MEDIA

May 9, 2014

Warrant, Privilege, Bankruptcy Case and Ponzi Scheme

Published in: New York Law Journal | volume 251

This column reports on several significant, representative decisions handed down recently in the U.S. District Court for the Eastern District of New York.  Judge Jack B.  Weinstein suppressed evidence seized pursuant to an insufficiently particular search warrant.  Judge Sterling Johnson, Jr., upheld an order of Magistrate Judge Cheryl L.  Pollak finding waiver of attorney-client privilege and work-product protection by a party that failed to submit a timely privilege log as required by the local rules.  Judge Dora L.  Irizarry, affirming a decision of Bankruptcy Judge Elizabeth S.  Stong, granted a motion for sanctions against an attorney.  And Judge Joseph F.  Bianco affirmed the decision of Bankruptcy Judge Carla E.  Craig avoiding certain presumably fraudulent transfers relating to a Ponzi scheme.

Search Warrant Particularity

In United States v.  Wiggins, 14 CR 3 (EDNY, April 3, 2014), Judge Weinstein granted a motion to suppress evidence seized in a defendant's apartment when the search warrant failed to specify an apartment number, the police knew or should have known that defendant lived in a multi-family building, and the judge issuing the warrant was knowingly misled on that point.

Defendant Shakeel Wiggins was charged with cocaine and firearms offenses.  The evidence at a suppression hearing showed that, before seeking a warrant to search defendant's apartment, the lead police detective verified defendant's address and tried to ascertain whether the building where he lived was a single or multiple residence.  The certificate of occupancy was issued for a single-family residence.  By visual surveillance, the detective saw that the house had one address, one front door, one doorbell and one mailbox.  He did not notice the two electric meters on the side of the house.

The detective also ran an "Accurint" report, which lists people who have lived or received mail at an address over many years.  The first nine results showed people with the surname Kahn.  Defendant Wiggins appeared as the 12th result.

A confidential informant provided information about defendant's illegal activities.  In applying for the warrant, the detective referred to a "private three story house." He told the team of agents executing the search that the house was "single family." The officers entered the building through an unlocked front door.  In the hallway there was a locked door leading to a first-floor apartment, and a second locked door leading to an upstairs apartment.  The search team rammed open the second door and the lead detective went upstairs, where he saw a member of the Khan family.  He then went downstairs and, after the door to defendant's apartment was rammed open, saw defendant inside running with a "long" black bag, which contained a rifle.  The officers also found crack cocaine and a handgun in the apartment.

If officers seeking a warrant to search a suspect's apartment know or should know that the building has multiple units, "the particularity requirement demands that the warrant specify which unit is to be searched." Slip op.  5.

The court found the lead detective "not credible" in aspects of his testimony and "reckless" in his conclusion that the house was single-family.  As Weinstein observed:

The Accurint report .  .  .  should have alerted the police that the house was a multiple-occupancy structure.  Proper surveillance, which would have shown multiple families entering and exiting the building, should have raised an additional red flag.  The utility records, which documented two separate accounts at the address, would have presented yet another red flag .  .  .  .  (Slip op.  9)

Nor could the search here be saved by the "good faith" exception to the exclusionary rule or the "inevitable discovery" doctrine.  Slip op.  10-12.

Waiver of Privilege

In McNamee v.  Clemens, 09 CV 1647 (EDNY, April 2, 2014), Judge Johnson upheld an order of Magistrate Judge Pollak, directing the production of documents on the ground that defendant waived any assertion of attorney-client privilege or work product protection.

Former professional baseball player Roger Clemens was sued for defamation by his former personal trainer, Brian McNamee, after Clemens said McNamee was lying when he claimed to have injected Clemens with performance-enhancing drugs.

McNamee served discovery demands for Clemens' communications with his agent and his public relations strategist.  In January 2013, Clemens objected, asserting attorney-client privilege and work product protection.  But he did not provide any privilege log, as required by Local Civil Rule 26.2, until August 2013 (when, after a motion to compel by McNamee, Magistrate Judge Pollak directed Clemens to produce the contested documents for in camera review.)

After reviewing more than 900 pages of emails, Pollak, by order dated Sept.  18, 2013, found that Clemens had waived any protection for the documents by failing: (1) to provide a privilege log in connection with his initial assertion of privilege or protection, and (2) to provide sufficient information, in the conclusory privilege log he belatedly submitted, to enable the court to determine whether the documents were, in fact, entitled to protection.  Pollak also found, upon reviewing the emails, that none of them had been shown to be entitled to attorney-client or work product protection.

