, 881 F.2d at 1173, 1183, cited with approval in Wang, 944 F.2d at 84; see also Santa Fe, 817 F.2d at 1020-21; Basic Energy, 273 F.3d at 660-661. The plan may also provide different treatment for different classes of investors. Wang, 944 F.2d at 85-88; see also Basic Energy, 273 F.3d at 660-661; Norwest Bank, 245 F. App’x, at 495; Commodity Futures Trading Comm’n v. Walsh, 712 F.3d 735, 738 (2d Cir. 2013); cf. S.E.C. v. Enter. Trust Co., 559 F.3d 649, 652 (7th Cir. 2009). Providing such differing treatment is particularly applicable when the aggregate losses suffered due to the scheme cannot be fully compensated by available proceeds. Wang, 944 F.2d at 86, 87; Santa Fe, 817 F.2d at 1021. However, pro rata distribution to all investors in several related funds has been approved based upon subsequently-discovered evidence of commingling, even though an earlier distribution had utilized a “tracing” approach. Commodity Futures Trading Comm’n v. Eustace, CIV.A. 05-2973, 2008 WL 471574 (E.D. Pa. 2008). In developing a pro rata scheme, the receiver need not adjust the plan to account for inflation which would award class members with longer investments differently than those with shorter, nor other variables. Walsh, 712 F.3d at 750, c.f. Bernard L. Madoff Investment Securities LLC, U.S. Bankruptcy Court, Southern District of New York, No. 08-1789 (ruling in the context of a bankruptcy case that investors were not entitled to adjustments in distributions for fictitious profits).
In S.E.C. v. Enter. Trust Co., 559 F.3d 649 (7th Cir. 2009), the receivership defendant, Enterprise Trust Co., managed more than $100 million in almost 1,200 accounts. Some customers used Enterprise only for custodial services (to hold securities they had purchased); others relied on Enterprise to select securities (managed accounts). Enterprise’s principal manager, Lohmeier, purchased options, engaged in short sales and made other risky trades in managed accounts that were supposed to be invested conservatively. When the risky investments lost money and stockbrokers demanded additional collateral, Lohmeier supplied it by using the assets in custodial accounts, without those investors’ knowledge. By the time the S.E.C. stepped in and froze Enterprise’s assets, more than half of the money entrusted to Enterprise had been lost.
Over the objections of several owners of managed accounts, the district court approved the receiver’s distribution plan, which returned 60% of original capital to custodial investors (who neither authorized risk-taking nor had any prospect of gaining from those risks), and between 25-50% to managed account investors (who permitted Enterprise to exercise some control over their assets, knew or could have known that risky investments had been made in their accounts and would have reaped the gains if Lohmeier’s investment strategy had succeeded). Three owners of managed accounts appealed the district court’s approval of the distribution plan. Noting that “District judges possess discretion to classify claims sensibly in receivership proceedings”, and citing Wang, Elliot, Forex and Basic Energy, the Court of Appeals affirmed the district court. Id. at 652. Interestingly, the Court of Appeals stated in dicta that “Owners of custodial accounts would have had a stronger objection to the plan” if any custodial account owners had appealed, by analogy to bankruptcy’s “absolute priority rule.” Id. at 653.
For a case limiting participation in distributions to those who have suffered actual out-of-pocket losses, see Santa Fe, 817 F.2d at 1020-21.
Typically, a pro rata distribution will involve a use of some form of a “net loss” calculation to determine each claim. In many cases, claimants will have received payments back from the entity in the receivership in one form or another, and so calculation of a claim should take this into account. Generally, the net loss method would deduct the total amount returned to the victim from the initial method to determine the base for which any distribution amount may be calculated. See S.E.C. v. Capital Consultants, LLC, 397 F.3d 733, 73-38 (9th Cir. 2005). However, other methods exist and may be preferable, depending on the circumstances and equitable considerations. For instance, the “rising tide” method, where the amount the claimant receives is deducted from the pro rata share of the distribution dollar for dollar may be used. Commodity Futures Trading Comm’n v. Wilson, 11-CV-1651-GCP-BLM, 2013 WL 3776902 (S.D. Cal. July 17, 2013) (showing preference for the rising tide method over the net loss method).
In some instances, responsibility for developing the distribution plan may be given by a consent decree to the S.E.C., C.F.T.C., F.T.C., or even the receiver. In such instances, it has been held that “…unless the consent decree specifically provides otherwise once the district court satisfies itself that the distribution of proceeds in a proposed SEC disgorgement plan is fair and reasonable, its review is at an end.” Wang, 944 F.2d at 85. Insofar as the drawing of distinctions between different classes of investors, the court also observed: “This kind of line-drawing—which inevitably leaves out some potential claimants—is, unless commanded otherwise by the terms of a consent decree, appropriately left to the experience and expertise of the SEC in the first instance. . . . The district court’s task is to decide whether, in the aggregate, the plan is equitable and reasonable.” Id. at 88. Furthermore, “[b]ecause the Receiver is a fiduciary and officer of this Court, this Court may and does give some weight to the Receiver’s judgment of the most fair and equitable method of distribution.” Eustace, 2008 WL 471574, at *5.
