All Mixed Up, Don’t Know What to Do the Eleventh Circuit Knows What to Do – Sorting Out Commingled Proceeds of a Ponzi Scheme

Contributed by Rich Mullen
Bankruptcy practitioners regularly puzzle over the complicated statutory web that is created when federal bankruptcy law intersects with state and other federal law, and many pride themselves on a keen ability to tackle questions that at first blush appear to have nothing to do with bankruptcy.  Such was the case in United States v. Rothstein (In re Rothstein, Rosenfeldt, Adler, P.A.), where the Government battled with the debtor’s chapter 11 trustee over whether certain ill-gotten gains obtained by the debtor’s Chairman and CEO could be forfeited to the Government when that money was commingled with the debtor’s receipts from legitimate business sources.  After noting that it had never before addressed the issue, the United States Court of Appeals for the Eleventh Circuit concluded that the money in the debtor’s bank accounts at the time the debtor’s Chairman and CEO was charged could not be directly forfeited to the Government because the accounts consisted of legitimate and illegitimate funds that could not be divided without difficulty.
In Rothstein, the law firm debtor found itself in bankruptcy after creditors filed an involuntary chapter 11 petition in the United States Bankruptcy Court for the Southern District of Florida claiming, among other things, that they were victims of a Ponzi scheme orchestrated by Scott Rothstein, who was a named partner and the Chairman and CEO of the debtor.  Just a few weeks after the filing of the involuntary petition, the United States Attorney for the Southern District of Florida filed a five-count information charging Rothstein with conspiring to violate the Racketeer Influenced and Corrupt Organizations Act, 18 U.S.C. § 1962(c), by employing the debtor to engage in mail and wire fraud and money laundering.  The charges were based on allegations similar to those made by the debtor’s creditors, namely that Rothstein operated a Ponzi scheme by fraudulently inducing investors to loan money and invest funds based on false statements, documents, and computer records.  Aside from seeking Rothstein’s criminal conviction, the information sought the forfeiture of property, including certain of the debtor’s bank accounts on the theory that the accounts constituted proceeds of Rothstein’s Ponzi scheme or property acquired with such proceeds.
Naturally, there was tension between the chapter 11 trustee, who was appointed by the bankruptcy court shortly after the filing of the involuntary petition, and the Government, which wanted to obtain forfeiture of Rothstein’s interests in the debtor’s property.  Over opposition from the chapter 11 trustee, the United States District Court for the Southern District of Florida entered an order restraining Rothstein and the debtor from disposing of property listed in the information, including certain of the debtor’s bank accounts.  After Rothstein pled guilty and agreed to forfeit to the Government the property listed in information, the chapter 11 trustee petitioned the district court to order the Government to return the debtor’s bank accounts listed in the information because those accounts were held in the debtor’s name.  The chapter 11 trustee also requested that the court declare that the debtor held interests in other property listed in the information because those assets were acquired with funds from the debtor’s bank accounts.
Notwithstanding the chapter 11 trustee’s petition, the district court sentenced Rothstein and ordered that he forfeit his right, title and interest to the property identified in the court’s preliminary order of forfeiture.  The Government immediately attempted to seize the funds held in certain of the debtor’s bank accounts, but one of the banks rejected the attempt due to the ongoing dispute between the chapter 11 trustee and the Government.  The bank sought guidance from the district court, which ordered the bank to turn the debtor’s bank accounts over to the Government.
The Government then moved to dismiss the chapter 11 trustee’s petition, and the district court granted the motion to the extent that it covered property other than the debtor’s bank accounts because the Government “unequivocally represented” that it would use the forfeited property to reimburse qualified victims through a restitution process that provided the chapter 11 trustee with an adequate remedy at law, and because it would be “patently unequitable” to return money to the debtor’s estate when it could be returned directly to the victims.  Later, the chapter 11 trustee moved for summary judgment as to the debtor’s bank accounts arguing that the accounts were indisputably the debtor’s accounts, and, after an ancillary hearing, the district court ordered that some portion of the funds held in the bank accounts be returned to the chapter 11 trustee because the funds did not constitute proceeds of Rothstein’s criminal conduct.  Nevertheless, after the Government’s motion for reconsideration, the district court ordered that funds in two of the debtor’s accounts more likely than not were “proceeds of fraud,” and should thus remain in the Government’s custody.
On appeal, the Eleventh Circuit concluded, likening the case to the Third Circuit’s decision in United States v. Voigt, that the debtor’s bank accounts were not forfeitable because they contained commingled proceeds that could not be divided without difficulty in that they were comingled with legitimate income the debtor received over a period of four years.  In reaching this conclusion, the Eleventh Circuit recognized that the Government proceeded under the theory that the accounts comprised proceeds of Rothstein’s Ponzi scheme, and that property can only be forfeited as proceeds when the Government establishes the “requisite nexus between the property and the offense.”  Further, the Eleventh Circuit stated that where the Government can make no such showing, it must resort to certain substitute asset provisions of 18 U.S.C. § 1963 and 21 U.S.C. § 853, which require the court to order forfeiture of property up to the value of commingled property where, as a result of any act or omission of the defendant, the proceeds have been commingled with other property that cannot be divided without difficulty.
The Eleventh Circuit clarified its holding, stating that its conclusion did not foreclose the Government from seeking forfeiture of Rothstein’s property interests that were neither proceeds of his criminal activity nor derived therefrom.  Thus, the Government could move to amend the judgment in order obtain forfeiture of substitute assets (up to the value of any forfeitable proceeds that have been commingled) such as Rothstein’s interests in the debtor, which would allow the Government to lay claim to Rothstein’s share of the debtor’s assets.
Finally, the Eleventh Circuit also ruled that, in relying on equitable principles, the district court erred in granting the Government forfeiture of the other properties listed in the information and the preliminary order of forfeiture.  Instead, the Eleventh Circuit directed the district court to resolve the factual issues of whether the other property was purchased with proceeds from the debtor’s bank accounts and whether the properties were acquired with proceeds of Rothstein’s criminal activity.
While the Eleventh Circuit did not give us any new insight into bankruptcy law per se, its decision in Rothstein does answer important questions concerning property that may be part of a debtor’s estate, and reminds us that a debtor’s reorganization can easily be impacted by non-bankruptcy federal and state law.  Through an interpretation of federal criminal law, the Eleventh Circuit protected some of the debtor’s assets because the debtor’s legitimate income could not easily be separated from the proceeds of the criminal activity of the debtor’s principal.  The decision is a potential boon to the debtor’s creditors, who may receive a greater recovery than they would have otherwise received.  Bankruptcy practitioners should take note because it is not uncommon for a business to find itself in bankruptcy as a result of unlawful acts of the business’s principals.