Divorce Settlements Funded By Proceeds of Fraud

This past June, the United States Court of Appeals for the Second Circuit asked the New York Court of Appeals to provide guidance on questions of New York law related to the proceeds of a divorce settlement where such proceeds were funded by ill-gotten gains.

In deciding Commodity Futures Trading Commission v. Walsh, 618 F3d 218 (2d Cir. 2010), the Second Circuit asked the Court of Appeals to enlighten them as to whether, under New York law, a wife could keep the money she received from her divorce settlement where a portion of the distributed assets were derived from her husband's illegal activities and where the wife did not know that those monies were the husband's criminal booty. The Court of Appeals basically answered “yes,” finding that a spouse who negotiated her settlement agreement in good faith and exchanged “fair consideration” for the assets that she received is entitled to keep the money, irrespective of the source. Therefore, according to the Court of Appeals, the government must obtain the funds to make the fraud victims whole from somewhere other than from the innocent, recipient spouse.

The Divorce Settlement

The Walsh case was brought by the Commodity Futures Trading Commission and the Securities and Exchange Commission (SEC) in an attempt to recapture stolen assets from Stephen Walsh. He stands accused of running a Madoff-like Ponzi scheme, which bilked so-called “investors” out of some $554 million. His partner pleaded guilty to the crime and is presumably aiding the government in its pursuit of Walsh.

The government named Janet Schaberg, Walsh's former wife, as a “nominal defendant” with a third-party interest in the stolen funds. The government sought to recoup some of the allegedly stolen monies from the proceeds of Schaberg's divorce settlement in order to return them to the defrauded investors.

In her divorce from Walsh, Schaberg had received approximately $17.5 million in cash and investments, as well as homes on Long Island and in Florida. There was no evidence, and the government made no allegation, that Schaberg had any idea that her husband was a swindler and that his investment fund was fraudulent. Still, the government argued that because the monies were procured by fraud, they could not be considered part of the marital estate in the first place ' by virtue of their status as stolen funds. In defense of her position that she was entitled to retain the proceeds of her settlement, Schaberg argued that she had executed the agreement in “good faith,” and, thus, had become “'a good-faith purchaser for the value of the assets.'” 2011 WL 2471544, 17 NY3d 162 (June 23, 2011) quoting Id. at 226. Schaberg asserted an ownership interest in the funds superior to that of her ex-husbands victims.

Questions for New York's Highest Court

In deciding whether Schaberg was entitled to keep the fraud-derived proceeds of her divorce settlement, and mindful of the fact that she did not know the funds were the proceeds of her ex-husband's fraud, the Second Circuit certified two questions to be answered by the Court of Appeals: 1) Does “marital property” within the meaning of New York Domestic Relations Law ' 236 include the proceeds of fraud?; and 2) Does the spouse pay “fair consideration” according to the terms of New York Debtor and Creditor Law ' 272 when she relinquishes in good faith a claim to the proceeds of fraud?

The Court of Appeals answered the first question in the affirmative, holding that “the proceeds of fraud can constitute marital property as defined in Domestic Relations Law ' 236 ' and it is therefore possible under the Domestic Relations Law to transfer assets derived from fraud to an innocent and unknowing spouse in a divorce proceeding.”

The court largely based this answer on public policy grounds, asserting that the parties' respective arguments forced the court to “weigh the competing interests of the original owners of funds stolen in a fraudulent scheme against the innocent former spouse of the defrauder.” The court reasoned that public policy demands that divorce agreements entered into in good faith by the recipient spouse must be honored, because such agreements represent the “'severance of [the husband and wife's] economic ties by an equitable distribution of the marital assets.'” 17 NY3d 162 citing O'Brien v. O'Brien, 66 NY2d 576, 583 (1985). To undo what was done in good faith would be to undermine the entire process of ending the economic partnership of marriage. The Court of Appeals stated: “To hold that the proceeds of fraud acquired by one spouse unbeknownst to the other cannot be subject to equitable distribution or conveyed through a settlement agreement as marital property would undermine one of the fundamental policies underlying the equitable distribution process, namely, finality.” (The court was further concerned that excluding fraud proceeds from the pot in this instance would “effectively undo court orders and settlement agreements for an indeterminate time.”)