Disqualifying defendants and their related parties, as well as those who participated in the development, implementation or marketing of the scheme, from participation in distributions has been upheld as reasonable, since it permits the disgorgement proceeds to be distributed to those who are most innocent. This was the case in Basic Energy, 273 F.3d at 660-661 (6th Cir. 2001), where defendants were excluded from participation in disgorgement proceeds and marketers of the scheme were reimbursed for a smaller fraction of their losses than were non-marketers.
Providing for a reasonable “claims bar date” has also been sustained by the courts.Hardy, 803 F.2d at 1038-1040.
Reduction in administrative costs is a consideration that may also be taken into account in developing a plan of distribution. Wang, 944 F.2d at 86-87, 87-88; see also Fischbach, 133 F.3d at 175; Elliott, 953 F.2d at 1566; S.E.C. v. Wencke, 783 F.2d 829, 837 (9th Cir. 1986).
In the context of an S.E.C. receivership distribution plan, due process requirements generally include giving investors that opportunity to have a fair hearing, present evidence, and appeal adverse rulings. As to the right of an investor affected by a plan of distribution to appeal the plan, see S.E.C. v. Enter. Trust Co., 559 F.3d 649 (7th Cir. 2009).
The broad discretion granted the Court in developing a plan of distribution is particularly important in addressing Ponzi-Pyramid marketing schemes, with their multiple investment programs, numerous investors, and non-defendants who may still have some truth of culpability. Thus in the Basic Energy receivership, the receiver recommended (and the Court adopted) a plan which created a single pool of assets for all investors, rather than tracking claims of investors in each of the multiple programs to the investors in that particular program. However, investors were classified as to whether they were “non-marketers” (claim full value), “substantial marketers” (claim reduced by 90%), “insubstantial marketers” (claim reduced by 10%), or defendants (claim reduced to zero). The Court also developed guidelines concerning the treatment of affiliates of defendants and marketers, various aspects of this plan were implicitly affirmed in the Sixth Circuit’s Basic Energy opinion.
Another interesting issue in dealing with asset distribution is the relative treatment of trade creditors vis-à-vis investor claimants. In view of the Court’s tremendous discretion in equity receiverships, the Court should also have broad latitude in resolving this issue. See, e.g., Norwest Bank, 245 F. App’x at 495. However, note that a bankruptcy trustee or judge would not have the same latitude if the matter were being handled in a bankruptcy.
The use of summary proceedings to implement the distribution plan and to administer the Estate is customary in federal receiverships and is perfectly permissible under “due process” rules so long as potential claimants are given the opportunity to be heard and to present their claims. Basic Energy, 273 F.3d at 668-671; Elliott, 953 F.2d at 1566-67, 1570-71; Hardy, 803 F.2d at 1040; Wencke, 783 F.2d at 834-839; United States v. Arizona Fuels Corp., 739 F.2d 455, 458-460 (9th Cir. 1984). See also Warfield v. Alaniz, 453 F. Supp. 2d 1118 (D. Ariz. 2006); S.E.C. v. Pension Fund of Am. L.C., 377 F. App’x 957, 961-62 (11th Cir. 2010). Thus, as the Eastern District of New York noted in F.D.I.C. v. Bernstein, 786 F. Supp. 170 (E.D.N.Y. 1992):
. . . One common thread keeps emerging out of the cases involving equity receivership—that is, a district court has extremely broad discretion in supervising an equity receivership and in determining the appropriate procedures to be used in its administration.
In keeping with this broad discretion, “the use of summary proceedings in equity receiverships as opposed to plenary proceedings under the Federal Rules [of Civil Procedure], is within the jurisdictional authority of a district court.” Such procedures “avoid formalities that would slow down the resolution of disputes. This promotes judicial efficiency and reduces litigation costs to the receivership,” thereby preserving receivership assets for the benefit of creditors. 786 F.Supp. 170, 177-78, citations omitted.
See also Hardy, 803 F.2d at 1038 (“A district judge supervising an equity receivership faces a myriad of complicated problems in dealing with the various parties and issues involved in administering the receivership. Reasonable administrative procedures, crafted to deal with the complex circumstances of each case, will be upheld. A district judge simply cannot effectively and successfully supervise a receivership and protect the interests of its beneficiaries absent broad discretionary power.”); United States v. Fairway Capital Corp., 433 F. Supp. 2d 226, 241 (D.R.I. 2006), aff’d, 483 F.3d 34 (1st Cir. 2007).
