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SEC v. CREDIT BANCORP

April 6, 2001

SECURITIES AND EXCHANGE COMMISSION, PLAINTIFF, STEPHENSON EQUITY COMPANY, PLAINTIFF-INTERVENOR,
v.
CREDIT BANCORP, LTD., CREDIT BANCORP, INC., RICHARD JONATHAN BLECH, THOMAS MICHAEL RITTWEGER AND DOUGLAS C. BRANDON, DEFENDANTS,CARL H. LOEWENSON, JR., ESQ., AS RECEIVER FOR CREDIT BANCORP, LTD., CREDIT BANCORP, N.V., AND THEIR SUBSIDIARIES AND AFFILIATED ENTITIES, THIRD-PARTY PLAINTIFF, CERTAIN UNDERWRITERS AT LLOYDS, LONDON, LONDON MARKET COMPANIES, GULF INSURANCE COMPANY, AND FEDERAL INSURANCE COMPANY, THIRD-PARTY DEFENDANTS.



The opinion of the court was delivered by: Robert W Sweet, U.S.D.J.

  O P I N I O N

Carl H. Loewenson, Jr. ("Loewenson"), the court-appointed receiver (the "Receiver") for defendant Credit Bancorp, Ltd. and related entities (collectively, "Credit Bancorp") has moved for an order declaring that Credit Bancorp's customers have priority over the United States (the "Government") and the States for payment from certain property (the "Protected Property") that is either currently in the receivership estate or is anticipated will be brought into that estate, pursuant to 28 U.S.C. § 2410(a)(1) and 28 U.S.C. § 1340, and declaring that in notifying the Court and the United States of the potential for tax liability the Receiver has discharged his obligations pursuant to 31 U.S.C. § 3713(b) and may not be held liable for effectuating a court-ordered plan of partial distribution of assets in the receivership estate. For the reasons set forth below, the motion is granted in part and denied in part.

Prior Proceedings

This action commenced on November 17, 1999, with the filing of a complaint by the Securities and Exchange Commission (the "SEC") against Credit Bancorp and its principals. The Court appointed Loewenson as Fiscal Agent for Credit Bancorp by order of November 23, 1999, and appointed him as Receiver for Credit Bancorp by order of January 21, 2000 (the "Order Appointing Receiver").

The Order Appointing Receiver directed the Receiver inter alia to marshal Credit Bancorp's assets. The order also directed the Receiver not to sell any securities and not to return to Credit Bancorp customers any securities or other assets deposited with Credit Bancorp, or into an account in the name of Credit Bancorp, without further order of this Court.

The Government was brought into this action in its capacity as the Internal Revenue Service (the "IRS") on November 8, 2000, when an initial motion (the "November 8 Motion") by the Receiver for a determination of priority was served on the Office of the United States Attorney for the Southern District of New York.*fn1

By opinion dated November 29, 2000, SEC v. Credit Bancorp, Ltd., 2000 WL 1752979 (S.D.N.Y. Nov. 29, 2000) [hereinafter, "Credit Bancorp X"], opinion dated January 19, 2001, SEC v. Credit Bancorp, 129 F. Supp.2d 263 (S.D.N.Y. 2001), and order dated January 19, 2001, the Court approved a plan of partial distribution of the receivership assets. The plan provides for what is in essence a pro rata return of customer-deposited property to the Credit Bancorp customers, either in the form of their deposited property, i.e., securities (where that property is under the Receiver's control), or in the form of cash or replacement securities (where the deposits were stolen, are missing, or are in securities accounts not under the Receiver's control). The plan requires customers to whom deposited securities are returned to make a cash "Undertaking" payment. The Undertaking proceeds are to be used to pay or secure Credit Bancorp's margin debts, to make a distribution to customers whose deposits were converted, and to provide for the ongoing cash needs of the Receivership. Implementation of the plan is subject to either a stipulation or an order by this Court granting the relief requested in the instant motion.

Subsequent to the filing of the November 8 Motion, the Receiver and the Government began negotiations regarding the subject of Credit Bancorp's tax liability, and the motion was ordered off the calendar on February 7, 2001. On February 28, 2001, the Receiver and the Government entered into a stipulation and order (the "Stipulation") which resolved certain tax matters but left others unresolved.