Clemens' counsel filed a Motion for Reconsideration before Pollak on Oct.  11, 2013, which was denied on Jan.  30, 2014.  On Feb.  7, 2014, Clemens filed a motion before the district court to modify or set aside and stay Pollak's orders.

Johnson denied Clemens' motion on both procedural and substantive grounds.  Procedurally, the rules do not provide for reconsideration motions before a magistrate judge, and the erroneous filing of such a motion did not stay or toll the running of Clemens' 14 days, under Fed.  R.  Civ.  P.  72, to make an objection to the district court regarding Pollack's Sept.  18, 2013, order.  Clemens' Feb.  7, 2014, motion under Rule 72 was therefore untimely.  Slip op.  6-7.  Substantively, Clemens could show nothing clearly erroneous or contrary to law in Pollak's findings that Clemens had waived any otherwise-applicable protections, first by failing to provide a privilege log, and again, in connection with the in camera review, by relying on conclusory, "unhelpful," and "vague" descriptions to meet the "heavy burden" that applies to movants seeking protection from their discovery obligations.  Slip op.  7-12.

Sanctions—Bankruptcy Court

In Dahiya v.  Deborah Kramer as Trustee of the Estate of Shahara Khan, 13 CV 3079 (EDNY, March 27, 2014), Judge Irizarry affirmed the decision of Bankruptcy Judge Stong, granting a motion for sanctions by the trustee against Karamvir Dahiya, counsel to a defendant in an adversary proceeding.

In December 2011, the trustee filed an adversary proceeding to recover alleged fraudulent conveyances from the debtor's son, Tozammel Mahia, who had received all the net proceeds of the sale of real property jointly owned by the debtor, Mahia and a third party.  After missing the deadline to respond to the complaint, Mahia retained Dahiya to represent him.

Dahiya filed an answer along with counterclaims alleging abuse of process and "constitutional torts," and seeking "1) an injunction barring the Trustee from bringing actions against a debtor's family unless she first demonstrates probable cause; 2) that the requirement to show probable cause be incorporated into the Local Bankruptcy Rules for this District; and 3) that the United States Trustee Office investigate whether lawsuits by panel trustees are abusive." Slip op.  2.  In March 2012, the trustee moved for sanctions, asserting that the counterclaims against her were "baseless, made in bad faith, protracted the adversary proceeding, and caused her to incur additional legal fees and increased malpractice and liability insurance premiums." Slip op.  3.

Subsequently, Dahiya missed deadlines, hired and fired counsel, moved to withdraw the references of both the adversary proceeding and the sanctions motion to the district court, and refused to participate in the sanctions hearing.  The motions to withdraw the references were denied by Irizarry on April 15, 2013.  The bankruptcy court, finding bad faith by Dahiya in bringing the counterclaims, imposed sanctions of $15,000.  Dahiya appealed, claiming that the bankruptcy court lacked jurisdiction over the sanctions motion.

The bankruptcy court imposed sanctions both under its inherent authority and 28 U.S.C.  §1927 (sanctions proper under §1927 when an attorney "so multiplies the proceedings in any case unreasonably and vexatiously").  As Irizarry determined, the bankruptcy court has inherent authority to impose sanctions derived from its power to "impose silence, respect, and decorum" and require submission to its orders.  Slip op.  6.  Dahiya fared no better in arguing that the bankruptcy court cannot impose sanctions under §1927 because it is not an Article III court of the United States.  Although there is a split in the circuits as to whether §1927 applies to bankruptcy courts, the Second Circuit has found that it does, so that they may issue sanctions.  Just as a court may issue sanctions under its inherent power where the claim lacks a colorable basis and was brought in bad faith, §1927 similarly requires bad faith.  Under §1927 courts may make sanction awards only against attorneys, while under their inherent power, courts may impose sanctions against attorneys and/or a party.

Irizarry analyzed the two counterclaims—abuse of process and constitutional torts—and determined that neither had a colorable basis.  Because filing and service of a summons and complaint are not a sufficient basis for an abuse of process claim, Dahiya's allegation that the trustee failed to investigate before initiating the adversary proceeding did not plead a cause of action for abuse of process.

