7th, 9th Circuit Cases To Affect Federal Equity Receiverships

The Securities and Exchange Commission, Federal Trade Commission, and Commodities
Futures Trading Commission often seek appointment of receivers in civil enforcement
actions, including those alleging operation of Ponzi-like investment schemes. Receivers
are generally tasked with taking over entities used to perpetrate schemes, conducting forensic
accountings, reporting their findings to the appointing court and recovering funds where
possible, for distribution to defrauded investors.

Recently, the 7th and 9th U.S.
Circuit Courts of Appeals addressed three key issues that arise in federal equity
receiverships - the impact of a claims bar date, distribution priority between investors and
creditors and the limits on a receiver's ability to recover from third-parties who file
bankruptcy.

In CFTC v. Lake Shore Asset Management Ltd. et al., 646 F.3d 401 (7th Cir.
2011), Judge Richard Posner addressed two important issues that arise in many
federal equity receiverships - allowance of late-filed claims and priority in
distribution between investors and creditors.

The court first addressed the appropriate standard for determining whether a
late-filed claim should be allowed. Notice of the deadline to submit claims had been
mailed to the investor, an Andorran bank, and the bank had failed to submit a claim.
The district court disallowed the claim and the bank appealed.

The 7th Circuit held that excusable neglect under Federal Rule of Civil Procedure
Section 60(b)(1) is the appropriate standard for determining whether a claim should
be allowed to be filed late. It described excusable neglect as an "all-relevant
circumstances" standard that balances the excuse of the claimant, the consequences
to the claimant if relief is denied and the consequences to the receivership estate if
relief is granted.

The court found that the bank's neglect was not excusable. Even if the proper
person at the bank did not receive notice, the bank had actual knowledge of the case
and the receiver's appointment, and made the incorrect assumption that it would
receive distributions automatically without taking action. Although the consequences
of disallowing the claim were substantial (i.e. no distributions from the receivership
estate), the consequences to the receivership estate if relief was granted were also
significant in that the receiver would have to recalculate distributions to all other
investors, and the reduction in distributions would likely "stir a hornet's nest" of
objections from other investors.

Note, although distributions were made before the appeal was decided, a reserve
sufficient to cover the bank's pro rata distribution, should its claim be allowed, was
maintained by the receiver. Had the bank not acted until after distributions were
made, the appeal might have been dismissed as moot.

The second issue involved the priority in distribution between investors and
non-investor creditors. An entity identified as GAMAG contended that it was not an
investor, but a non-investor creditor due to the nature of its relationship with the
receivership entities, and therefore was entitled to priority over investors. The 7th
Circuit found that there was no meaningful difference between Lake Shore's
relationships with GAMAG and with other investors. Accordingly, it affirmed the
district court's denial of GAMAG's request for priority.

More interesting than the result, however, is that the 7th Circuit apparently agreed
in dicta that if GAMAG had properly been deemed a creditor, it would have been
entitled to priority. The court stated that "creditors are usually paid ahead of
shareholders in insolvency proceedings, whether the proceedings take the form of
bankruptcy or of receivership." It explained that the priority creditors enjoy over
investors "mirrors the contractual allocation of risk and reward" for the success of the
business. The decision likens receiverships to bankruptcy cases in several places.
Other courts have drawn the same comparison, but many also note that there are
significant differences. Some courts have local rules that address the issue. See
Central District of California, Local Rule 66-8 (providing that receiverships should
be administered in accordance with bankruptcy practice).

The 7th Circuit could have simply rejected the argument that GAMAG was a
creditor and affirmed on that basis. Instead, the decision indicates that the priority
scheme in bankruptcy should apply and a distribution plan should not be approved
unless non-investor creditors are given priority over investors. This would be a
significant change in equity receivership law, which for many years has left the issue
of distribution priority among investors and non-investor creditors to the district
court's broad discretion to achieve equity under the unique circumstances of each
case.

In Sherman v. SEC (In re Sherman), 2011 DJDAR 14223 (Sept. 19, 2011), the 9th
Circuit addressed the scope of Bankruptcy Code Section 523(a)(19), which excepts
from discharge debts for the violation of federal or state securities laws, or common
law fraud in connection with the purchase or sale of security. The court held that
amounts an attorney was ordered to disgorge in connection with an SEC enforcement
action were not excepted from his bankruptcy discharge. The attorney had
represented securities laws violators, but had not himself violated securities laws.

In 1997, the SEC instituted an enforcement action against several companies,
which led to the appointment of a receiver. Richard Sherman represented some of
the defendants in the enforcement action. The receiver obtained orders directing
Sherman to disgorge funds that were determined to be ill-gotten gains, some of
which Sherman had withdrawn from his trust account and some of which he received
in a contingency case. The SEC conceded that Sherman had not committed any
securities violations himself.

Four days before the hearing on the disgorgement motion, Sherman and his wife
filed a petition for Chapter 7 bankruptcy. The Shermans were later granted a
discharge. In a subsequent adversary proceeding, Sherman sought a declaration that
his obligation to disgorge funds had been discharged notwithstanding Section
523(a)(19). The bankruptcy court granted summary judgment in favor of Sherman. It
concluded that the disgorgement order did not arise from a violation of securities
laws. It further ruled that "Section 523(a)(19) was intended to apply to 'wrongdoers'
and not to persons who are simply found to owe a debt which the SEC is authorized
to enforce."

The SEC appealed to the district court, which reversed. The court adopted a
broader interpretation of Section 523(a)(19), treating as paramount the Sarbanes-Oxley Act's goal of "protect[ing] investors by improving accuracy and
reliability of corporate disclosures made pursuant to the securities laws." It expressed
particular concern that "[r]eading a limitation into the SEC's ability to enforce its
powers to obtain disgorgement of ill-gotten funds in an appropriate case...would
frustrate the ability of the SEC to enforce the federal securities laws." Sherman
appealed.

While affirming the general proposition that ill-gotten gains may be disgorged
from innocent third-parties, the 9th Circuit agreed with the bankruptcy court that
Section 523(a)(19) prevents the discharge of debts for securities-related wrongdoings
only in cases where the debtor is responsible for the wrongdoing. It emphasized the
goals of the Bankruptcy Code, including granting debtors a "fresh start," and the U.S.
Supreme Court's rule of construing discharge exceptions narrowly. As a result, the
court said, "in cases...where neither party claims the debtor is responsible for any
securities-related wrongdoing...the debtor must be treated like an 'innocent' for the
purposes of [Section] 523(a)(19)." Judge Raymond C. Fisher issued a spirited
dissent, arguing that the funds at issue were the product of securities fraud, merely
held in trust by Sherman, and therefore Section 523(a)(19) should apply. Judge
Fisher emphasized the central role disgorgement plays in enforcing securities laws.

Section 523(a)(19) was added to the Bankruptcy Code in 2002, and few appellate
courts have addressed this issue. Given the relative absence of case law on the issue,
it is too early to tell whether the Sherman decision will notably impact Section
523(a)(19) jurisprudence. Notably, the 9th Circuit's opinion does not affect
alternative methods of pursuing disgorgement. Rather, it merely limits the
application of Section 523(a)(19) to situations where the debtor has violated
securities laws. Both the Sherman opinion and its dissent suggest that a different
tactic - constructive trust for instance (assuming the funds could be traced) - might
have yielded a different result. Nonetheless, it will be interesting to see whether
other circuits follow the 9th Circuit's majority opinion or Judge Fisher's dissent.