Serving as Receiver in a Federal or State Regulatory Action
By Holden, Frederick, Jr.*
Governmental regulators frequently appoint or move a court to appoint a receiver, conservator, trustee or liquidator as part of the agency’s effort to enforce a statute regulating investment, banking, insurance or other business activities. These “regulatory receivers” occupy a challenging, but potentially satisfying role in these government enforcement proceedings. Such a receiver has an opportunity to deliver compensation to the victims of fraud, embezzlement or other wrongdoing. As there are few reported decisions under most of the applicable regulatory statutes, the receiver and his or her legal counsel are often faced with issues for which there is no obvious precedent. This presents challenges, but also an opportunity to fashion remedies best suited to the circumstances of each particular case.
This article first discusses what regulatory receiverships are and then contrasts them with ordinary receiverships. A discussion of the various parties to such a receivership follows, then concludes with a discussion of how flexibility in claim payment procedures may promote an equitable outcome.
Contrasting Legal bases of Regulatory and
In a typical federal regulatory action, the appointment of a receiver is based entirely on the court’s inherent equitable powers, rather than on specific statutory authorization. With only a handful of reported decisions to guide the receiver and the court, these cases are generally governed by principles of equity, with a healthy dose of analogy to the U.S. Bankruptcy Code and practice under it.
There are also receiverships that are a hybrid of regulatory and ordinary receiverships. Unlike purely regulatory receiverships, these may involve governmental policy goals but the appointment of a receiver is obtained under the rents and profits clause of a governmental lender’s deed of trust. The duty of the receiver in these cases is primarily to operate, refinance or recapitalize the receivership estate for a public interest, while the regulatory agency forecloses. Each agency’s requirements and goals are very specific. For example, the California Department of Housing and Community Development may seek a receiver to operate a low-income housing development for a public purpose: to serve low-income or disabled populations. Such a receiver is subject to many restrictions on the operation of such properties, such as rent control and occupancy profiles, but otherwise conducts an ordinary receivership.
In the purely regulatory receivership discussed in this article, the legal proceeding is brought by a government agency to have a licensee or other business entity enjoined from certain conduct the agency views as injuring the public. Often the need is for at least a conservatorship (typically the first step for an insurance company), a full receivership (where current management needs to be removed from control), or a liquidation of the assets of the business.
Where liquidation of the defendant’s assets, rather than rehabilitation or sale of one asset, is a goal of the government’s case, judges do not always adopt the government’s view. Appointment of a receiver is, in the federal courts, often viewed as a “drastic remedy.” A receivership in this circumstance may therefore be (but usually is not) temporary and short term, designed to allow the government access to the business for the purposes of investigation or audit.
Selecting the Regulatory Receiver: A Complex Process
A background in the industry in which the business is operating may be essential, depending on the agency petitioning for the appointment of a receiver (or a conservator, liquidator or trustee).
The nominating (or appointing) agency may require the successful candidate to have identified his or her general counsel that would be engaged not only to handle matters in the supervising court, but also to coordinate foreign representation, such as offshore litigation to recover assets. It is commonplace for years of litigation to be required to recover assets, press claims against directors and officers, seek coverage under insurance policies and avoid pre-receivership transfers. Both the receiver and his or her counsel are expected to be cost effective. Creative fee proposals from both the receiver and legal counsel are often useful in obtaining engagements.
