The distribution scheme embodied in federal bankruptcy law serves several important functions. In Chapter 7, the detailed statutory distribution scheme imposes order on the chaos that might otherwise attend the liquidation of business assets. In Chapter 11, the fixed order of priority claims and the “absolute priority rule” – along with the requirement that similarly situated classes receive identical treatment – provide predictability within the confirmation process and a framework for out-of-court negotiations.
But not all resolutions of business insolvency afford this level of predictability. In particular, state and federal receiverships afford the prospect of considerably greater flexibility and discretion on the part of the appointed receiver and the appointing court.
The scope of a receiver’s discretion was illustrated early this month by the 7th Circuit Court of Appeals’ approval of a federal receiver’s proposed pro rata distribution of the assets of six insolvent hedge funds.
SEC v. Wealth Management LLC, — F.3d — 2010 WL 4862623 (7th Cir., Dec. 1, 2010) involved an SEC enforcement action against Appleton, Wisconsin-based investment firm Wealth Management LLC and its principals, alleging, among other things, misrepresentation and fraud. At the SEC’s request, the Wisconsin District Court appointed a receiver for Wealth Management and its six unregistered pooled investment funds.
The receiver’s plan, approved by the District Court, was relatively straightforward: All investors would be treated as equity holders, and would receive pro rata distributions of the over $102 million invested in the funds. Two investors who had sought redemption of their investments pre-petition disagreed and appealed the receiver’s plan. The essence of their argument was that Wisconsin law (and Delaware law, which governed several of the funds), required that investors who sought to redeem their investments be treated not as equity holders, but as creditors of the failed funds. As a result, their redemption claims were of a higher priority than investors who had not sought to withdraw their funds. The investors also relied on 28 USC § 959(b), which provides that receivers and trustees must “manage and operate” property under their control in conformity with state law.
The 7th Circuit rejected this argument, finding instead that federal receivers and trustees need not follow the requirements of state law when distributing assets under their control. Holding that “equality is equity,” the court found that to give unpaid redemption requests the same priority as any other equity interest “promotes fairness by preventing a redeeming investor from jumping to the head of the line . . . while similarly situated non-redeeming investors receive substantially less.”
The Wealth Management decision highlights the flexibility and ambiguity of the receivership system – itself a critical distinction from the well-defined priorities of federal bankruptcy law. Though the 7th Circuit’s reasoning – rooted in “similarly situated claims” – is consistent with the policy objectives of the Bankruptcy Code, the result is diametrically opposed to the scheme of priorities on which Wealth Management’s investors undoubtedly relied.
Wealth Management – like many receivership cases – is a case based on federal securities fraud. But federal and state receiverships are applicable in a variety of contexts – including business dissolutions, directorship disputes, marital dissolutions, and judgment enforcement. Where a proposed distribution to creditors can be fairly characterized as “equitable” under the circumstances of the case and where it represents a fair exercise of the receiver’s fiduciary duty on behalf of the receivership estate, the flexibility of a receivership may justify its typically high cost.