JANUARY 3, 2011, 1:01 P.M. ET

http://online.wsj.com/article/SB10001424052748704111504576059613947208394.html?mod=googlenews_wsj

By the time Scott Rothstein was charged with racketeering, money laundering and fraud on Dec. 1, 2009, the South Florida attorney's white Lamborghini, 304 pieces of jewelry, 87-foot yacht and other assets were already in the hands of the U.S. government.

Creditors of Rothstein Rosenfeldt Adler PA, Rothstein's law firm, filed an involuntary bankruptcy petition against the firm the day after Rothstein's assets were seized, but they were too late. The assets creditors were counting on to pay their claims were gone.

Mr. Rothstein's creditors are the losers in what bankruptcy attorneys say is an aggressive push by the federal government to seize the spoils of business empires that have collapsed in fraud.

Created to ensure crime doesn't pay, federal forfeiture laws allowed the government to seize the proceeds of Mr. Rothstein's $1.2 billion Ponzi scheme. It can do what it likes with the proceeds, keeping some—or a lot—for itself and making some available to Mr. Rothstein's victims. Unlike with federal bankruptcy laws, however, no federal judge is required to sign off on what is done with the recovered proceeds, nor does the law require one cent to be set aside for Rothstein's legitimate business creditors.

When the worlds of bankruptcy and crime collide, the line that is drawn between assets subject to forfeiture and those subject to bankruptcy proceedings is murky at best, and there is no overarching law awarding superiority to one system. So turf wars are being waged over the assets of admitted Ponzi-scheme operators Mr. Rothstein, Bernard Madoff and Marc Dreier, pitting bankruptcy trustees against federal prosecutors in highly scrutinized battles with billions of dollars at stake.

"In the past, prosecutors had largely deferred to bankruptcy estates and receivers to go ahead and gather assets," said Edward H. Davis Jr., a founding shareholder in the law firm of Astigarraga Davis in Miami. "That attitude has changed."

Nowhere has the rancor been more visible than in Mr. Rothstein's case, where Herbert Stettin, the Chapter 11 trustee liquidating Rothstein Rosenfeldt Adler, has spent the past year fighting for a say in the fate of the seized assets.

Mr. Stettin most recently appealed a U.S. district court's rulings denying his challenges to the forfeiture of Mr. Rothstein's assets, some of which Mr. Stettin insists were technically property of the Rothstein firm and therefore should be made available to the firm's creditors. It hasn't been an easy fight.

"Once there's a forfeiture, it's very hard to stop that train from rolling down the track," Assistant U.S. Trustee Sandra Rasnak said at a law firm panel discussion in November.

In fact, U.S. District Judge James I. Cohn has largely sided with prosecutors, questioning the appropriateness of shuffling the seized assets to the bankruptcy court.

"It would be patently inequitable to return that money to RRA's estate when it can be returned directly to the clients and qualified investors," Judge Cohn wrote in an order last summer.

With the number of billion-dollar Ponzi schemes exposed in the past two years, bankruptcy attorneys are questioning the utility of forfeiture and the impact it has on creditors.

"Pain is being intensified because of forfeiture actions which are pulling money away from these bankruptcies or receiverships to compensate the victims," said bankruptcy attorney Joseph J. Wielebinski of Munsch Hardt Kopf & Harr.

According to Mr. Davis, forfeiture works well when it concerns crimes like drug dealing, in which victims aren't easily discernible. It doesn't work as well, he said, when there are "known and discernible" victims, like Ponzi-scheme investors.

"The purpose of forfeiture is to take the gain out of crime," Mr. Davis said, pointing out that although returning criminal proceeds to victims is a key component of forfeiture, it isn't obligatory. The government also uses the proceeds to fund its forfeiture efforts and to compensate local, state and foreign governments and law-enforcement partners.

According to a financial statement for the fiscal year ended Sept. 30, 2009, the Department of Justice's Asset Forfeiture Program reported $1.4 billion in seized assets. That year was just the fourth time that deposits topped $1 billion since the fund's creation in 1984, a feat the Justice Department attributed to the $492.8 million in "extraordinary forfeiture income" brought in from just five major fraud cases.

Of the assets forfeited in the 2009 fiscal year, a Justice Department spokeswoman said $152 million was applied to victim compensation. That is 65% less than the $439.2 million handed out to victims in the 2008 fiscal year, even though that year saw a lower dollar value of seized assets.

Under the law, the government "has sole discretion on what to do with the forfeited assets," said Kathy Bazoian Phelps, a member in Danning, Gill, Diamond & Kollitz LLP who often represents bankruptcy trustees.

"The question becomes: What happens to that forfeited property? Is it ultimately getting to the defrauded victims? Because there's no judicial oversight, it's unknown," she said.

The lack of judicial oversight is one reason that bankruptcy trustees like Jenner & Block LLP partner Ronald R. Peterson say the government isn't the best equipped to handle the complex process of evaluating the validity of victims' claims and determining how to fairly distribute forfeited funds.

"These guys busted their ends to get difficult convictions in a very short period of time," Mr. Peterson said, but "in the terms of getting money out to victims, there's nobody like bankruptcy trustees. We have experience doing that. We have a bankruptcy court that's designed to do just that—there's a whole process there that's set up."

Some judges, like U.S. District Judge Louis L. Stanton, have favored the utility of bankruptcy in administering assets and claims. In 2009, Judge Stanton overruled the objections of federal prosecutors to side with a group of Mr. Madoff's Ponzi-scheme victims looking to force the investment manager into bankruptcy.

"No opponent to the relief sought by the motion offers as familiar, comprehensive, and experienced a regime as does the Bankruptcy Code for staying the proliferation of individual lawsuits against Mr. Madoff individually, marshaling his personal assets other than those criminally forfeitable, and distributing those assets among his creditors according to an established hierarchy of claims," Judge Stanton wrote in his April 10, 2009, opinion.

Judge Stanton shot down the often-cited objection to the expense of bankruptcy, calling such concern "speculative" and outweighed by the benefits Mr. Madoff's victims would receive in a "bankruptcy trustee's orderly and equitable administration."

But prosecutors and bankruptcy trustees aren't always at each other's throats.

"Whenever feasible, the government attempts to work with bankruptcy trustees and receivers to ensure that the maximum amount of forfeited funds is returned to innocent victims, while at the same time accommodating the trustee's fiduciary duty to secured and unsecured creditors who are not victims," said a spokeswoman for the Justice Department.

The government struck a deal with the trustees in the bankruptcies of disgraced New York attorney Marc Dreier and his law firm Dreier LLP in which the trustees agreed not to challenge the forfeiture in exchange for $9.5 million and dozens of pieces of seized artwork.

Even so, the bitterness of the battle wasn't lacking from the motion the law firm's trustee submitted in support of the deal.

"The trustee strongly disagrees with the appropriateness of the use of forfeiture laws in the context here," Chapter 11 trustee Sheila M. Gowan said in court papers last year. "The bankruptcy system has been used as the traditional means for distributing assets after the collapse of Ponzi schemes for more than 70 years, and it is the superior system for doing so."

With the public eye trained on their every move, prosecutors and bankruptcy trustees will continue butting heads as they race to demonstrate the superiority of their respective systems.

"In these big Ponzi cases there are big dollars involved, and there are a lot of people watching," Ms. Phelps said. "Neither the government nor the trustee wants to be the ones sitting on their hands."