In United States v. Daugerdas, the Court (Walker, Lynch, Chin) offered a lifeline to the wife of a defendant convicted of tax fraud, who sought to assert a third-party interest in funds that the Second Circuit had previously determined were forfeitable to the government as proceeds of the defendant’s crimes.  The U.S. District Court for the Southern District of New York concluded that petitioner Eleanor Daugerdas failed to state a claim that she was entitled to retain funds that her husband, defendant Paul Daugerdas, had gratuitously transferred to her.[1]  She sought to argue that the tainted funds had been commingled with legitimately earned funds prior to their transfer and therefore could not easily be traced back to Paul’s crimes.  But the question of whether the seized funds arose from Paul’s criminal activity had been decided in the affirmative by the district court as part of Paul’s sentencing.  As a result, the district court held that Eleanor could not relitigate the issue of whether those funds should be characterized not as criminal proceeds but as substitute assets, which would require the government to seek forfeiture of other property belonging to Paul.

The Second Circuit, however, disagreed and concluded that because Eleanor had been barred by statute from participating in Paul’s criminal proceedings, due process demanded that she be given the opportunity to plead a plausible claim that (1) the funds were forfeitable only as substitute assets, and (2) the funds were under her ownership and control before the government’s interest in them vested.  While the panel acknowledged that Eleanor likely would face an uphill battle in her efforts to demonstrate her right to retain the funds, the panel’s decision was motivated by the basic principle that an individual may “not [be] bound by an adjudication of [an] issue . . . in a proceeding in which she was not permitted to participate.”

Legal Framework of Criminal Forfeiture

In a criminal forfeiture proceeding, governed by 21 U.S.C. § 853, a court first determines the government’s interest in the funds sought to be forfeited as compared to the defendant’s interest.  Where the funds are identified as proceeds of the defendant’s fraud, the government’s interest in those proceeds vests as soon as the funds are generated—a concept known as “relation back,” see § 853(c).  Under these circumstances, the government’s interest in the proceeds is superior to that of any subsequent gratuitous recipient of those funds and the funds will be forfeited.

Where, however, fraudulent proceeds have been “commingled with other [lawfully earned] property which cannot be divided without difficulty,” § 853(p)(1)(E), a court must instead order the forfeiture of substitute property belonging to the defendant, up to the value of the missing proceeds.  The commingled funds are treated not as offense proceeds, but rather as substitute assets and, under these circumstances, the government’s interest in the assets does not necessarily vest at the time of the underlying offense because § 853(c)’s relation-back provision is not applicable to substitute assets.[2]  Thus, in the case of substitute assets, it is possible that a third-party gratuitous transferee’s interest in the commingled funds may be superior to that of the government.

However, there is no statutory guidance for addressing a situation in which “a third-party petitioner’s interest, which may have been inferior to the defendant’s . . . at the moment of the offense conduct, could nevertheless be superior to the government’s later-attaching interest.”  This is the precise scenario presented in Daugerdas.

Factual Background and Prior Proceedings

For more than a decade, former tax attorney Paul Daugerdas designed fraudulent tax shelters for a range of clients, generating more than $164 million in criminal proceeds.  These fraudulent proceeds were initially collected by Paul’s law firm before they were disbursed to Paul.  Over the course of several years, Paul transferred ownership of his personal accounts containing his income from the law firm to his wife Eleanor, who was not implicated in Paul’s underlying crimes.  Paul was indicted in 2009 and convicted in 2013 for his role in the conspiracy to commit tax fraud.

During his criminal proceedings, Paul twice raised the argument that the fraudulent funds were combined with other funds legitimately earned by Paul’s law firm before they were distributed to him—that is, that the fraudulent proceeds were “irrevocably commingled” with untainted funds.  The district court rejected this argument and found that the funds were fully forfeitable as criminal proceeds; the Second Circuit affirmed.  See 837 F.3d 212, 218 (2d Cir. 2016).  Interestingly, Paul never argued that the funds could not be forfeited because they no longer belonged to him.

Because § 853(k)(1) barred Eleanor from directly intervening in her husband’s criminal proceedings, in 2014 Eleanor separately filed a petition pursuant to § 853(n) to determine her claim to the funds that Paul had gradually transferred over to her.  The crux of her argument was that the government had failed to demonstrate—by an analysis of deposits into and disbursements out of Paul’s law firm accounts—that commingling had not occurred prior to the payment of the funds from the law firm to Paul.  As a result of the commingling, Eleanor contended, the contested funds were forfeitable only as substitute assets.  And, because the government may recover substitute property only from the defendant’s assets, the government could not recover these funds because Paul’s interest in them was extinguished (and Eleanor’s interest vested) before the government’s interest vested.  The district court granted the government’s subsequent motion to dismiss Eleanor’s petition, holding that Eleanor lacked statutory standing and failed to state a claim. The court held that the previous rulings in Paul’s criminal proceedings established that the funds were forfeitable as proceeds and, as such, the government’s interest in the funds vested as soon as they were generated, thereby rendering the government’s interest superior to Eleanor’s.  Eleanor was not permitted to relitigate the issue.

The Panel’s Opinion

The Second Circuit panel vacated the order dismissing Eleanor’s petition filed pursuant to § 853(n), remanding so to provide Eleanor an opportunity to file an amended petition, if she could assert facts that would go beyond those in her current petition.

