. '.:,

, , ,~":

. , "'~:

~~..?

, '·f:.,

, .. " .: '.. '

..- ."

. ; .-:.. " .y•...

( .

Federal Trad.· Camara.ion

Wash1nqton, D'. C•. . 20580 .

(202).326-3285

DATIID.mpps~ . LESLZB. RICB MEUWf '., Att:Qmey• . ' .'.

" . ..-: . ' .. '.'

JAY c:.s~ .'

Deputy General Counsel: ..'

zRtms.r.. ir. XSDsTAM" .As.iaunt General couria.l ., .. '.

SBc:DRITUs .• AND' EXaWfGZ. c;oJQIIsSiOIf',"'> .'

'. Pl.intift-Appell~.~ ...•...•. ' '.

Dr TBB mn'tED STATES com nOPAP~ .'

l'Oa TIlE SBCOIfD cmc:orr '..

" .. '

'. :.

Appdlanu.

DENlfIS 8. LEVIn /kla··D. DIAMOIfD,

Di'tERNATIORAL GOLD, mc., DIAMOIfD BOLDDfGS, S.A.

and 8ERIfHARD MElD,

Detendanu,

:': : ....

On Appeal ProIa t:ba unit:ect Stat_ Di.trict Court

for ~. Southam Diatrict ot Ifew York

V890021

. ~:' '.,

......

i8~tS294,.· 88-6296". ;8-629a.~. 88-6300, 8i~630~ ·arid·· 88-63~:~'

BRID' I'OR TIlE ~EJtAL TRADZ COMMISSIOR AS AllICUS "ctnUAE

ARDEll AY ASSOCXA'1'ZS, .t: al., tJltIITED STATES OF AMERICA,

R08EllT K. laLlaS, DDlfIS 8. LBVDfB, and !fEW YORK

S'rAD DDAR1'JIEII'1' or TAXA'l'IO AHD rDQlfCE,

0 ••

. :.," ..

. t:

COMMISSION AUTHORIZED:
TABLE OF CONTENTS

TABLE OF CONTENTS

TABLE OF AUTHORITIES

STATEMENT OF THE ISSUES.

INTEREST OF THE FEDERAL TRADE COMMISSION .

STATEMENT OF THE CASE. .

SUMMARY OF ARGUMENT. • •

ARGUMENT • • • • • • •

i

ii

1

2

6

8

9

I.

II.

THE DISTRICT COURT'S IMPOSITION OF

A CONSTRUCTIVE TRUST IS WITHIN ITS

STATUTORY AUTHORITY TO FORMULATE

EQUITABLE REMEDIES FOR VIOLATIONS

OF FEDERAL SECURITIES LAWS •.•.

THE COURT'S AUTHORITY TO IMPOSE

A CONSTRUCTIVE TRUST CANNOT . BE THWARTED BY THE FORUM STATE'S ~ONSTRUCTlVE TRUST DOCTRINE .

9

11

III. A CONSTRUCTIVE TRUST DEFEATS

IRS PRIORITY CLAIMS . . • •

CONCLUSION . . . . . . . . . • . .

i

15

19
TABLE OF AUTHORITIES

CASES:

Burks v. Lasker, 441 U.S. 471 (1979) .

Beatty V. Guggenheim ExP1QratiQn CQ.,

225 N.Y. 380, 122 N.E. 378 (1919).

Atlas. Inc. V. United States,

459 F. Supp. 1000 (D. N.D. 1978)

V. Alaska Land Leasing. Inc.,

NQ. 84-5416 (C.D. Cal. July 23, 1984).

15

15

15, 16

12

16

11

13, 17

14

10

10

10

16

3

. . . . . . . . .

372 F. Supp. 563

American Serve CQ. v. HendersQn,

120 F.2d 525 (4th Cir. 1941) •

AgpilinQ V. United States,

363 U.S. 509 (1960) •••••

AlscQ-Harvard Fraud LitigatiQn,

523 F. Supp. 790 (O.O.C. 1981)

pennis v. United States,

(E.D. Va. 1974)••••

V. CQ PetrQ Marketing GrQUp. Inc.,

680 F.2d 573 (9th Cir. 1982) •••••

V. ~, 591 F.2d 1211 (6th Cir.),

~. denied, 442 U.S. 921 (1979).

v. Muller, 570 F.2d 1296

(5th Cir. 1978)•••••••

ASSQc. Brick MasQn CQntractQrs. Inc. v. HarringtQn,

820 F.2d 31 (2d Cir. 1987) .•.•.••.•.•

ChiCagQ Board Qf Trade V. JQhnsQn,

26~ U.S. 1 (1924)••••••.••

V. Alaska Land Leasing. Inc.,

5 Trade Reg. Rep. (CCH) ! 22,459

(July 14, 1987)••••••••• 4

ii
TABLE OF AUTHORITIES

CaNT' 0

CASES:

v. Austin Galleries. Inc., 1988-2 Trade

Cas. (CCH) ! 68,340 (N.D. Ill. 1988) ...

v. Eyans Products Co., 5 Trade Reg. Rep.

(CCH) ! 22,480 (Oct. 22, 1987) ....

v. H.N. Singer. Inc., 668 F.2d 1107

(9th Cir. 1982)•••.•.......