Dahiya also failed to allege actual or special damages with sufficient particularity.  Finally, his subjective belief that the trustee abused process in commencing the adversary proceeding because she knew that the debtor and her family did not have a lot of money and were immigrants was baseless: "this Court finds that the Bankruptcy Court did not err in finding that Dahiya could not have had a reasonable belief that his abuse of process claim had factual support." Slip op.  12.

Dahiya based his constitutional tort counterclaim, not on any article or amendment to the constitution, but on his belief that his client had the right to be left alone and in peace with his family.  Irizarry agreed with the bankruptcy court that neither counterclaim was colorable, noting that Dahiya had let his personal convictions overwhelm his professional judgment.  Given Dahiya's record of bringing similar counterclaims against other trustees, the bankruptcy court reasonably concluded that he had acted in bad faith and that his actions multiplied the proceedings and caused "significant and unnecessary delay." The $15,000 award was also reasonable.  Slip op.  16.

Ponzi Scheme

In Schneider v.  R.  Kenneth Barnard, as Chapter 7 trustee of Janitorial Close-Out City Corp., 13 CV 4901 (EDNY, April 2, 2014), Judge Joseph Bianco affirmed the decision of Bankruptcy Judge Carla Craig that the trustee was entitled to avoid transfers made in connection with a Ponzi scheme.

The bankruptcy court found that beginning in 2002, Laurie Schneider became the principal and officer of seven businesses in three categories: music and entertainment services for corporate and private clients; wholesale sales of janitorial supplies and purchase of equipment and machinery from China; and purchasing and selling foreclosed residential properties.

Beginning in January 2007, Laurie solicited funds from nearly 200 third-party investors at a time when those debtors did not have sufficient cash to pay off current obligations and used investors' funds to pay off other investors.  Schneider transferred the funds at issue to her mother Linda Schneider, the party in this bankruptcy appeal, in furtherance of the scheme.

From March 2005 to January 2009, debtors made payments to Linda Schneider, to be used as rent money enabling Laurie and her husband to live in a house owned by Linda.  In 2009, Linda Schneider exercised control of several debtor bank accounts, made payments into her own bank account in the amount of $77,000 and only transferred $50,000 to debtors.  The bankruptcy court found that the trustee could avoid transfers from these debtors to Linda Schneider in the amount of $185,612.

Under section 548(a)(1)(A) of the Bankruptcy Code and New York Debtor & Creditor Law §276, a trustee may avoid transfers made by the debtor with "actual intent" to "hinder, delay, or defraud" present or future creditors.  Transfers made by a Ponzi entity are presumed to have been made with actual intent.  Because a "'Ponzi' scheme is a fraudulent arrangement that uses later acquired funds or products to pay off previous investors," the operator must know that investors remaining at the end of the day will lose their money, and when funds are transferred out there is an inference that the debtors had the intent to hinder, delay or defraud creditors.  Slip op.  8.  Accordingly, the Ponzi scheme presumption of intentional fraud applies to almost all transactions made by a Ponzi entity.  The only condition imposed by some courts is that the transfer must have some connection to the Ponzi scheme.

As Bianco concluded, the bankruptcy court's finding that the Ponzi scheme began in January 2007 was well supported by the record.  Laurie began to enter into written investment agreements beginning on Jan.  1, 2007, and did not maintain sufficient cash to meet the minimum obligations under those agreements.  The rent transfers were made in furtherance of the Ponzi scheme because they provided free housing to Laurie and her husband, enabling Laurie to extract value from the Ponzi scheme to the detriment of the investors.

Under the Bankruptcy Code, only the intent of the transferor is relevant.  Authority is split over whether the Debtor and Creditor Law requires proof of the transferee's fraudulent intent.  In Bianco's view, "the Bankruptcy Court correctly decided that DCL §276 requires only proof of the transferor's fraudulent intent; the transferee's intent is relevant only to a good faith defense." Slip op.  12.

The bankruptcy court also correctly concluded that the transfers to Linda Schneider were avoidable as constructive fraudulent conveyances, primarily because no value was provided to the debtors in exchange for the transfers.  The rent transfers benefitted only Laurie and her husband, and Linda Schneider provided no corresponding value for the retention of the $27,000 in her bank account.

Harvey M.  Stone and Richard H.  Dolan are partners at Schlam Stone & Dolan.  Bennette D.  Kramer, a partner of the firm, assisted in the preparation of the article.

[This article is reprinted with permission from the May 9, 2014, issue of the New York Law Journal.  Copyright © 2014 ALM Properties, Inc.  All rights reserved.  Further duplication without permission is prohibited.]