How To Fight 'Relief Defendant' Status In SEC Actions

By Perrie Weiner, Jerome Tomas and Aaron Goodman 
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Law360 (May 14, 2020, 12:32 PM EDT) --
Perrie Weiner
Jerome Tomas
Aaron Goodman
The ostensible mission of the U.S. Securities and Exchange Commission is to protect investors; maintain fair, orderly and efficient markets; and facilitate capital formation. The SEC Division of Enforcement does that, in part, through nonpublic investigations, which may result in civil or administrative charges or, if referred to a U.S. attorney's office, criminal charges.

Particularly in this COVID-19 environment, where the number of SEC investigations is increasing and money is tight, you can expect the SEC to cast an ever-wider net in enforcement actions to achieve complete disgorgement from all parties who received ill-gotten gains — good and bad actors alike. That is why what you are about to read is so important.

One of the SEC's most powerful enforcement mechanisms and deterrents, is the ability to seek disgorgement — i.e., the recovery of ill-gotten gains.  However, in certain cases, the hedge fund or corporate defendant, or their principal(s), is no longer in possession of the entire amount of ill-gotten gains, which the SEC seeks to have disgorged.

In fact, over the years a body of case law has developed, holding that the court may order the return of monies or assets, including in those circumstances where the party in possession is not accused of wrongdoing.[1]

Although there are certainly instances where third parties are in possession of ill-gotten gains as a part of a broader scheme to avoid detection or collection, that is not always the case. For example, if a hedge fund makes distributions of what the SEC deems to be illegal proceeds, the SEC will often expand its investigation to determine whether there are any third-party recipients in possession of those funds. 

At times, unknowing participants will receive the fruit of a fraudulent scheme without having any intention of being part of such a scheme. This innocent recipient — agent, trustee, receiver, partner, employee, spouse, parent or friend — may still be named by the SEC in an enforcement action as a so-called relief defendant. However, if the party can show a legitimate interest in or ownership claim to the funds, they may not be named.

As a result of COVID-19 and the related market disruption and carnage on Wall Street, the SEC, now more than ever, is actively investigating potentially manipulative and fraudulent trading activity. As increased trading-related enforcement actions become more likely, so does the likelihood that the SEC will aggressively pursue naming non-culpable third parties as relief defendants. Recent experience with the SEC Division of Enforcement serves as a reminder of the key questions and issues anyone facing potential relief defendant status should ask. 

Who is a relief defendant?

Where the SEC believes that a party is wrongfully in possession of the proceeds of a securities law violation, it may bring an action in federal district court seeking an order requiring that party to relinquish those funds. Such parties are referred to as relief defendants.  Relief defendants are nominal defendants who, although not themselves accused of wrongdoing, are alleged to have nonetheless received ill-gotten gains.

The federal securities laws do not expressly provide the SEC with the authority to seek and obtain such relief from a nonculpable third party. Instead, the SEC seeks, and federal district courts grant, such relief under the general power of federal district courts to provide equitable relief. Disgorgement of unjustly retained wealth — the relief sought against nominal or relief defendants — is a long-standing remedy within a court's equity powers.[2]

Under this equitable theory of recovery, the SEC treats the bad actor and nonculpable third-party recipient the same — i.e., there is no meaningful difference — for the purpose of disgorgement.[3] Indeed, a court may order the very same relief — disgorgement of all of the fraudulent proceeds — against a person not accused of wrongdoing.[4] However, courts cannot order relief defendants to return funds where those defendants can show they have a legitimate claim to the funds.[5]

The most common relief defendants are individuals who typically take possession of money or property, such as trustees, receivers, agents and depositories, including, at times, law firms and lawyers acting in that capacity.[6] But potential relief defendants are not limited to these categories of individuals or entities. A relief defendant could be anyone who has received a perceived benefit flowing from the misconduct of another and does not have legitimate claim to those funds — or rather, where the SEC has insufficient evidence of the party's legitimate claim.

In that case, the result is not enviable. Unless this party can negotiate a resolution through a restitution-type agreement with the SEC in advance of the filing — often the case where a receiver has been appointed — the party will be named as a relief defendant in a publicly filed enforcement action. The filing, alone, can lead to adverse publicity and negative inferences, despite the fact that the recipient has done nothing wrong. 

What is required to establish a legitimate claim?

Most parties that have been involved in an SEC investigation view it as a victory not to be named as a substantive defendant at all.  However, in certain cases, exposure may linger where the SEC believes that a party is in possession of assets derived from securities law violations to which they do not have a legitimate claim. Establishing a legitimate claim to these assets is paramount in avoiding relief defendant status in these cases.

What if the party worked for the money and received those payments for services rendered in the ordinary course? What if the party received the funds as a part of a routine distribution? What is clear is that mere possession of what the SEC claims to be ill-gotten gains is insufficient.