3

4

3, 10

v. Leland Indus .. Inc., (1983-1987 Transfer

Binder) Trade Reg. Rep. (CCH)

! 22,297 (C.D. Cal. Oct. 11, 1985) . . . . . .. 4

v. Rainbow Enzymes. Inc.,

No. Civ-87-1522 (D. Ariz. 1988) .•.

v. Rare Coin Galleries of America.

1986-2 Trade. Cas. (CCH) ! 67,338 . (D. Mass. 1986)•••.•.•.•..

. ... ..

Inc. ,

5

3, 10

V. Rare Coins of Georgia, 5 Trade Reg.

Rep. (CCH) ! 22,309 (N.D. Ga. Dec. 5, 1988).

v. U.S. Oil Gas CO&p.,

748 F.2d 1431 (11th Cir. 1984)

v. U.S. Oil Gas CO&p.,

No. 83-1702-Civ-Hoeveler

(S.D. Fla. July 10, 1987).

4

2, 9, 10

4, 5

v. World Trayel Vacations Brokers,

861 F.2d 1020 (7th Cir. 1988) ..••

v. Worldwide Factors, Ltd.,

No. Civ-S-88--293-RDF (LRL)

(D. Nev. May 19, 1988) •••.

Inc. , 2

5

First National Bank of Cartersville v. Hill, . 412 F. Supp. 422 (N.D. Ga. 1976) •..••.

Hecht Co. v. Bowles, 321 U.S. 321 (1944) •.

Holmberg v. Armbrecht, 327 U.S. 392 (1946) .

iii

16

15

12, 13
TABLE OF AUTHORITIES

CONT' 0

CASES:

In re Bevill. Bresler & Schulman. Inc.,

Civ. No. 85-2224 (ORO) (O.N.J. Jan. 10, 1989).. 14

In re Independent Clearing HQuse CQ.,

41 B.R. 985 (Bankr. O. Utah 1984),

aff'd in part, rev'd in part sub nom.

In re Universal Clearing House CQ.,

62 B.R. 118 (0. Utah 1986) .•..•..

In re JQhnsQn, 80 B.R. 791

(Bankr. E.O. Va. 1987) ..

In re NQrth American CQin & Currency. Ltd.,

767 F.2d 1573 (9th Cir. 1985) .....•.

In re TeltrQnics. Ltd,

649 F.2d 1236 (7th Cir. 1981).

MQrgan v. ~, 419 F.2d 993

(7th Cir. 1969)•.. .•.•

Niagara MQhawk PQwer v. Bankers Trust CQ.

Qf Albany, 791 F.2d 242 (2d Cir. 1986) .

PQrter v. Warner HQ1ding CQ.,

328 U.S. 395 (1946) .•..•.

Reliance Insurance CQ. v. BrQwn,

40 B.R. 214 (W• 0 • Mo. 1984). •

Republic Qf Philippines v. MarcQs,

806 F.2d 344 (2d Cir. 1986).

RQbinsQn v. Pan American WQrld Airways. Inc.,

777 F.2d 84 (2d Cir. 1985) ....•...•

v. Capital CQunsellors. Inc.,

332 F. supp. 291 (s.D.N.Y. 1971)

v. Certain UnknQwn Purchasers,

817 F.2d 1018 (2d Cir. 1987) •.

v. Levine, 689 F. supp. 317

(S.D.N.Y. 1988)•......

iv

15

14

14

14

12

14

10

18

11, 14

12

10

9

passim
TABLE OF AUTHORITIES

CONT'O

CASES:

SIC v. R.J. Allen' Associates. Inc.,

386 F. Supp. 866 (S.D. Fla. 1974) ...

v. Texas Gulf Sulphur Co.,

446 F.2d 1301 (2d Cir.), ~. denied,

404 U.S. 1005 (1971) .

Sperry v. Bargqren, 523 F.2d 708

523 F.2d 708 (7th Cir. 1975) •

Sprague v. Ticonic National Bank,

307 U.S. 161 (1939) .

United States v. Fontana, 528 F. Supp. 137

(S.D.N.Y. 1981) .•.• .•...•

STATUTES:

Commodity Exchange Act:

7 U.S.C. S 2 •.

7 U.S.C. S 13a-l

First Judiciary Act:

1 Stat. 73 • • . •

Federal Trade Commission Act:

S 5(a), 15 U.S.C. S 45(a) ....•

S 13(b), 15 U.S.C. S 53(b) ..••...

S 19, 15 U.S.C. S 57b••.........

Internal Revenue Code:

S 6321, 26 U.S.C. S 6321

Investment Advisors Act (lAC) ..

Investment Company Act (ICA) •.

v

10

10

12

13

16, 17, 18

9

9

12

2

passim

3

7, 8, 15

13

13
TABLE OF AUTHORITIES

CONT'D

STATUTES CONT'D:

Securities and Exchange Act:

S 10(b), 15 U.S.C. S 78j(b).

S 14(e), 15 U.S.C. S 78n(e).

Securities Investor Protection Act (SIPA) ..