In the Stipulation, the Government agreed not to assert a federal tax lien for any tax "owed by Richard Blech or any other defendant" against the assets to be distributed pursuant to the plan of partial distribution. The Government further agreed that the Receiver would not be personally liable as a consequence of proceeding with the plan for such tax liability accruing before the Receiver's appointment on January 21, 2000. The Government specifically reserved its right, however, to assert a tax lien or to assert priority as to income generated by estate assets after January 21, 2000 (the "Post-Receivership Income"), any future insurance proceeds, any securities held in accounts in the name of Credit Bancorp that are not specifically identifiable as customer-deposited securities, and any asset, property, or rights to property of defendant Richard Jonathan Blech ("Blech"). The Government also reserved its right to seek to hold the Receiver personally liable for tax liability based on such income or assets.

By motion of March 1, 2001 (the "March 1 Motion") the Receiver renewed the motion for a determination of priority with respect to those not resolved by the Stipulation. Submissions were received, and the matter was marked fully submitted on March 28, 2001.*fn2

Facts

The following facts are gleaned from the declarations, exhibits, and other submissions to the Court.*fn3 These submissions include inter alia extensive evidence regarding the operations of Credit Bancorp.*fn4

Credit Bancorp operated a fraudulent investment or "Ponzi" scheme prior to the filing of this suit by the SEC. Credit Bancorp solicited customers to deposit securities, cash, and other assets with the promise of a return in the form of a "custodial dividend" based upon a percentage of the market value of the deposits or, in the case of certain customers, to invest the customers' cash and mutual funds at above-market rates in mutual funds to be managed by Credit Bancorp.*fn5 Credit Bancorp represented to customers that it engaged in "riskless arbitrage" trading. At least two hundred customers took Credit Bancorp up on this offer of a "riskless" investment opportunity.

The marketing materials distributed by Credit represented and the underlying contracts entered into between Credit Bancorp and the customers provided that deposits were to be held in trust under the control of a designated trustee and were insured by Lloyds of London. Customers were specifically advised that the deposits were not the property of Credit Bancorp and that creditors of Credit Bancorp would have no recourse to the property.

Typically, customers executed two documents when they placed their deposits with Credit Bancorp: (1) a Credit Facility Agreement (the "CFA"); and (2) a Trustee Engagement Letter (the "Trustee Letter").*fn6 Both of these documents provided that the deposits would be held in trust, that equitable title remained with the customer, and that Credit Bancorp's sole interest in the deposit was as collateral in the event the customer borrowed from Credit Bancorp. Thus, a model CFA, included in Credit Bancorp's marketing materials, specifically provided that Credit Bancorp had a security interest in the "collateral" to be held by the "Trustee," Model CFA ¶ 2.5, and that the Trustee would not "at any time sell, trade or otherwise dispose of the Collateral, except as expressly authorized" in the agreement, id. ¶ 4.1. Under the model CFA, Credit Bancorp had a security interest in the collateral only to "secure the repayment of an `Advance,'" which is defined as a payment to the customer from Credit Bancorp under the "credit facility." Id. ¶¶ 2.4, 2.5. Only twelve Credit Bancorp customers are indebted to Credit Bancorp for a loan made pursuant to this arrangement.

These securities are to be held in a Credit Bancorp Ltd. account and may not be sold or otherwise disposed of except as provided for in the [Credit Facility Agreement]. In the case of a creditor claim against Credit Bancorp and an attempt to seize the securities, I am instructed to immediately return the securities to you. At no time am I to release the securities to any third party. As the securities are being delivered as collateral for the implementation of the credit facility with Credit Bancorp, title is held by you.

Id.

Although certain details of the CFA and Trustee Letter differed from customer to customer as the result of individual negotiations, they share the following essential elements: (1) they created an express trust; (2) the customer deposits were to be held in accounts in which the designated trustee was the sole signatory; and (3) Credit Bancorp was not to receive any property interest in the deposit, except where loans were extended by Credit Bancorp to the customer, in which case the deposit was to serve as collateral.