The court noted that at the core of the purpose of New York's equitable distribution law is the recognition that marriage is an economic partnership and that a spouse's non-financial contributions should be accounted for in the distribution of marital property. It further observed that the Domestic Relations Law defines marital property “expansively” and the definition of marital property is “broadly construed.” Given that the statute is silent as to fraudulently procured marital assets, the court found that the fraudulent character of the funds did not bear on their classification as marital assets. In other words, it did not matter how the funds were obtained, just that they were acquired during the marriage and, thus, were marital property to be included in the marital pot for equitable distribution purposes.

The court concluded that “monies obtained by fraud cannot be followed by the original owner into the hands of an innocent former spouse who now holds them (or assets derived from them) as a result of a divorce proceeding where that spouse in good faith and without knowledge of the fraud gave fair consideration for the transferred property.” The Court of Appeals thereby solidified Schaberg's superior ownership interest.

The second question posed by the Second Circuit required a look at the feature of New York Debtor and Creditor Law ' 278 that focuses on the right of a creditor to fraudulent proceeds so long as fair consideration was given in exchange for them. New York Debtor and Creditor Law ' 278 states that “a creditor whose claim has matured may have a fraudulent conveyance set aside 'against any person' other than a good faith purchaser for valued, defined as 'a purchaser for fair consideration without knowledge of the fraud.”

In assessing what constitutes “fair consideration” in the context of a divorce agreement, the court set forth a two-part test. Specifically, the court explained that the first prong was “to determine whether the spouse relinquished rights to untainted assets in the marital estate.” If so, in the court's estimation, that relinquishment would “clearly constitute fair consideration.” The second prong requires a court “to look beyond the tangible marital property at issue because New York recognizes other forms of legitimate consideration, including nonmonetary consideration.” In Walsh, the court found that Schaberg's relinquishment of certain rights ' for example her right to inheritance, or her general waiver of “other rights and remedies” ' constituted fair consideration that would validate the agreement without regard to the character of the marital assets that she took pursuant to her divorce.

The court made it clear that its analysis hinged on its finding that at least part of the marital estate was obtained legitimately. However, if the entirety of the marital assets had been the proceeds of crime, no amount of consideration ' fair or otherwise ' would give the recipient spouse a valid claim.

The court then re-fashioned the Second Circuit's second certified question and, in doing so, foreclosed the government's argument that the proceeds that Schaberg received were never valid marital assets. The proper question, the Court of Appeals asserted, was this: “Is a determination that a spouse paid 'fair consideration' according to the terms of New York Debtor and Creditor Law ' 272 precluded, as a matter of law, where part or all of the marital estate consists of the proceeds of fraud?” The court answered in the negative and found that New York Debtor and Creditor Law ' 272 did not preclude such a finding. It then punted the issue back to the Second Circuit for a factual determination of the precise nature and sufficiency of the fair consideration given by Schaberg in return for the assets she currently holds.

In a pointed dissent, Justice Eugene F. Piggot Jr. criticized the majority for reformulating the second certified question calling the move “unnecessary.” Justice Piggot wrote that fair consideration was not established by Schaberg's “relinquishing future claims” to the fraudulent proceeds of the marital assets. He further stated that in reformulating the question, the court, without cause, ignored the Second Circuit's assumption that the marital assets were primarily fraudulent, and noted that, in surrendering “future claims” to fraudulent proceeds, the innocent spouse merely gains an interest in the property by virtue of being married to the person who committed the fraud.

Conclusion

Ultimately, the Walsh decision is a victory for non-moneyed spouses unknowingly married to those whose hearts are filled with larceny. In such cases, fraud victims may be left out in the cold. However, the good news for fraud victims is that truly innocent spouses are few and far between.

Alton L. Abramowitz, a partner in Mayerson Stutman Abramowitz, LLP, is the First Vice President of the American Academy of Matrimonial Lawyers and a member of this newsletter's Board of Editors. Valerie H. Tocci is an associate of the firm and the primary author of this article.