Rules and Regulations:,

17 C.F.R. S 240.10b-5.

17 C.F.R. S 240.14e-3.

MISCET,T,mEOUS:

2, 6

2, 6

14

6

6

1 Pomeroy, Equity Jurisprudence (4th ed.) S 155.. 13

5 Scott, Trusts (3d ed.) S 462.4 . . • . • . .

Bogert, Trusts, Trustees (2d rev. ed.) S 472.

D. Dobbs, Remedies S 4.3 (1973) ..

vi

.

. . 18

18

11
'.

.-'

IN THE UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

Nos. 88-6294, 88-6296, 88-6298, 88-6300, 88-6302, and 88-6304

SECURITIES AND EXCHANGE COMMISSION,

Plaintiff-Appellee,

v.

DENNIS B. LEVINE a/k/a MR. DIAMOND,

INTERNATIONAL GOLD, INC., DIAMOND HOLDINGS, S.A.

and BERNHARD MEIER,

Defendants,

ARDEN WAY ASSOCIATES, et al., UNITED STATES OF AMERICA,

ROBERT M. WILKIS, DENNIS B. LEVINE, and NEW YORK

STATE DEPARTMENT OF TAXATION AND FINANCE,

Appellants.

On Appeal from the United States District Court

for the Southern District of New York

BRIEF FOR THE FEDERAL TRADE COMMISSION AS AMICUS CURIAE

S'l'A'l'RUNT OF THE ISSUES

1. Whether the district court, in imposing a constructive

trust on defendants' ill-gotten gains for the benefit of

defrauded investors, properly employed its equitable powers to

remedy violations of the federal securities laws.

2. If the district court's imposition of a constructive

trust was proper, whether the ill-gotten gains were thereby held

free -of federal tax liens.
'I.

INTEREST QF THE FEDERAL TRADE CoqISSIOR

The Federal Trade Commission ("FTC" or "Commission"), as

amicus curiae, respectfully submits this brief pursuant to Rule

29 of the Federal Rules of Appellate Procedure. The FTC supports

the position of the plaintiff-appellee, Securities and Exchange

Commission ("SEC"), that the district court was correct in

determining that illegal insider-trading profits, which had been

disgorged into a receivership account following settlement of

charges that the defendants had violated Sections 10(b) and 14(e)

of the Securities and Exchange Act, 15 U.S.C. SS 78j(b) and

78n(e), were held in constructive trust for the benefit of

injured investors free of tax liens. 1

The FTC is charged by Congress, inter AliA, with

enforcement of Section 5(a) of the Federal Trade Commission Act

("FTC Act" or "Act"), 15 U.S.C. S 45(a), which prohibits "unfair

or deceptive acts or practices in or affecting commerce." Under

Section 13(b) of the Act, 15 U.S.C. S 53(b), the Commission is

authorized to initiate federal district court proceedings to

enjoin violations of the FTC Act and to secure such monetary

equitable relief as may be appropriate in each case. See, ~.,

v. World Travel Vacations Broker. Inc., 861 F.2d 1020, 1031

(7th Cir. 1988); v. U.S. Qil & Gas Corp., 748 F.2d 1431, 1434

1 The FTC expresses no opinion on any other issues raised

in this appeal.

2
(11th Cir. 1984); v. H.N. Singer, Inc., 668 F.2d 1107, 1113

(9th Cir. 1982).2

Under Section 13(b), the FTC has filed numerous cases

seeking to enjoin fraudulent and deceptive practices and to

obtain monetary equitable relief to redress consumer injury.

Typically, these cases have involved consumers who purchased

investments such as land leases, rare coins, and art, in reliance

on false or deceptive representations as to facts that were

material to their decision to purchase. For example, in v.

Alaska Land Leasing. Inc., No. 84-5416 (C.D. Cal. July 23, 1984),

consumers allegedly were told that the defendants'· eXPert

geologists had selected certain Alaskan lands as. having high

potential for the commercial recovery of oil and gas when, in

fact, these geologists had determined that this land haa little

or no such potential. In v. Rate Coins Galleries of America,

~., 1986-2 Trade Cas. (CCH) ! 67,338 (D. Mass. 1986),

defendants allegedly misrepresented the grade, value, and

investment potential of rare coins, which were, in fact, worth

only a fraction of what consumers paid for them. In v.

Austin Galleries, Inc., 1988-2 Trade Cas. (CCH) !! 68,340, 68,341

(N.D. Ill. 1988), consumers were told that graphic prints were

original prints by Dali and Picasso when, the Commission has

2 In addition to Section l3(b), Section 19(a)(2) of the FTC

Act authorizes the Commission to sue in district court to obtain

both equitable monetary relief and some types of damages for

consumers injured by practices held to be unfair or deceptive in

a prior FTC administrative proceeding.

3
alleged, the prints were not originals by the named artists, but

merely reproductions.

In numerous pending cases brought under Section 13(b), the

FTC has sought and obtained, as preliminary relief, the freeze or

sequestration of millions of dollars possessed by the

perpetrators of deceptive practices. If it prevails on the

merits, the Commission then requests the court to disburse these

frozen funds to consumers who have been'parted from their monies

by the defendants' deceptive practices. 3 This Court's

resolution of the present case may significantly affect the FTC's

ability to accomplish restitution in pending and future cases and

thereby to perform its st~tutory mission in an effective and

efficient manner.