The model CFA provided that Credit Bancorp would "maintain its insurance coverage under [certain enumerated policies] . . . which provide insurance coverage of the Collateral." Model CFA ¶ 4.3. The CFA also contained the following assignment provision:

In the event of a loss of the Collateral, in whole or in part, any proceeds remitted to CBL from any insurance claims, in whole or in part, which are the subject of this transaction, are hereby assigned by Credit Bancorp to [the customer]. This assignment, although no loss has occurred or is expected to occur, is hereby declared to be part of the consideration for [the customer] entering into this AgreemenT.*fn7

Id. ¶ 4.5.

Credit Bancorp did not honor the promises made in the CFA or Trustee Letter, or the representations made to the Bob Mann customers. Securities deposited by customers were pledged as collateral for margin loans from various brokerage houses or even sold outright. Cash deposited by the Bob Mann customers was immediately converted and directed to a Credit Bancorp account with Credit Suisse in Geneva (the "Credit Suisse account"). By the time the complaint in this action was filed Credit Bancorp had dissipated tens of millions of dollars of its customers' assets.

Consistent with the classic structure of a Ponzi scheme, funds in the Credit Suisse account and the proceeds of margin loans from Credit Bancorp's brokerage accounts were used for payments to customers in the form of custodial dividends, loans secured by customer deposits, and the return of deposited funds. These monies were also used for Credit Bancorp operating expenses, Credit Bancorp investments, options trading, and Blech's personal expenses.

In a declaration submitted by Kenneth B. Lynch ("Lynch"), who was at one time outside general counsel for Credit Bancorp, Lynch recounts conversations with Blech in which Blech described his use of funds held in Credit Bancorp accounts for his personal needs and described the source of these funds as being customer deposits or the proceeds of loans secured by those deposits:

[Blech told Lynch that Blech took] funds from CBL's accounts, including funds from deposits by CBL's customers, for his own personal use . . . [that Blech] variously used funds from customer deposits or from the proceeds of loans secured by customer deposits . . . for . . . personal needs . . . [that] CBL's investments in the Bahia Vista Hotel, the Montecristo yacht, CBL Worldkey, and the University of Southern Europe . . . came from . . . funds in Credit Bancorp's accounts . . . [and] that the funds in CBL's accounts came from customer deposits and from the proceeds of loans secured by customer accounts.

Lynch Decl. ¶¶ 9-11.*fn8

The receivership estate includes assets spread out over two continents in a variety of forms, including securities held in accounts in the name of Credit Bancorp or the Receiver, a money market account at Citibank in New York containing the proceeds of the sale of customer securities by the Receiver, interests in the University of Southern Europe in Monaco and Hotel Bahia Vista in France, and the Montecristo, a yacht moored on the French Riviera. The cash assets and potential future cash receipts of the receivership are: (1) approximately $9 million in proceeds from the sale, pursuant to this Court's order of June 23, 2000, of 900,000 shares of the common stock of Centigram Communications Corporation ("Centigram") to Centigram, a Credit Bancorp customer; (2) the proceeds, if any, from the third-party action instituted by the Receiver against Credit Bancorp's insurers (the "Coverage Action"), which is currently pending before this Court; and (3) proceeds from the Undertaking to be paid by those customers seeking the return of their deposited securities under the plan of partial distribution.

The Receiver has not yet obtained control over certain assets, namely, securities and cash located in Europe (the "European Assets) in accounts with European financial institutions that do not recognize the Receiver's authority, and assets which Blech has claimed are his personal property.

The partial distribution plan relies on assets and income presently within the Receiver's control, the Undertaking payments, and the European assets, to fund the distribution. These assets and income are not sufficient to make the customers whole. The Undertaking payment is presently estimated at approximately 30% of the current market value of the customer's deposit.*fn9 Thus, the plan affords the customers a recovery rate of approximately 70%.

Credit Bancorp maintained corporate offices in California, New Jersey, and Kentucky.

At the time this action commenced, assets held by Credit Bancorp were located in California, Maryland, Nebraska, New York, and New Jersey, as well as Switzerland, the United Kingdom, and Canada.

There are presently no federal or state tax liens against Credit Bancorp or the receivership.