This past June, the United States Court of Appeals for the Second Circuit asked the New York Court of Appeals to provide guidance on questions of New York law related to the proceeds of a divorce settlement where such proceeds were funded by ill-gotten gains.

In deciding Commodity Futures Trading Commission v. Walsh , 618 F3d 218 (2d Cir. 2010), the Second Circuit asked the Court of Appeals to enlighten them as to whether, under New York law, a wife could keep the money she received from her divorce settlement where a portion of the distributed assets were derived from her husband's illegal activities and where the wife did not know that those monies were the husband's criminal booty. The Court of Appeals basically answered “yes,” finding that a spouse who negotiated her settlement agreement in good faith and exchanged “fair consideration” for the assets that she received is entitled to keep the money, irrespective of the source. Therefore, according to the Court of Appeals, the government must obtain the funds to make the fraud victims whole from somewhere other than from the innocent, recipient spouse.

The Divorce Settlement

The Walsh case was brought by the Commodity Futures Trading Commission and the Securities and Exchange Commission (SEC) in an attempt to recapture stolen assets from Stephen Walsh. He stands accused of running a Madoff-like Ponzi scheme, which bilked so-called “investors” out of some $554 million. His partner pleaded guilty to the crime and is presumably aiding the government in its pursuit of Walsh.

The government named Janet Schaberg, Walsh's former wife, as a “nominal defendant” with a third-party interest in the stolen funds. The government sought to recoup some of the allegedly stolen monies from the proceeds of Schaberg's divorce settlement in order to return them to the defrauded investors.

In her divorce from Walsh, Schaberg had received approximately $17.5 million in cash and investments, as well as homes on Long Island and in Florida. There was no evidence, and the government made no allegation, that Schaberg had any idea that her husband was a swindler and that his investment fund was fraudulent. Still, the government argued that because the monies were procured by fraud, they could not be considered part of the marital estate in the first place ' by virtue of their status as stolen funds. In defense of her position that she was entitled to retain the proceeds of her settlement, Schaberg argued that she had executed the agreement in “good faith,” and, thus, had become “'a good-faith purchaser for the value of the assets.'” 2011 WL 2471544, 17 NY3d 162 (June 23, 2011) quoting Id. at 226. Schaberg asserted an ownership interest in the funds superior to that of her ex-husbands victims.

Questions for New York's Highest Court

In deciding whether Schaberg was entitled to keep the fraud-derived proceeds of her divorce settlement, and mindful of the fact that she did not know the funds were the proceeds of her ex-husband's fraud, the Second Circuit certified two questions to be answered by the Court of Appeals: 1) Does “marital property” within the meaning of New York Domestic Relations Law ' 236 include the proceeds of fraud?; and 2) Does the spouse pay “fair consideration” according to the terms of New York Debtor and Creditor Law ' 272 when she relinquishes in good faith a claim to the proceeds of fraud?

The Court of Appeals answered the first question in the affirmative, holding that “the proceeds of fraud can constitute marital property as defined in Domestic Relations Law ' 236 ' and it is therefore possible under the Domestic Relations Law to transfer assets derived from fraud to an innocent and unknowing spouse in a divorce proceeding.”

The court largely based this answer on public policy grounds, asserting that the parties' respective arguments forced the court to “weigh the competing interests of the original owners of funds stolen in a fraudulent scheme against the innocent former spouse of the defrauder.” The court reasoned that public policy demands that divorce agreements entered into in good faith by the recipient spouse must be honored, because such agreements represent the “'severance of [the husband and wife's] economic ties by an equitable distribution of the marital assets.'” 17 NY3d 162 citing O'Brien v. O'Brien , 66 NY2d 576, 583 (1985). To undo what was done in good faith would be to undermine the entire process of ending the economic partnership of marriage. The Court of Appeals stated: “To hold that the proceeds of fraud acquired by one spouse unbeknownst to the other cannot be subject to equitable distribution or conveyed through a settlement agreement as marital property would undermine one of the fundamental policies underlying the equitable distribution process, namely, finality.” (The court was further concerned that excluding fraud proceeds from the pot in this instance would “effectively undo court orders and settlement agreements for an indeterminate time.”)