In,at'least two, recent fraud cases brought by the Commission

to secure a fund fQr injured consumers, the Internal Revenue

Service ("IRS") is attempting to satisfy tax liens with impounded

funds. If these efforts succeed, the amount of money left to

distribute to injured consumers will be significantly reduced.

For example, in v. U.S. Oil' Gas CohP., No. 83-1702-Civ3 The FTC has previously distributed millions of dollars to

consumers under final court orders for restitution. See, ~.,

v. Leland Indus .. Inc., (1983-1987 Transfer Binder) Trade

Reg. Rep. (CCa) ! 22,297 (C.D. Cal. OCt. 11, 1985) ($ 2.5 million

restitution for purchasers of oil lease filing services); v.

Alaska Land Leasing. Inc., 5 Trade Reg. Rep. (CCa) ! 22,459 (July

14, 1987); l%C v. Eyans Products Co., 5 Trade Reg. Rep. (CCa)

! 22,480 (Oct. 22, 1987) ($ 3.3 million redress for purchasers of

prefabricated homes as to which availability of long-term ' financing was allegedly misrepresented); v. Rare Coins of

Georgia, 5 Trade Reg. Rep. (CCH) ! 22,309 (N.D. Ga. Dec. 5, 1988)

($ 150,000 restitution for purchasers of overgraded rare coins).

4
Hoeveler (S.D. Fla. July 10, 1987), the IRS has placed a three

million dollar jeop~rdy assessment on the estate of a principal

of U.S. Oil' Gas Corporation. The estate contains approximately

$ 2.75 million that would go to the Commission for distribution

to injured consumers unless the money is diverted to the payment

of taxes. Additionally, in the same case, the IRS has seized

$ 432,000 held by an individual defendant in a safe deposit box,

not withstanding an asset freeze order entered by the court at

the Commission's request. Likewise, in v. Worldwide Factors,

~., No. Civ.-S-88--293-RDF (LRL) (D. Nev. May 19, 1988), the

IRS has indicated its intention"to assert a claim against a fund

of assets worth over $ 1.5 mi~lion established by an asset freeze

order entered at the FTC's request. 4 "

Because "many Section 13(b) cases involve fraud or conduct

approaching fraud", the defendants in such cases have not

infrequently engaged in wrongdoing beyond the specific practices

that led to the FTC challenge. Such wrongdoing may include

failure to pay state and federal taxes. Were this Court to

construe the applicability of constructive trusts in the narrow

fashion appellants suggest, the Commission would be severely

hampered in returning monies to victims of fraud as the FTC Act

authorizes.

4 In v. Rainbow Enzymes. Inc., No. Civ-87-1522 (D.

Ariz. 1988) following the district court's decision in the

instant case, the IRS acquiesced in the Commission's proposed

plan that $ 1.5 million obtained from defrauded participants in a

pyramid promotion scheme be returned to them.

5
~.,

STATgUNT OF THE CASE

On May 12, 1986, the SEC filed a complaint charging

defendant Dennis B. Levine and his related companies with

violations of Sections 10(b) and 14(e) of the Exchange Act,

15 U.S.C. 55 78j(b) and 78n(e), and Rules 10b-5 and 14e-3,

17 C.F.R. 55 240.10b-5 and 240.14e-3. The district court granted

the SEC's motion for a temporary restraining order freezing

approximately $ 11.5 million in illegal insider-trading profits.

On June 6, 1986, the district court approved a settlement that

required the defendants to disgorge the funds into a receivership

account.

On July 1, 1986, the SEC filed a similar action against

l

defendant Wilkis and his related companies. On July 2, 1986, the

district court approved a settlement similar to ~vine's and

ordered Wilkis to disgorge approximately $ 3.3 million of his

ill-gotten gains.

On November 16, 1987, the SEC filed proposed plans of

distribution for the disgorged assets. Under the SEC proposal,

defrauded investors would receive 55% of the fund and the

federal and state tax authorities the remaining 45%. Various

parties, including the IRS, objected to the proposed plans. The

IRS, supported by the defendants, took the position that the

federal tax claims were entitled to priority over all other

6
claims, because no liens other than federal tax liens had

4ttached to the disgorged assets (Br. 11).5

The district court refused to approve the SEC-proposed

plans and also rejected the contention of the IRS that the

federal tax claims had priority over all other claims. v.

Leyine, 689 F. Supp. 317 (S.D.N.Y. 1988). The court held that

the disgorged assets were held in constructive trust for the

benefit of defrauded investors (~. at 323). Because the

defendants had acquired the disgorged assets through wrongful

means, equitable title arose in the injured investors from the

time the funds were wrongfully obtained. The assets could not,

therefore, ,properly be considered "property of the taxpayer"

within the meaning of Section 6321 of the Internal Revenue Code,

26 U.S.C. S 6321 (~. at 321-22). Consequently, the assets in

the constructive trust were not susceptible to an IRS lien (~.

at 323).

On OCtober 27, 1988, the district court entered 'an order

approving the SEC's amended distribution plan, which provided for

the distribution to injured investors of all funds remaining

after paYment of administrative expenses. The United States, New

York Department of Taxation, defendants Levine and Wilkis, and

plaintiffs in a pending private action against Levine all sought

permission to take an interlocutory appeal. On December 9, 1988,

this Court granted the petitions for interlocutory review.