The panel identified a simple defect in Eleanor’s petition, explaining that the government’s motion to dismiss a § 853(n) petition must be evaluated according to the same standard as a motion to dismiss a civil complaint pursuant to Federal Rule of Civil Procedure 12(b)(6).  In other words, a court must accept as true all factual allegations contained in the petition.  Eleanor’s petition, however, was devoid of any plausible factual allegations; rather than pleading facts suggesting that the fraudulent funds had been commingled with legitimate funds, she alleged only that the government did not establish that the funds had not been commingled.  While the distinction is a subtle one, Eleanor’s contentions amount to a legal argument, which a court is not obligated to accept as correct at the motion-to-dismiss stage.  At oral argument, Eleanor’s counsel argued that she should be permitted to cure this defect in her petition by pleading additional facts relating to the alleged commingling.  The panel agreed, concluding that if such facts exist, denying Eleanor the opportunity to present them “would raise significant due process concerns.”

Statutory Standing

The panel did go on to agree with the district court that, even if Eleanor had plausibly alleged that the funds had been commingled, § 853 did not give her standing to assert her claims.  Eleanor filed her petition pursuant to § 853(n), which provides the “exclusive means by which a third party may lay claim to forfeited assets.”  DSI Assocs. LLC v. United States, 496 F.3d 175, 183 (2d Cir. 2007).  But § 853(n) limits Eleanor’s ability to bring a petition, regardless of whether the funds are considered proceeds or substitute assets: § 853(n)(6)(A) requires that a third party demonstrate that her interest in forfeited property “was superior to any right, title, or interest of the defendant at the time of the commission of the acts which gave rise to the forfeiture of the property.”  Although in the case of substitute assets some courts have interpreted “the acts which gave rise to the forfeiture” to refer to actions other than the underlying criminal conduct,[3] the panel invoked several canons of statutory interpretation in support of its conclusion that, regardless of whether the funds in question are deemed criminal proceeds or substitute property, § 853(n)(6)(A) provides relief only where the third party’s interest vests before the underlying crimes were committed.  Moreover, a third party’s interest in the funds vis-à-vis the defendant’s interest is the same in both scenarios; it is only the third party’s interest vis-à-vis the government’s that may change and § 853(n)(6)(A) makes no reference to the government.  Thus, the panel saw no basis for treating the two scenarios differently under § 853(n)(6)(A).  Because Eleanor concededly took ownership of the contested funds after the commission of Paul’s crimes, § 853(n) does not authorize her to present her claim, regardless of how the funds are characterized.

Procedural Due Process

The panel did not end its analysis there, however, due to lingering “constitutional concerns” that would arise were Eleanor entirely denied the right to assert her claim to the contested funds.  The panel criticized the district court’s determination that Eleanor could not relitigate whether the funds had been irrevocably commingled because Paul had previously made—and lost—that argument during his criminal proceedings.  The panel explained: “The Due Process Clause does not permit us to hold that a third party is precluded from asserting, in her own right, her entitlement to property she claims is hers, on the ground that she is bound by a determination that the property belonged to someone else, when that determination was made in a separate proceeding in which she was not permitted to participate.”

The panel concluded that if Eleanor can plead a plausible claim that (1) the funds are properly characterized as substitute assets, rather than offense proceeds, and (2) her ownership interest in the funds vested before the government’s interest did, the Due Process Clause entitles her to make that claim, regardless of the limitations set forth in § 853(n).

Analysis

This is a ruling that will benefit other third-party forfeiture claimants who previously might have been denied the right to litigate an issue that was determined against them at a sentencing proceeding in which they could not participate.  It is unfair—and now unconstitutional—for the forfeiture rules to prevent a claimant from having an opportunity to litigate her entitlement to the property to be forfeited.  In some cases, these assets have considerable value, and the Circuit has been careful to hold the government to an appropriately demanding standard.  In addition, as the government increases its emphasis on asset forfeiture, it is understandable that previously unresolved issues will now be decided.  We have blogged about several of those decisions, most recently in our post discussing Federal Insurance Company v. United States, Nos. 16-2967-op and 16-3402-cr, which addressed whether a corporation might obtain a constructive trust in the forfeited property generated by its malfeasant employee, and in our discussion of United States v. Ohle, No. 16-601-cr, in which the Circuit discussed the civil nature of § 853(n) proceedings and the time to appeal a district court’s order on such a petition.

What obstacles will Eleanor Daugerdas face on remand, according to the Circuit?  First, Eleanor must prove the contested assets were commingled with untainted funds before they were disbursed to Paul by his law firm.  If Paul—who presumably had more information regarding the financial practices of his employer than Eleanor does—could not convince the district court that the funds had been commingled, it may be difficult for Eleanor to succeed in proving this fact.  However, the Court explained that Paul had less incentive than Eleanor to prove that the funds belonged to a third party and not the government—after all, Paul would not end up with the money in either scenario.  In fact, a defendant like Paul “might actually get a windfall if the money he owes is paid off with someone else’s property.”  It is possible that Eleanor, with this greater incentive, will be able to make her case persuasively to the district court.  The panel also raised a concern that even if the funds had been commingled, it is possible that the government will argue that Paul’s partnership compensation nevertheless was wholly derived from fraudulent legal work and therefore should still be viewed as criminal proceeds.

The panel also left open an important question for remand:  when did the government’s interest in the assets vest?  This issue has led to disagreement among courts within the Circuit and, since it appears that Paul transferred at least some of the contested funds to Eleanor after he was indicted, the district court might not rule that Eleanor holds a superior claim to the entire pool of funds.  But these are factual questions yet to be determined, and even if Eleanor is not wholly successful in her litigation, the panel recognized that procedural due process is a bedrock constitutional principle and that Eleanor has a right to be heard on these issues.  On remand, Eleanor must be given the opportunity to defend her interests and the property she claims is hers.