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Receiverships ?? A Better Alternative to Bankruptcy for Government Regulators?
Karen Cordry, Bankruptcy Counsel
For some regulators, such as those that are watchdogs for the banking and insurance industries, it is relatively common to use receiverships to replace the management of problematic entities, whether those companies are suffering financial distress through no fault of their own, or have been engaged in a criminally fraudulent enterprise, or anything in between. Other regulators, such as in the environmental or consumer protection area, may occasionally attempt to obtain a receiver, but the process is far less common there. At a recent conference for securities regulators held in Atlanta, NAAG Bankruptcy Counsel engaged in a lively “Point, Counterpoint,” with David Dantzler of Troutman Sanders LLP, who often serves as a receiver in the securities area.
The discussion began with NAAG Counsel presenting the case for using the bankruptcy process. She noted that creditors can force a debtor into bankruptcy and the Bankruptcy Code provides that a trustee “shall” be appointed, even in a reorganization case in Chapter 11, if there is evidence of prior misconduct or mismanagement by current management. (A trustee is always appointed if there is a Chapter 7 liquidation.) The trustee has total control over all of the assets of the estate, as well as its privileges, and can waive them and open the books to government regulators to assist in their investigations. The trustee is also charged with obeying the law and should be able to end any misconduct by the debtor. The bankruptcy filing creates an automatic stay that ensures that the limited assets will be preserved and made available ratably and equitably to victims and other creditors and not dissipated in endless, duplicative litigation –– while preserving an exception for police and regulatory litigation by the government. Bankruptcy has a national scope and national jurisdiction and a large body of established law (albeit the law is far less settled than one would expect from a field of law that is constitutionally mandated to be “uniform”). The bankruptcy trustee has extensive powers to avoid fraudulent transfers and, unlike most private parties, the power to avoid preferential transfers as well, i.e., those that allow one creditor to receive more than what would otherwise be its fair share of the estate.
Troutman Sanders LLP
In response to these arguments, Dantzler expounded on the virtues of using the receivership process in securities cases, in particular, and in government regulation cases, in general. The initial virtue he extolled was that receivership allows the government to be proactive and not merely to react to a debtor’s choice to file bankruptcy. NAAG Counsel added that, while it was true that Chapter 7 cases automatically had trustees and they could be appointed in Chapter 11, the reality was that debtors in involuntary Chapter 7 cases could very easily convert them to Chapter 11 and regain control of the assets. Further, for either Chapter 7 or 11, filing an involuntary bankruptcy requires that one must have creditors with undisputed debts (which is usually not the case with the government’s claims), and the debtor must not be generally paying its bills as they come due, which may again not be true if the only debts going unpaid are those of the victims or the costs of cleaning up contaminated property.
Dantzler next noted that, in Chapter 11, the courts have adopted an extremely high standard to show cause to displace management –– and have held that, if the current corrupt or incompetent management has appointed new, “independent” management in its stead, then the incompetence and/or misfeasance of prior management can be disregarded. To be sure, the court is expected to ensure that the new management is truly “independent,” but there is still a difference between being hired by (and being in at least a psychological sense beholden to) those who violated the law and having one’s appointment procured by those sworn to uphold the law. That difference, even if only subconscious, can also affect the underlying approach of judges adjudicating the case before them. When a receiver is requested, the court typically is dealing with a government plaintiff suing a party labeled “defendant,” which sets up the typical “white hat, black hat” scenario for the court. On the other hand, in a bankruptcy setting, when one requests a trustee, one is dealing only with the “debtor” –– the object of the court’s attention and solicitude –– and is seeking to displace the management of that entity, which is presumed to be the best party to operate for the benefit of all creditors, because of the concerns of only one group of creditors.
Moreover, outside of bankruptcy, the issue of appointing a receiver is normally a matter solely between the governmental entity and the debtor. While the interests of other parties, such as trade creditors, are not to be ignored in enforcing the receivership, they normally are not consulted in deciding on the appointment. In bankruptcy, on the other hand, traditional creditors are parties that are always officially recognized in the case and allowed to comment on and object to any action in the case, particularly one that might focus payments away from business operations and towards the victims of those operations. The split in approach between victim creditors (whether consumers or those charged with cleaning up contaminated land) and trade creditors is particularly difficult in cases where the government believes that “business as usual” by the debtor is exactly the problem. Where the government’s goal may be to shut down or dramatically restructure an offender’s operations, the participatory process in bankruptcy can substantially increase the number of players that may seek to oppose the government’s actions.
As Dantzler explained, while the standard for appointing a receiver is also relatively high outside bankruptcy, it does, in practice, require quite the same extraordinary showing as in bankruptcy. Once appointed, the receiver, as in bankruptcy, controls the debtor’s privileges and records and can be expected to be more cooperative about complying with the government’s information requests and/or considering its settlement proposals. Too often in bankruptcy, particularly in closely held corporations, the management/owners, despite their fiduciary duties to creditors, use the corporation’s assets to engage in a scorched earth defense to ensure that liability will not extend beyond the debtor to the owner’s own personal assets. The receiver has no interest in protecting the owner’s assets, so he can act more freely to settle litigation based on its own merits.