5 The abbreviation ("Br.") refers to Brief for The United

States as Appellant.

7
L

SYMMARY OF ARGID'RNT

In impressing illegal insider-trading profits with a

constructive trust, the district court was exercising its

inherent judicial power to fashion equitable remedies for

violations of federal law. The district court correctly

determined that a constructive trust could be imposed when the

principles of equity so required, and that the forum state's

constructive trust doctrine could be interpreted in a manner

consistent with such principles. Particularly in the area of

federal enforcement of statutory equitable rights, the district

court's power to fashion appropriate remedies should be broadly

construed.

The manner in which the court imposed the constructive trust

in this case forestalled application of any federal tax claim •

priorities against the funds. Although the defendants' tax

liabilities arising from the ill-gotten gains are not at issue

here, the ability of the IRS to attach tax liens to those funds

is. The IRS may only attach a lien on "property" or "rights to

property" that belong to the taxpayer. See 26 U.S.C. S 6321.

Here, the district court concluded that although the defendants

held legal title to these funds, equitable title arose in the

injured investors from the time the funds were wrongfully

obtained. Thus, no tax liens could attach because the funds were

never the defendants' "property".

The IRS argues that the taxpayers had equitable title to

the illegally obtained funds until the constructive trust was

8
decreed by the court. The court, however, held that the

defendants never had full title because the constructive trust,

once imposed, related back to the time of the wrongdoing. This

conclusion was fully in keeping with the court's equitable

remedial powers. The fundamental purpose of a constructive

trust is to make the wrongdoer a trustee responsible for

preserving the assets in his possession for the benefit of the

rightful owners. In the apparent view of the IRS, the "trustee"

may freely dissipate the assets until a court order establishes

the trust explicitly. This interpretation of the law would

severely frustrate the FTC's ability to effect restitution to

defrauded consumers.

ARGtDIElfl'

I. THE DISTRICT COURT'S IMPOSITION OF A CONSTRUCTIVE TRUST IS

WITHIN ITS STATUTORY AUTHORITY TO FORMULATE EQUITABLE ~MEDIES FOR VIOLATIONS OF FEDERAL SECURITIES LAWS

The law is well-settled that, where federal regulatory

agencies have been granted authority to enforce the law by means

of a suit for injunction in federal court, they may seek the full

range of equitable remedies (including disgorgement and

restitution) that a federal district court, sitting in equity, is

empowered to fashion. 6 See, ~., v. Certain Unknown

Purchasers, 817 F.2d 1018, 1020 (2d Cir. 1987); lIt v. u.S. Qil &

6 Under 15 U.S.C. S 53(b), the FTC can seek to invoke the

full breadth of the court's equitable authority and request

imposition of such relief as is necessary to remedy violations of

any law enforced by the FTC. Similarly, the CFTC can invoke the

court's inherent equitable powers under 7 U.S.C. S 13a-1 to

enforce compliance with the Commodity Exchange Act, 7 U.S.C. S 2.

9
Gas CQhP., 748 F.2d 1431, 1432-34 (11th Cir. 1984); v. CQ

PetrQ Marketing GrQUp. Inc., 680 F.2d 573 (9th Cir. 1982); v.

H.N. Singer. Inc., 668 F.2d 1107, 1113 (9th Cir. 1982); v.

~, 591 F.2d 1211 (6th Cir.), ~. denied, 442 U.S. 921

(1979); SEC v. Texas Gulf Sulphur CQ., 446 F.2d 1301, 1307 (2d

Cir.), ~. denied, 404 U.S. 1005 (1971). The scope of the

CQurts' inherent equitable powers is even qreater when, as in

these cases, the public interest is at stake. Porter v. Warner

HQlding CQ., 328 U.S. 395, 397-99 (1946).

Equitable remedies are essential to the federal requlatory

aqencies' ability to combat civil fraud. Restitution and

disqorqement are bottomed on the recoqnition that a wronqdoer

should not be allowed to retain property that in equity and qOQd

conscience do not belonq to him. Remedies fQ prevent unjust

enrichment and redress injured consumers become meaninqless,

however, if the ill-qotten qains can be freely dissipated. To

preserve assets for effective ultimate relief, the federal

aqencies have successfully invoked the district court's power to

fashion appropriate preliminary and ancillary orders for asset

freezes, accountinqs, receiverships, and immediate discovery.7

7 See, ~., u.S. Oil & Gas, 748 F.2d at 1431 (receiver

appointment aff'd); CQ PetrQ Marketing, 680 F.2d at 584

(receiver appointment, accountinq, and disqorqement aff'd)i

v. Muller, 570 F.2d 1296 (5th Cir. 1978) (asset freeze aff'd);

v. Rare CQin Galleries Qf America. Inc., 1986-2 Trade Cas.

(CCH) ! 07,338 (D. Mass. 1986) (asset freeze qranted); SEC v.

R.J. Allen & AssQciates. Inc., 386 F. Supp. 866, 881 (S.D. Fla.