The court noted that at the core of the purpose of New York's equitable distribution law is the recognition that marriage is an economic partnership and that a spouse's non-financial contributions should be accounted for in the distribution of marital property. It further observed that the Domestic Relations Law defines marital property “expansively” and the definition of marital property is “broadly construed.” Given that the statute is silent as to fraudulently procured marital assets, the court found that the fraudulent character of the funds did not bear on their classification as marital assets. In other words, it did not matter how the funds were obtained, just that they were acquired during the marriage and, thus, were marital property to be included in the marital pot for equitable distribution purposes.

The court concluded that “monies obtained by fraud cannot be followed by the original owner into the hands of an innocent former spouse who now holds them (or assets derived from them) as a result of a divorce proceeding where that spouse in good faith and without knowledge of the fraud gave fair consideration for the transferred property.” The Court of Appeals thereby solidified Schaberg's superior ownership interest.

The second question posed by the Second Circuit required a look at the feature of New York Debtor and Creditor Law ' 278 that focuses on the right of a creditor to fraudulent proceeds so long as fair consideration was given in exchange for them. New York Debtor and Creditor Law ' 278 states that “a creditor whose claim has matured may have a fraudulent conveyance set aside 'against any person' other than a good faith purchaser for valued, defined as 'a purchaser for fair consideration without knowledge of the fraud.”

In assessing what constitutes “fair consideration” in the context of a divorce agreement, the court set forth a two-part test. Specifically, the court explained that the first prong was “to determine whether the spouse relinquished rights to untainted assets in the marital estate.” If so, in the court's estimation, that relinquishment would “clearly constitute fair consideration.” The second prong requires a court “to look beyond the tangible marital property at issue because New York recognizes other forms of legitimate consideration, including nonmonetary consideration.” In Walsh, the court found that Schaberg's relinquishment of certain rights ' for example her right to inheritance, or her general waiver of “other rights and remedies” ' constituted fair consideration that would validate the agreement without regard to the character of the marital assets that she took pursuant to her divorce.

The court made it clear that its analysis hinged on its finding that at least part of the marital estate was obtained legitimately. However, if the entirety of the marital assets had been the proceeds of crime, no amount of consideration ' fair or otherwise ' would give the recipient spouse a valid claim.

The court then re-fashioned the Second Circuit's second certified question and, in doing so, foreclosed the government's argument that the proceeds that Schaberg received were never valid marital assets. The proper question, the Court of Appeals asserted, was this: “Is a determination that a spouse paid 'fair consideration' according to the terms of New York Debtor and Creditor Law ' 272 precluded, as a matter of law, where part or all of the marital estate consists of the proceeds of fraud?” The court answered in the negative and found that New York Debtor and Creditor Law ' 272 did not preclude such a finding. It then punted the issue back to the Second Circuit for a factual determination of the precise nature and sufficiency of the fair consideration given by Schaberg in return for the assets she currently holds.

In a pointed dissent, Justice Eugene F. Piggot Jr. criticized the majority for reformulating the second certified question calling the move “unnecessary.” Justice Piggot wrote that fair consideration was not established by Schaberg's “relinquishing future claims” to the fraudulent proceeds of the marital assets. He further stated that in reformulating the question, the court, without cause, ignored the Second Circuit's assumption that the marital assets were primarily fraudulent, and noted that, in surrendering “future claims” to fraudulent proceeds, the innocent spouse merely gains an interest in the property by virtue of being married to the person who committed the fraud.

Conclusion

Ultimately, the Walsh decision is a victory for non-moneyed spouses unknowingly married to those whose hearts are filled with larceny. In such cases, fraud victims may be left out in the cold. However, the good news for fraud victims is that truly innocent spouses are few and far between.

Alton L. Abramowitz, a partner in Mayerson Stutman Abramowitz, LLP, is the First Vice President of the American Academy of Matrimonial Lawyers and a member of this newsletter's Board of Editors. Valerie H. Tocci is an associate of the firm and the primary author of this article.