Discussion

I. The Property As To Which The Receiver Seeks Imposition Of A Constructive Trust And The Effect Of This Remedy

The Receiver seeks a determination that the following property is subject to a constructive trust in favor of the Credit Bancorp customers and is therefore unavailable to pay any tax liability of Credit Bancorp: (1) customer-deposited assets in accounts in the name of Credit Bancorp; (2) interest and dividends earned on those assets; (3) proceeds from the wrongful sale, misappropriation, or margining of customer-deposited assets; (4) assets acquired by Credit Bancorp or Blech with customer-deposited assets, proceeds from those assets, or the pledging of any of those assets; (5) proceeds from the sale of customer-deposited assets during the course of the receivership; (6) customer Undertakings made pursuant to the plan of partial distribution and any securities or other assets acquired by the Receiver with the proceeds of such Undertakings; and (7) any insurance proceeds recovered for the loss of customer-deposited assets (collectively, the "Protected Property").*fn10 The Protected Property includes virtually all of the assets in the receivership estate and much of the property that it is anticipated will be delivered to the Receiver, either by operation of the plan of partial distribution or through the Receiver's marshalling activities.

The federal Debt Priority Statute, 31 U.S.C. § 3713, and the federal Lien Priority Statute, 26 U.S.C. § 6321 et seq., provide the federal government with priority over other claimants as to the payment of debts, including tax debts, owed by a debtor. See 31 U.S.C. § 3713(a)(1) (according priority to a claim of the United States under enumerated circumstances); 26 U.S.C. § 6321 (according priority to lien of the United States, except as otherwise provided in 26 U.S.C. § 6323).

If the Protected Property is subject to a constructive trust in favor of the Credit Bancorp customers, as urged by the Receiver, then Credit Bancorp has no property interest in these assets. See Part III.A., infra. The Receiver and the Government concur that under these circumstances the Protected Property could not be applied to satisfy the tax liability of Credit Bancorp or, to put it another way, the customers' claim to that property would take priority over the claim of the United States. See Gov't Mem. at 23; see generally Kennebec Box Co. v. O.S. Richards Corp., 5 F.2d 951, 952 (2d Cir. 1925).*fn11

II. Subject Matter Jurisdiction

A. The Jurisdictional Bar On Actions Seeking To Restrain The Assessment Or Collection Of Federal Taxes

The Declaratory Judgment Act provides in relevant part:

In a case of actual controversy within its jurisdiction, except with respect to Federal taxes . . . , any court of the United States, upon the filing of an appropriate pleading, may declare the rights and other legal relations of any interested party seeking such declaration. . . .

28 U.S.C. § 2201(a) (emphasis added). The Anti-Injunction Act states in relevant part that "no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom such tax was assessed." 26 U.S.C. § 7421(a).

Thus, according to the Government, subject matter jurisdiction is lacking because (1) the relief sought is "with respect to Federal taxes," 28 U.S.C. § 2201(a), (2) the relief sought is purely declaratory, and (3) no exception to the jurisdictional bar applies.

The instant action involves an equity receivership. However, while a district court has "broad powers" and "wide discretion" to fashion relief in an equity receivership, see, e.g., SEC v. Elliot, 953 F.2d 1560, 1566 (11th Cir. 1992), a court cannot expand its jurisdiction by creating a receivership, see Orth v. Transit Inv. Corp., 132 F.2d 938, 945 (3d Cir. 1942); First Nat'l Bank in Albuquerque v. Robinson, 107 F.2d 50, 54 (10th Cir. 1939). Therefore, it must be ascertained whether there is an independent basis for subject matter jurisdiction over the Receiver's motion that does not run afoul of the jurisdictional bar.
B. Subject Matter Jurisdiction Under The Quiet Title Provision Of 28 U.S.C. § 2410(a)(1)

The Receiver maintains that subject matter jurisdiction over this motion exists pursuant to the quiet title provision of 28 U.S.C. § 2410, and 28 U.S.C. § 1340. Section 2410 is not itself a jurisdictional statute but, rather, pertains to whether the United States has waived sovereign immunity with respect to the matter at issue, and provides in relevant part:

[T]he United States may be named a party in any civil action or suit in any district court, . . . to quiet title to . . . real or personal property on which the United ...

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