1974) (receiver appointed); SEC v. Capital CQunsellQrs. Inc., 332

F. Supp. 291, 304 (S.D.N.Y. 1971) (receiver appointed).

10
The constructive trust is but another form of ancillary

relief available to a court in exercising its equitable powers.

D. Dobbs, Remedies S 4.3 (1973); Republic of Philippines v.

Marcos, 806 F.2d 344, 355-56 (2d Cir. 1986) (preliminary

injunction and constructive trust decreed). Through the

constructive trust, equity converts the wrongdoer into a trustee

holding the property for the benefit of the rightful owner. D.

Dobbs, Remedies S 4.3; Beatty v. Guggenheim Exploration Co., 225

N.Y. 380, 386, 122 N.E. 378, 380 (1919) (Cardozo, J.), cited in

Marcos, 806 F.2d at 355. Therefore, the theory of constructive

trusts is the legal underpinning of the remedies for unjust

enrichment and restitution. "A constructive trust is the

formula through which the conscience of equity finds expression."

Beatty, 225 N.Y. at 386, 122 N.E. at" 380.·

II. COURT'S AUTHORITY TO IMPOSE A CONSTRUCTIVE TRUST CANNOT

BE THWARTED BY THE FORUM STATE'S CONSTRUCTIVE TRUST DOCTRINE

When the lower court ordered that the defendants' disgorged

assets be held in constructive trust for the defrauded investors,

the court was implementing a federal equitable remedy in an

action brought under the federal securities laws. The court

determined, in fact, that the forum state's law contemplated

imposition of such a trust, effective at the time the unlawful

taking of funds occurred. (689 F. Supp. at 323.) Even were this

Court to read state law requirements less favorably, however, the

district court should nonetheless be affirmed.

The Supreme Court and this Circuit have found that when

state law cannot be reconciled with controlling federal statutory

11
authority, the state law must give way to the requirements of

federal equity. In Holmberg v. Armbrecht, 327 u.s. 392, 397

(1946), the Supreme Court held that the doctrine of equitable

tolling (whereby a statute of limitations is tolled until the

plaintiff could reasonably discover the right of action concealed

by defendant's fraud) is read into every federal statute,

including those in which state statutes of limitation would

12

constructive trust doctrine within technical state-defined

otherwise govern. "It would be too incongruous to confine a

It is likewise incongruous to confine the federal

period is an exercise of the court's discretionary power to

prerequisites for constructive trusts, inconsistent with settled

federal equitable doctrines. 9 The power of a federal court to

fashion appropriate measdres to carry out the intent of the

federal legislation." Robinson v. Pan American World Airways.

federal right within the bare terms of a State statute of

limitation unrelieved by the settled federal equitable doctrine

as to fraud * * *" ~.8 This Court has further expanded on the

Holmberg doctrine to find that "the selection of a limitations

Ever since the First Judiciary Act, 1 Stat. 73, federal

district courts have been given cognizance of suits "in equity,"

which "constitute that body of remedies, procedures, and

practices which had been evolved in the English Court of

8 The equitable tolling of statutes of limitation doctrine

is applied to actions brought under the federal securities laws.

See Morgan v. KQ£h, 419 F.2d 993, 996-97 (7th Cir. 1969); Sperry

v. Barggren, 523 F.2d 708, 710-11 (7th Cir. 1975).

9

1n&., 777 F.2d 84, 86 (2d Cir. 1985), cited in Assoc. Brick Mason

Contractors, Inc. v. Harrington, 820 F.2d 31, 37 (2d Cir. 1987).
decree that property obtained through fraud or deception should

be restored to its rightful owner cannot be undermined by the

forum state's law. 10 Such a result would severely undercut the

ability of federal agencies, such as the SEC and FTC, to achieve

effective, consistent, and nationwide enforcement of statutes

designed to protect consumers throughout the country. As the

Supreme Court stated in Holmberg: . We have the duty of federal. courts, sitting as national

courts throughout the country, to apply their own principles

in enforcing an equitable right created by Congress. When

Congress leaves to the federal courts the formulation of

remedial details, it can hardly expect them to break with

historic principles of equity in the enforcement of

federally-created equitable rights. 327 u.s. at 395.

Because the instant case involves equitable remedies created

pursuant to a federal statute, the doctrine of constructive

trust should be flexible and not confined by a rigid reading of

Chancery, subject, of course, to modifications by Congress."

Sprague v. Ticonic National Bank, 307 u.S. 161, 164-65 (1939).

Thus, for example, although some states may require a breach of

fiduciary duty as a prerequisite for the imposition of a

constructive trust, this was not the case in early English

Chancery practice and need not be the case in federal equity

practice. 1 Pomeroy, Equity Jurisprudence (4th ed.) S 155.

10 As the Supreme Court stated in Burks v. Lasker, 441 U.S.

471, 479 (1979), "although a state statute cannot be considered

inconsistent with federal law merely because the statute causes

the plaintiff to lose litigation, federal courts must be ever

vigilant to insure that application of state law poses no

significant threat to any identifiable federal policy or

interest." (citations omitted.) ( The Court held that in suits

alleging violations of the Investment Company Act (ICA) and the

Investment Advisors Act (IAA), federal courts should apply state

law in determining authority of directors to discontinue

derivative suits to the extent such law is consistent with the

policies of the lCA and lAA.)