Summary proceedings are used in receivership cases because they promote judicial efficiency and reduce time and costs associated with a receivership. The Elliott court stated:
The government’s and parties’ interests in judicial efficiency underlie the use of a single receivership proceeding. Smith v. Am. Indus. Research Corp., 665 F.2d 397, 399 (1st Cir.1981). A summary proceeding reduces the time necessary to settle disputes, decreases litigation costs, and prevents further dissipation of receivership assets. SEC v. Wencke, 783 F.2d 829, 837 (9th Cir.1986), cert. denied, 479 U.S. 818, 107 S.Ct. 77, 93 L.Ed.2d 33 (1986). United States v. Arizona Fuels Corp., 739 F.2d 455, 460 (9th Cir.1984).
Elliott, 953 F.2d at 1566.
The use of summary proceedings in receivership cases has been upheld when the parties have been given a full and fair opportunity to present their claims and defenses.S.E.C. v. Universal Fin., 760 F.2d 1034, 1037 (9th Cir. 1985). Summary proceedings survive due process challenges as long as the summary procedure provides the parties adequate notice, an opportunity to file responsive pleadings and perform discovery and the right to present evidence and cross-examine witnesses at a hearing before the court. S.E.C. v. Black, 163 F.3d 188, 199 (3d Cir. 1998); Wencke, 783 F.2d at 838;Elliott, 953 F.2d at 1567.
Courts have also specifically upheld a receiver’s ability to seek turnover orders through summary proceedings. Commodity Futures Trading Comm’n v. Topworth Int’l, Ltd., 205 F.3d 1107 (9th Cir. 1999). In Topworth, a court appointed receiver sought the turnover of assets held by a non-party which he believed rightly belonged to the receivership estate and which were the subject of a default judgment entered against defendant Topworth. At a hearing initiated by the receiver to show cause why those monies should not be paid into the receivership estate, the Court entered an Order directing that the monies be turned over to the receivership estate. Id. at 1111. Topworth appealed the order, claiming that the summary procedure used by the district court was improper and violated due process. Id. The appellate court rejected Topworth’s argument, stating “for claims of nonparties to property claimed by receivers, summary proceedings satisfy due process so long as there is adequate notice and opportunity to be heard.” Id. at 1113. See also S.E.C. v. Ross, 504 F.3d 1130, 1142 (9th Cir. 2007) (Where court is attempting to determine if receivership is rightful owner of property in the hands of another, “a mere custodian [of the receivership property] is generally entitled simply to notice and an opportunity to be heard.”); Fairway Capital Corp., 433 F. Supp. 2d at 241-47 (rejecting the necessity of a plenary trial because the Court provided claimant with “an opportunity to present evidence and make arguments regarding the disputed facts.”) For a detailed discussion of due process issues, seeElliott, 953 F.2d at 1566-68, 1570.
Note, however, that the Ninth Circuit has held that summary proceedings may only be utilized in fraudulent conveyance proceedings or in other matters involving a “nominal” defendant, where the basis for the proceeding is not the defendant’s own wrongful conduct. Ross, 504 F.3d at 1141-1145. And the Ninth Circuit has held that where claims are legal, rather than equitable, there is a constitutional right to a trial by jury. Eberhard v. Marcu, 530 F.3d 122, 135-137 (2d Cir. 2008).
A receiver need not separately serve process on the various claimants in a receivership claims procedure so long as the claimants are given adequate notice. Fairway, 433 F. Supp. 2d at 237. A federal court is not required to abstain from exercising its jurisdiction over claims in a receivership estate simply because of a pending parallel proceeding in state court. Id. at 238-240.
A receiver may properly deny claims that are not substantiated by the claimant.Fairway, 433 F.Supp.2d at 246-47.
A receiver’s findings of fact and conclusion of law made in connection with his acceptance or rejection of creditor claims will be reviewed de novo by the court if objected to. Fairway, 433 F. Supp. 2d at 231-32.
As to the right of an investor affected by a plan of distribution to appeal the plan, seeS.E.C. v. Enter. Trust Co., 559 F.3d 649 (7th Cir. 2009).
The Circuits are in disagreement as to what constitutes an appealable order where distribution plans are involved. In S.E.C. v. Capital Consultants, 453 F.3d 1166 (9th Cir. 2006), the Court of Appeals for the Ninth Circuit held that an order finally determining the rights of some, but not all, claimants to a receivership distribution plans was not appealable as a “collateral order,” though the order might be appealed pursuant to Rule 54(b) of the Federal Rules of Civil Procedure if, but only if, the requirements of that Rule (an express determination by the district court that “no just reason for delay exists” coupled with the entry of judgment) are satisfied. See also Commodity Futures Trading Comm’n v. Forex Liquidity LLC, 384 F. App’x 645, 647 (9th Cir. 2010). This is contrary to the holdings of the Sixth Circuit in Basic Energy, 273 F.3d at 665-67 and the Fifth Circuit in S.E.C. v. Forex Asset Mgmt. LLC, 242 F.3d 325, 330-31 (5th Cir. 2001), both of which held that such orders were appealable as “collateral orders.”
