The Application of Federal Common Law to Overcome Conflicting State Laws in the Supplemental Disgorgement Proceedings of an SEC Appointed Receiver


In spite of the Erie doctrine, the application of federal common law has survived to overcome conflicting state laws in diversity actions where a federal law, interest or function is implicated. A federal court’s authority to substantively implement a federal common law rule over state law is clearest when the party to the action is a federal entity, namely an agency of the U.S. Government deriving its authority from the Constitution or some source of federal law. Analyzing such authority becomes more difficult in circumstances where parties to a diversity lawsuit are private citizens (not necessarily possessing any direct federal authority) seeking to have federal common law adopted to displace state law. While the application of federal common law in private diversity actions has been held to be proper by the Supreme Court in certain cases, the analysis and justification for doing so has remained relatively unclear.

As a result, federal courts are left with limited guidance as to when the application of federal common law is proper between private parties. Furthermore, a federal court’s authority to hear disputes among diverse citizens is not limited to actions where the court derives its jurisdiction from 28 U.S.C § 1332 making analysis in certain situations even more problematic. Special authority is granted under 28 U.S.C § 1367 to federal courts for hearing actions which are ancillary or supplemental to a federal court’s original jurisdiction over cases involving federal claims or federal questions. The Supreme Court has never directly addressed what the proper application of federal common law should be, or whether application would be proper at all, in the novel situation where a federal court is exercising ancillary or supplemental jurisdiction between private litigants under 28 U.S.C. § 1367.

It would seem appropriate to allow the substantive application of federal common law where the federal government is a party to an action in such ancillary proceedings given the clarity of the Supreme Court’s justification for doing so where the authority of the governmental agency or entity flows from the Constitution or some federal source of law whereby the action itself furthers some federal purpose. However, it is less certain whether a rule of federal common law may be applied substantively over state law in favor of a private litigant in such a proceeding. Surprisingly, this question has been addressed under the extremely novel and narrow circumstances surrounding the disgorgement proceedings of SEC appointed receivers appointed to disgorge fraudulent transfers made as part of multi-jurisdictional Ponzi schemes.

A fraudulent conveyance action brought before a federal court by a receiver against an investor who has received fraudulent transfers in the form of “profits” as part of a Ponzi scheme is not brought under federal law nor is it connected in any way to the Federal Bankruptcy Code. Furthermore, no federal uniform fraudulent conveyance statute exists under which the receiver may file an action for disgorgement. As a result, the cause of action against the investor must be brought under the color of state fraudulent conveyance law. Consequently, extraordinary conflicts-of-law issues arise in these disgorgement proceedings where transfers have been made to investors across state lines as part of multi-state Ponzi schemes because of the great divergence from jurisdiction to jurisdiction in fraudulent conveyance law as well as other relevant state law which may be applicable to the proceeding.

In such disgorgement proceedings, elaborate, eloquent and well-reasoned arguments can be made for the application of state law favorable to the Ponzi scheme investor through complex and detailed conflicts of law analysis since it is never clear which state law is applicable when considering the form in which the transfers are made and to the entity or entities to which the transfers are made. Additionally, an investor investing as a shareholder of an offshore entity can conceivably manipulate state veil-piercing piercing doctrines to thwart disgorgement. As a consequence, uniformity of outcome in such proceedings is lost and the receiver is burdened with choice of law issues and analysis anew with each subsequent disgorgement action filed against Ponzi scheme investors from different jurisdictions. This substantially increases the receiver’s time and cost of litigation and ultimately decreases the total amount of recovered funds available for distribution to defrauded investors.

It has been directly suggested by the 8th Circuit that a receiver appointed by a federal court to disgorge fraudulent transfers as part of a Ponzi scheme is serving a federal interest and function; the primary reason being that a federally appointed receiver serves as a quasi-federal entity (similar to the FDIC) to enforce the Securities and Exchange Acts by disgorging illegal profits made from violations of the Acts and is thus simultaneously serving a federal interest and function. This proposition supported the application of a uniform fraudulent conveyance rule under a federal common law standard in one such ancillary proceeding and could conceivably serve as the standard in the future for other similar ancillary proceedings involving private litigants. Furthermore, the decision may have broader implications concerning the substantive application of federal common law over state law in ancillary proceedings.

It is well recognized that the application of federal common law implicates major constitutional concerns. Indeed, a federal court exercising authority to implement common law does “engage in interstitial ‘lawmaking,’ as part of the process of interpreting positive law” raising serious separation of powers issues. Federal judge-made law may also have the consequence of impeding upon the autonomy and independence of states by preempting state law signaling federalism concerns. Although the Supreme Court has arguably narrowed the scope of federal common law to “several well-recognized enclaves,” it has done so by “‘simply [listing] areas of law or categories of cases in which federal common law is permissible’ without providing any ‘underlying rationale other than grandfathering.’”

It is the purpose of this paper to trace the development of SEC appointed receiverships in the Ponzi scheme context and analyze whether the analogy made by the 8th Circuit, namely that these receivers are quasi-federal agents serving federal purposes and functions, can be reconciled with the Erie doctrine. Part I of this paper will give a general overview of the evolution of federal common law since the Supreme Court’s decision in Erie. A careful analysis of the development of federal common law in the post-Erie era reveals that the substantive application of a rule of federal common law over state law would be met with the least level of objection when two circumstances are satisfied all of which are directly implicated in the ancillary disgorgement proceeding of the SEC appointed receiver.

The first scenario is when the party claiming the benefit of the federal common law rule derives their authority directly from either the Constitution or some federal source of law creating a “uniquely federal interest.” The second circumstance is when the consequence of not substantively adopting the federal common law formulation over state law shatters uniformity in outcome having the ultimate consequence of frustrating an integral federal purpose of an Act of Congress or some other integral federal policy. Simultaneously, the frustration of federal purpose must also be the result of a state law’s conflict with the federal purpose which will either override or will be irrelevant to a state’s reliance on the displaced law.

When these circumstances are implicated, it is generally the case that traditional constitutional dangers of substantively applying federal common law are not implicated. Specifically, this paper will show that the federalism concerns of the Erie doctrine are not at issue when federal common law is adopted in the disgorgement proceedings of SEC appointed receivers. However, separation of powers issues (the analysis of which is conspicuously less developed in the major Supreme Court cases allowing the adoption of federal common law rules over state law) may be of concern when considering what law should be adopted as federal judge-made law in ancillary proceedings to displace conflicting state laws. Nevertheless, it is likely not to a degree significant enough to allow for the frustration of integral federal functions.

Part II of this paper will show how the 8th Circuits reasoning in Bryan v. Barlett falls within the scheme enumerated above. First, this part will give a brief overview and background of Ponzi schemes and the impetus behind appointment of receivers for the benefit of defrauded investors from such schemes. Secondly, this part will highlight the conflicts of law issues which arise in ancillary disgorgement proceedings brought by federally appointed receivers over entities used in multi-state Ponzi schemes. Furthermore, it will discuss how resolution of these issues can frustrate the receiver’s ability to recover “false profits” from investors for the benefit of defrauded investors and how conflicts analysis can conceivably benefit investors investing as offshore entities upsetting the receiver’s recovery efforts. This portion of Part II will primarily discuss how the facts of a multinational Ponzi scheme led a Federal District Court in the Western District of Virginia exercising ancillary jurisdiction to adopt the Uniform Fraudulent Transfers Act (UFTA) as federal common law using the 8th Circuits rationale.

Part III concludes.


Commercial Law | Conflict of Laws | Constitutional Law | Jurisdiction | Litigation | Securities Law

Date of this Version

April 2006