And, despite an early demand by the SEC that a third party give up significant assets or face enforcement action, such equitable relief is only available where the SEC can prove both that assets were illegally obtained and that the nonculpable party has no independent interest or claim to the funds.[7]

To establish a legitimate claim, a nonculpable party in possession must only show an ownership interest in, or claim to, the assets to preclude relief defendant status.[8] Indeed, because this is an equitable remedy, where a party has an ownership interest in the property at issue in the litigation, they are by definition not a proper relief defendant and cannot be a target for disgorgement.[9]

While the courts have not provided specific guidelines on what is sufficient to constitute an ownership interest or legitimate claim, it is widely recognized that where a party has provided consideration — something in exchange — for the assets, then the party is not properly the subject of relief status.[10] In contrast, where a relief defendant gave no consideration for the asset, they do not have a legitimate claim.  

Consideration, sufficient to defeat relief status, can come in many forms, including: outstanding loans from the nonculpable party;[11] services provided in exchange for the assets at issue;[12] or an investment by the nonculpable party giving rise to the proceeds.[13]

However, a gratuitous transfer, without consideration, does not give rise to a legitimate claim.[14] For example, where a corporation is owned in name by the defendant's mother but used by the defendant to channel proceeds of his securities law violations, the defendant's mother may be a proper relief defendant.[15] As such, although there are many grounds upon which a party may assert a legitimate claim, in practice, the burden will be on the party to convince the SEC staff of the legitimacy of their claim. 

How does a party challenge relief status in an SEC investigation?

If the SEC enforcement staff believe that a party has not engaged in substantive violations of the federal securities laws, but is nevertheless in possession of ill-gotten gains to which they are not entitled, the staff may either issue a Wells notice indicating an intent to name that party as a relief defendant, or in certain circumstances, might simply add the party as a relief defendant in the enforcement action.  

The Wells notice will indicate primarily that the SEC intends to name the identified party as a relief defendant from whom they intend to seek disgorgement. It will then be in that party's discretion whether to make a Wells submission or, alternatively, submit a white paper to the SEC enforcement staff to establish the legitimacy of their claim to the funds. Alternately, the party could seek a meeting with the staff, either in lieu of or after making such a submission. 

The exact approach taken and breadth of the arguments a party makes in any submission, will vary depending upon the facts of the case. However, it is an almost certainty that the challenge would involve setting forth legal, factual and policy arguments that support a legitimate claim.

This may be the first time that the SEC staff has really examined the nuances of the legitimate claim to these funds, as they are often more focused on the substantive violations during an investigation. Any submission or presentation should be viewed not only as a defense maneuver, but also an attempt to educate the SEC on the challenges it would face if the matter was litigated.

Furthermore, since an order against a relief defendant requires the district court to exercise its equitable powers, arguments about the fairness of seeking this relief should be highlighted in any discussions with the SEC enforcement staff and in any Wells, or other, submission.

A successful challenge could mean the stark difference between a party being publicly named in an enforcement action — potentially leading to negative press and negative inferences with a negative impact to their career or reputation — or emerging without any mention of their involvement in the complaint or SEC press release.

During and after COVID-19, and based upon our current experience, you can assume there will be a surge of SEC investigations and enforcement actions naming, in addition to bad actors, others who unknowingly received ill-gotten gains, in an effort to obtain disgorgement. If you are on the receiving end of a Wells notice where the recommendation is to pursue you as a relief defendant, you should engage counsel expert in this area to go from being a relief defendant to not a defendant at all.

Perrie Weiner and Jerome Tomas are partners, and Aaron Goodman is counsel, at Baker McKenzie.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] SEC v. Milan Capital Grp., Inc. , 00 CIV. 108 (DLC), 2000 U.S. Dist. LEXIS 2191, at *8 n.3 (S.D.N.Y. Feb. 29, 2000) (citing SEC v. Cavanagh , 155 F.3d 129, 136 (2d Cir. 1998)). 

[2] See SEC v. Texas Gulf Sulphur Co. , 446 F.2d 1301, 1307 (2d Cir. 1971).

[3] SEC v. Cross Fin. Servs. , 908 F. Supp. 718, 726 (C.D. Cal. 1995). 

[4] SEC v. Cavanagh , 155 F.3d 129, 136 (2d Cir. 1998).

[5] CFTC v. Walsh, 618 F.3d 218, 226 (2d Cir. 2010). 

[6] See Janvey v. Adams , 588 F.3d 831, 835 (5th Cir. 2009). 

[7] SEC v. Cherif , 933 F.2d 403, 414 n.11 (7th Cir. 1991).

[8] SEC v. Founding Partners Capital Mgmt. , 639 F. Supp. 2d 1291, 1294 (M.D. Fla. 2009). 

[9] SEC v. George , 426 F.3d 786, 798 (6th Cir. 2005) (citation omitted).

[10] FTC v. LeadClick Media, Ltd. Liab. Co. , 838 F.3d 158, 177 (2d Cir. 2016) (internal citation omitted); see also Walsh, 618 F.3d at 226; SEC v. Rosenthal, 426 F. App'x 1, 3 (2d Cir. 2011). 

[11] Janvey, 588 F.3d at 835.

[12] CFTC v. Kimberlynn Creek Ranch, Inc. , 276 F.3d 187, 192 (4th Cir. 2002). 

[13] See Janvey, 588 F.3d at 835.

[14] See Cavanagh, 155 F.3d at 137. 

[15] See SEC v. Hickey , 322 F.3d 1123, 1130-32 (9th Cir. 2003).

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