Thursday, March 23, 2017

Sham loan doesn’t defeat relief defendant jurisdiction

By John M. Jascob, J.D., LL.M.

Addressing an issue of first impression, the Ninth Circuit ruled that putative relief defendants in an SEC disgorgement proceeding could not divest a court of jurisdiction over them simply by asserting a facially colorable claim to the disputed funds. The panel held that the district court properly asserted jurisdiction to determine the legal and factual legitimacy of the appellants’ claim that they received the $5 million at issue as a loan. The district court also did not err in finding that the loan was a sham and that the funds transferred to the appellants were ill gotten as a matter of law (SEC v. World Capital Market, Inc., March 21, 2017, Tallman, R.).

“Loan” agreement. The SEC had filed a motion for an order of disgorgement against the appellants, alleging they had received $5 million of the approximately $57 million of dollars unlawfully raised by Phil Ming Xu and his related entities in an international Ponzi scheme. One of the appellants, who provided legal advice to Xu regarding tax, corporate, and immigration matters, was aware by the fall of 2013 that Xu and his entities were under investigation by the SEC for securities law violations.

When the appellant learned in February 2014 that Xu’s outside securities law counsel had recommended settling with the SEC for $64 million, he texted Xu and advised him to “drop” his outside counsel because the settlement sum was “ridiculous.” He also wrote: “Perhaps the new counsel can delay the negotiations so that your assets seem less.” Three weeks later, Xu transferred $5 million from the bank account of one of his entities to the appellant’s attorney-client trust account.

Although Xu asked the appellant to hold the funds for future business endeavors, the appellant responded that he would not simply hold the funds. Instead, on the day after the transfer, the appellant prepared and executed a document he later characterized as a “loan agreement.” The appellant further testified that the loan was in furtherance of previously discussed proposals to set up a fund for future investments in Africa, and that the “no recourse” language in the agreement meant that he could do whatever he wanted with the money in terms of investment ventures. The appellant later wired almost $1 million of the funds to a company retained by Xu to help establish a political action committee and for which the appellant acted as general counsel.

In May 2014, the SEC amended its complaint against Xu to add the individual appellant and the company as relief defendants. Although the appellants argued that they were not proper relief defendants because they had a legitimate claim to the $5 million they received from Xu, the district court ruled that the appellants had no legitimate claim to the funds because the loan agreement with Xu was a sham.

Question of legitimacy. On appeal, the appellants contended that once they advanced a facially colorable claim to the disputed funds as loan proceeds, the district court was immediately divested of jurisdiction to adjudicate the legitimacy of their claim and proceed any further against them as relief defendants. Instead, they insisted that they would have to be named as defendants either in the SEC’s underlying civil enforcement action against Xu or in a stand-alone lawsuit, with all of the rights attending a civil action.

The Ninth Circuit panel disagreed, however, rejecting the individual appellant’s argument that the receiver could not proceed against him as a relief defendant because the putative loan agreement gave him “presumptive title” to the money. This position begged the question, according to the appellate court, because it necessarily assumed that the loan was not a sham—the very issue the district court resolved in deciding whether to allow the proceedings to continue.

Accordingly, the panel joined the Fourth Circuit in holding that relief defendants cannot defeat jurisdiction simply by asserting an ownership interest in the disputed funds. Rather, they must assert an interest both “recognized in law” and “valid in fact.” Otherwise, any third party with a custodial claim to the proceeds of securities violations committed by others would be able to defeat relief defendant jurisdiction “simply by stating a claim of ownership, however specious,” the court reasoned.

Sham loan. The appellate panel next held that there was no clear error in the district court’s finding that the $5 million transfer as a loan was a sham. In concluding the loan agreement was a ruse designed to keep $5 million of Xu’s money out of the reach of the SEC, the district court relied not only on its rejection of the individual appellant’s "incredible" testimony, but also on impeaching evidence such as: the appellant's text message to Xu advising him to delay the SEC negotiations so that they could make his assets “seem less;” Xu’s transfer of the $5 million less than three weeks later, before any discussion of a potential loan, along with a contemporaneous request to “hold” the money; the cursory agreement prepared by the appellant after the transfer, which lacked the normal provisions of a valid loan agreement; the appellant's testimony that he had no personal legal obligation to repay the $5 million; and a request by Xu to return the $5 million just nine days after the transfer. Accordingly, the Ninth Circuit affirmed the ruling of the lower court.

The case is No. 15-55325.