By Sarah N. Lynch
WASHINGTON (Reuters) - U.S. regulators sought to overturn a 2012 court ruling that prohibited victims of Allen Stanford's $7 billion Ponzi scheme from seeking compensation, in an unprecedented legal battle between the government and an industry-backed fund that protects investors.
In oral arguments on Wednesday, a lawyer for the U.S. Securities and Exchange Commission urged the U.S. Court of Appeals for the District of Columbia to force the fund to start court proceedings so that victims can file claims to recover at least a portion of the millions of dollars they lost.
The Securities Investor Protection Corp (SIPC), which administers the fund, has refused to do so, saying it believes Stanford investors do not meet the legal definition of "customer" under a federal law that is designed to protect investors if their U.S. brokerage collapses.
SIPC uses funds paid for by the brokerage industry to compensate investors if that happens.
A federal district judge agreed with SIPC's position in July 2012, and tossed out the SEC's lawsuit.
But pressure from a well-organized group of investors who lost money in the scheme and some members of Congress has helped keep the fight alive.
Two of the judges on the panel put lawyers representing the SEC and SIPC through a series of rigorous and difficult questions, often playing devil's advocate with each side. A third judge on the panel was not present for the arguments.
The judges gave no strong hints on how they may rule.
However, Chief Judge Merrick Garland asked a series of questions about whether the SEC could simply write new rules that would compel SIPC to act, as opposed to seeking a resolution in court.
The SEC, as SIPC's regulatory supervisor, has argued that it has the legal authority and discretion to force the fund to take action.
"Is there anything stopping the SEC from issuing a rule defining 'customer' the way that you want to define it here?" Garland asked.
"I don't believe so," replied John Avery, the attorney arguing the SEC's case. But if it were challenged, he added, the SEC would land right back in court again.
Allen Stanford was sentenced in 2012 to 110 years in prison for bilking investors with fraudulent certificates of deposit issued by Stanford International Bank, his bank in Antigua.
Many of the investors who purchased these products, however, did so through his Houston, Texas-based brokerage, Stanford Group Co.
At the heart of the case is the question of whether the victims of Allen Stanford's Ponzi scheme meet the legal definition of "customer."
SIPC argues that the investors in the scheme entrusted their money to the offshore, unregulated Antiguan bank and not to the U.S. broker-dealer.
Moreover, they say that Stanford's investors actually did receive their certificates of deposit as promised, even though they turned out to be virtually worthless.
The law, they said, is not designed to combat fraud or guarantee an investment's value.
The SEC, however, says the location of the Stanford bank is irrelevant because the entire business organization was operating one massive fraud, and that in fact no actual certificates of deposit truly existed.
"It's very difficult to draw a meaningful distinction between any of these Stanford entities, which were all part of the scheme, they were all in on the scheme, they didn't follow corporate formalities and the money was commingled," SEC attorney John Avery argued. "We believe the money, at least constructively, stayed with SGC."
SIPC's attorney Michael McConnell urged the court not to allow the SEC to simply lump the Stanford business entities together so the investors can file claims.
He added that the investors received disclosures explicitly telling them the Antiguan bank was not SIPC-protected or U.S.-regulated.
"You have people who in the face of disclosure statements clearly to the contrary, go off to an offshore bank seeking ... outlandishly high rates of return knowing that it is not covered by the securities laws," he said.
"Effectively, what the SEC is telling us is that SIPC should implicitly give free insurance coverage to a fly-by-night organization."
(Reporting by Sarah N. Lynch; Editing by Phil Berlowitz)