13
~.

the elements of constructive trusts under state law. 11 In

Marcos, 806 F.2d at 356, this Circuit stated that the state law

of constructive trust can be adopted by the federal court only

"where adoption of state law does not conflict with federal

policy." The clear implication is that state law must yield

where it conflicts with overriding federal enforcement needs.

Federal courts have followed this reasoning in deviating from

state constructive trust doctrines when their application would

conflict with the underlying equities of the federal bankruptcy

statutes12 and the Securities Investor Protection Act ("SIPA").13

"An appeal to the equity jurisdiction conferred on federal

district courts is an appeal to the sound discretion which guides

11 See Niagara Mohawk Power v. Bankers Trust Co. of Albany,

791 F.~d 242, 245 (2d Cir. 1986) (theory of unjust enrichment

was dependent on federal common law because the equitable rights

were-generated by HUO's activities pursuant to federal statutes

and, therefore, the district court erred in applying the

heightened New York standard for piercing the corporate veil).

12 In re North American Coin & Currency. Ltd., 767 F.2d

1573, 1575 (9th Cir. 1985) (cites omitted) (state constructive

trust doctrine not applied, in part, because it would result in

injured customers being treated unequally); In re Teltronics. ~., 649 F.2d 1236, 1240-41 (7th Cir. 1981) (constructive trust

imposed and funds kept out of bankruptcy estate because defrauded

customers treated equally); In re Johnson, 80 B.R. 791, 799-800

(Bankr. E.O. Va. 1987) (constructive trust imposed and funds kept

out of bankruptcy estate defeating IRS lien because defrauded

investors treated equally).

13 In re Bevill. Bresler & Schulman. Inc., Civ No. 85-2224

(ORD) (O.N.J. Jan. 10, 1989) (available on 1989 u.S. Oist. LEXIS

272) (state law doctrine of constructive trust must give way to

the policy of SIPA because to do otherwise would frustrate its

purpose; citing Chicago Board of Trade y. Johnson, 264 u.S. 1, 10

(1924), for the proposition that under the Supremacy Clause of

the Constitution, inconsistent state laws must give way to a

federal statute).

14
the determinations of courts of equity. * * * Flexibility rather

than rigidity has distinguished it." Hecht Co. v. Bowles, 321

U.s. 321, 329 (1944). The lower court correctly found that the

forum state's constructive trust doctrine must be interpreted in

a fashion consistent with federal equity principles. If state

law could not be reconciled with federal policy, it would have to

yield to the federal statutory authority.14

III. A CONSTRUCTIVE TRUST DEFEATS IRS PRIORITY CLAIMS

Under the tax lien provisions of 26 U.S.C. Section 6321, the

IRS can gain priority status by attaching "property" or "rights

to property" belonging to defendants. The IRS reliance on

Aquilino v. United States, 363 U.S. 509, 512 (1960), and its

.progeny for the proposition that the question of property

ownership is one of state law is inapposite (Br. 24-25). In the

context of the proper imposition of a constructive trust, there

is little controversy as to the question of ownership once the

14 If state law must yield, the federal courts need not

fashion a constructive trust doctrine out of whole cloth.

Imposition of a constructive trust generally requires proof of

three elements: (1) a wrongful act; (2) specific property

acquired by the wrongdoer that is traceable to the wrongful

behavior; and (3) an equitable reason why the party holding the

property should not be allowed to keep it. Alsco-Harvard Fraud

Litigation, 523 F. Supp. 790, 806-07 (D.D.C. 1981) (citations

omitted). See American Sery. Co. v. Henderson, 120 F.2d 525 (4th

Cir. 1941); In re Independent Clearing House Co., 41 B.R. 985

(Bankr. D. Utah 1984), aff'd in part, rev'd in part sub nom. In

re Universal Clearing House Co., 62 B.R. 118 (D. Utah 1986). In

the instant case, the IRS does not contest that the funds were

obtained by a wrongful act; that the funds should be disgorged to

prevent unjust enrichment; and that all but $ 1.6 million of the

funds can be traced to the wrongful act. If the SEC prevails in

its argument that the $ 1.6 million is also traceable, those

funds can be held in constructive trust as well.

15
trust arises. 15 When title to property is bifurcated, so that

the taxpayer owns bare legal title and serves as a trustee for

the benefit of a third party, the taxpayer's interest is

insufficient for a tax lien to attach. Aquilino, 363 U.S. at

513-15. Courts that have addressed the issue of whether the

imposition of a constructive trust defeats IRS priority tax

claims have held that, by definition, once the constructive trust

arises, the taxpayer as a constructive trustee lacks a sufficient

interest in the trust property to permit a tax lien to attach.

See United States v. Fontana, 528 F. Supp. 137, 143 (S.D.N.Y.

1981); Atlas. Inc. v. United States, 459 F. Supp. 1000, 1005 (D.

N.D. 1978); First National Bank of Cartersville v. Hill, 412 F.

Supp. 422, 426 (N.O. Ga. 1976); pennis v. United States, 372 F.

Supp. 563, 566 (E.D. Va. 1974).