One major difference, of course, is that there is only one, national bankruptcy law. Receiverships, on the other hand, can be created based on the authority of many federal and state laws. Moreover, the general concept of an “equity receiver,” i.e., a party with full authority to operate the company during litigation, is an equitable remedy that exists in federal (and many states’) common law, without the existence of a specific authorizing statute. As a result of this multiplicity of authority, both the blessing and the bane of receiverships is that they possess great flexibility. In large measure, they operate based solely on the authority granted by the court order that authorizes the receiver. Thus, as Dantzler noted, it is critical to ensure that such an order is sufficiently broad and comprehensive to ensure that the receiver is granted the powers necessary to fully control the entity’s assets and litigation. Such an order can, for instance, impose a stay on litigation that parallels the scope of the automatic stay in bankruptcy. Although it will not be effective prior to its service, the bankruptcy stay goes into effect as soon as a petition is filed. (A model of such an order, as well as Dantzler’s paper discussing receiverships and NAAG Counsel’s discussion of the various bankruptcy statutes, rules, and cases are available from NAAG.) One problem that will always exist with receiverships, as opposed to bankruptcies, is that they require a court to exercise far-reaching authority under a process with which it has little familiarity or certainty that it has such authority. This may result in the court being unwilling to authorize the full range of authority that is always available in bankruptcy.
One of the critical points is that, for federal receivers, there are two sections that expand the receiver’s authority nationwide – 28 U.S.C. § 754 allows the receivership order to be filed in other districts and 28 U.S.C. § 1692 then extends the territorial jurisdiction of the original court to include any district where the order was filed under Section 754. This process, once implemented, gives the receivership court jurisdiction that can be roughly equivalent to that of the bankruptcy court, although it does require a substantial amount of additional paperwork that can cause delays in the order becoming fully effective. State court receivers may have considerably more difficulty in being able to ensure they can control all of the defendant’s property if it is scattered over a number of states.
Receivers have essentially the same authority as bankruptcy trustees to bring actions to avoid fraudulent transfers, but generally will not be able to attack preferential transfers. If this appears to be a major source of revenues in the case, Dantzler conceded this was an area in which bankruptcy would have the edge. On the other hand, he asserted that receivers have tended to fare better than bankruptcy trustees in avoiding application of the in pari delicto defense when suing on behalf of the corporation. In bankruptcy, that defense has often been used to preclude the trustee from suing on behalf of the corporation against those who assisted in the misconduct. To be sure, the creditors, as such, are allowed to bring such litigation, but it is usually far more difficult for them to join together to do so, rather than to have the corporation bring the litigation and distribute the proceeds thereof to them.
However, the initial filing is not the end of the story, since a determined fraudster still has an option after a receivership is filed, namely, to file its own voluntary bankruptcy and demand that control of the assets be returned to it. Normally, under 11 U.S.C. § 542, any party holding “property of the estate” is required to turn such assets over to the debtor immediately upon the filing of the case. An exception is made, however, in 11 U.S.C. § 543(d)(1) for assets that are being held by a “custodian” such as a receiver. The court “may,” in its discretion, decline to require the assets to be turned over if the creditors would be “better served” by allowing the assets to remain with the receiver. Thus, while this exception is not automatic, it does provide a basis for the receiver (and the entity seeking the receiver’s appointment) to argue that the receiver should remain in place. This will obviously be most effective in situations where there is a well-structured receivership order in place, where the receiver has been doing its job effectively and economically, and where the process has been in place for some time. It will also be important to show the underlying basis for the receivership, i.e., the fraud or gross mismanagement of the debtor’s affairs so that the bankruptcy court will be convinced that it would be to the detriment of the creditors to allow that same management to seize control of the debtor again.
The bottom line is that receiverships are a way for the government to act proactively. Instigating an involuntary bankruptcy case is difficult and obtaining a trustee in such a case is equally difficult. Having a receiver appointed, while not a routine matter, can plainly be done more easily than in a bankruptcy case. More importantly, it can also be done earlier in that it need not require a showing of “insolvency” in the way that is required in a bankruptcy case. Receiverships also often operate with less of the formal trappings – and consequent expenses – of a bankruptcy case. While not a panacea, it is clearly an arrow that government regulators should explore and place in their quiver. If they can utilize the federal procedures, there are existing mechanisms to deal with a number of issues. If they will normally be proceeding under state law, they will need to explore that law and determine what the practices are and, perhaps, if necessary, work to implement additional statutory and administrative procedures to handle the sorts of issues that may arise. What they should not do is let this valuable tool go to waste.
David Dantzler is the practice group leader of the Securities Litigation Practice Group at Troutman Sanders. His practice is focused on corporate and securities litigation, including cases involving allegations of fraud, breach of fiduciary duty, and other business torts. He has also served as lead counsel for court-appointed receivers in enforcement actions filed by the SEC, FTC, and CFTC.
Karen Cordry is Bankruptcy and Special Issues Counsel for NAAG. She serves as a resource person to the states for all issues relating to the effect of bankruptcy on the activities of the Attorneys General.
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