·The critical issue, therefore, is whether the lower court

was correct in stating that the equitable title arose in the

injured investors from the time the defendants illegally obtained

the funds. The IRS argues that the taxpayers had equitable title

to the illegally obtained funds until the constructive trust was

decreed by the Court, thereby creating a window of time during

which the tax liens could attach (Br. 15-16; 31-33).

15 See Sections I and II of the Argument. The lower court

properly employed its equitable powers to impose a constructive

trust to remedy violations of the federal securities laws.

16
, ,

In FQntana, 528 F. Supp. at 146, however, the court

addressed this precise issue and held that "New YQrk law hQlds a

constructive trust to exist from the time of the occurrence of

the circumstances giving rise to the duty to surrender the

property in question to another." In finding that a constructive

trust related back to the time of the wrongdoing, the court

interpreted the New York law as incorporating nQtions Qf general

equity. The court noted that allQwing the IRS to seize property

that, should the wronged party prevail, social conscience would

reconvey, was a fundamentally unfair result that the New York

Court of Appeals would reject. ~. at 145. The court

specifically rejected the IRS argument against the relation back

theory as an attempt to narrow the reach of equity. 14. at 146.

Relying on Fontana, the district court in the instant case

found that New York law clearly permitted it to hold that the

constructive trust arose at the time the defendants' wrongfully

obtained the funds. In addition, because this state rule was

consistent with the federal equitable policies at issue, the

application of the state rule by the district court was proper.

Burks, 441 U.S. at 480.

The IRS argues that a line can be drawn between the instant

case and cases involving theft, embezzlement, and similar

misconduct, conceding that a constructive trust can relate back

in those situations but only because, under state property law,

title never passed (Br. 32). To limit the relation back of

constructive trusts in this fashion overlooks the fact that the

17
constructive trust arises to vindicate a statutorily prescribed

federal interest in restitution for fraudulent acts. Cases of

federal civil fraud in which the Commission is involved present

compelling interests in the relation back theory that should be

considered under federal law. 16

Narrowing the relation back theory of constructive trust

would severely impair the ability of the FTC to obtain monetary

equitable relief for defrauded consumers. Even where a court had

determined that funds were properly held in a constructive trust

because they had been taken from consumers by means of fraud or

other serious deception, such funds would nonetheless be

available to satisfy the tax obligations of the wrongdoer prior

to the time a constructive trust was declared by the court.

This approach fails to account for the strong federal interest in

compensating the victims of fraudulent and deceptive practices

prohibited by the securities laws and the Federal Trade

Commission Act. Although there is an inevitable tension between

the federal interest in restitution and the Government's revenue

priorities, we do not believe that those priorities necessarily

contemplate the payment of taxes with funds fraudulently obtained

and rightfully belonging to another.

16 "It would seem that there is no foundation whatever for

the notion that a constructive trust does not arise until it is

decreed by a court. It arises when the duty to make restitution

arises, not when the duty is subsequently enforced." 5 Scott,

Trusts (3d ed.) S 462.4. Accord Fontana, 528 F. Supp. at 145;

Reliance Insurance Co. v. Brown, 40 B.R. 214 (W.O. Mo. 1984);

Bogert, Trusts & Trustees (2d rev. ed.) S 472.

18
,.

CQRCLUSION

For the foregoing reasons, the decision and orders of the

district court should be affirmed insofar as the court determined

that funds disgorged into a receivership account were held in

constructive trust for the benefit of injured investors from the

time the misconduct occurred.

Respectfully submitted,

KEVIN J. ARQUIT

General Counsel

JAY C. SHAFFER

Deputy General Counsel

ERNEST J. ISENSTADT

Assistant General Counsel

February 1989

HEATHER HIPPSLEY

LESLIE RICE MELMAN

Attorneys

Federal Trade Commi,sion

Washfnqton, D.C. 20580

(202) 326-3285

19
1989, copies of the foregoing Brief for the Federal Trade

commission as Amicus CUriae were served by Airborne Express on

" }

CERTIFICATE OF SERVICE

I hereby certify that on this "

day of February,

."

the following:

Rosalie Hronsky, Esq.

Office of the Attorney General

State of New York

120 Broadway

New York, New York 10271

Stanley Nemser, Esq.

Wolf, Popper, Ross, Wolf & Jones

845 Third Avenue

New York, New York 10022

David Berger, Esq.

Berger & Montague, P.C.

1622 Locust Street

Philadelphia, Pennsylvania 19103

Geqrge Reycraft, Esq. Cadwalad~r, Wickersham & Taft

100 Maiden Lane

New York, New York 10038

Arthur Liman, Esq.

PaUl, Weiss, Rifkind, Wharton & Garrison

1285 Avenue of the Americas

New York, New York 10019

Gary P. Naftalis, Esq.

Kramer, Levin, Nessen, Kamin & Frankel

919 Third Avenue

New York, New York 10022
";1;

and by first-class mail, postage-prepaid on the followingl

Gary R. Allen, Esq.

Department of Justice

Tax Division

P.o. Box 502

Washington, D.C. 20044

Richard A. Kirby, Esq.

Securities and Exchange Commission

450 Fifth Street, N.W.

Washington, D.C. 20549

-/ /~

~(6{u d~e/:J"---- /

Leslie Rice Melman

Attorney

2