In receiverships initiated by California regulatory agencies, the governmental agency often controls who is, in effect, the receiver. See, e.g. Calif. Fin. C. §§ 3100 et seq. The regulator nominally serves as the conservator or liquidator, with his or her powers delegated to “special deputies.” These are sometimes private-practice receivers. In federal cases, the plaintiff agency nominates a candidate or multiple candidates to the U.S. District Judge, who makes the appointment. Appointment is usually at an unnoticed TRO hearing or shortly after it. Some U.S. District Judges defer to the agency’s wishes on the appointment, while others do not. As regulatory receiverships present challenges that can be unique, judges in these cases are more likely to believe they know who is best-suited to accomplish the tasks at hand than in ordinary receiverships. The regulated person or entity may file a chapter 11 petition under the U.S. Bankruptcy Code to interfere with the process. This tactic can be defeated if it is anticipated. For example, in In re First Independent Trust Company, 101 B.R. 206 (Bankr. E.D.Cal. 1989), the bankruptcy court dismissed a chapter 11 case in its first 24 hours, as it would have interfered with the agency’s enforcement of its regulatory requirements. Receivers should also analyze early on whether the debtor is eligible to file a petition under Bankruptcy Code § 109(b)(governing who may be a debtor).
The Actions of the Defendant/Licensee Vary
from Case to Case
The Role of the Court Depends on the Controlling Statute and Inclinations
of the Judge
California regulatory receiverships are generally quasi-administrative proceedings. Only some events and activities are subject to court review. Federal courts typically defer to the reasoned recommendations of the plaintiff agency, once the agency has met its high burden for appointment of receiver. Federal courts in California have very broad power to fashion how the receiver will be supervised and what proposals by the receiver will be approved. See SEC v. Hardy, 803 F.2d 1034 (9th Cir. 1986).
The Government Agency Usually is Active in the Case
In federal and California cases the agency will generally stay thoroughly involved throughout the term of the receivership. The receiver will need to consult frequently with the agency to assure that the receiver’s proposals are supported. The authorizing statute or appointing court likely also will require or expect the agency to review all professional fees and expenses sought in connection with receivership administration.
What Role the Claimants/ Victims May Play Depends
on the Controlling Statute
In California cases claimants are often active. Creation of committees of the class of claimants being protected in the receivership is commonplace. The committee can become an important ally for the receiver in disputes with the defendant.
Asset Recovery Rules Differ from those in Ordinary Insolvencies
Where seeking funds from persons other than the investors, a receiver cannot assert the claims that belong to the investors. A corporation in receivership can, however, be viewed as having been damaged in the amount of the investors’ claims. That enables the receiver to, in effect, assert all investors’ and creditors’ claims against the persons who caused or negligently allowed the fraud or other wrongdoing to occur.
The receiver can assert those claims far more efficiently and as effectively as the individual victims can. Although a receiver stands in the defendant’s shoes for many purposes, the defenses of in pari delicto, unclean hands and inequitable conduct do not apply to a receiver. FDIC v. O’Melveny & Meyers, 61 F.3d 17 (9th Cir. 1995). It is sometimes necessary, however, to include the victims themselves in a settlement, to obtain a “global” resolution.
The receiver may seek and receive assistance from a defendant in locating records and locating and valuing assets, cooperation perhaps inspired by the defendant's desire for leniency in a criminal prosecution. The receiver must be wary, and assure there is a third-person witness at all meetings with the defendant and keep the regulatory agency and prosecutors fully informed of such relationships.
A Custom-Tailored Claims Submission and Review Process can be Appropriate
The receiver’s first concern is to determine the class of claimants to be benefited by the receivership. A regulatory receiver should analyze early in the case whether, on a fair-value balance sheet, there is any hope for general creditors. General creditors are not the real victims in most of these cases (it is not uncommon for the largest creditor claims to be held by insiders and by the defendants’ lawyers). Therefore even though the bankruptcy courts disfavor application of trust principles to defeat a pro rata distribution of assets, in cases involving investment frauds trust law is very important. Tracing principles are often appropriately used to place investors (those who entrusted funds to the defendant, not shareholders in the defendant) ahead of ordinary creditors for purposes of distribution and to provide useful guides. See FTC v. Crittenden, 823 F.Supp. 699, 703 (C.D. Cal. 1993), aff’d 19 F.3d 26 (9th Cir. 1994), cert. denied 115 S.Ct. 645 (1994).
Therefore it is sometimes appropriate to recognize multiple trusts. Where defrauded investors constitute the class of claimants to be protected by the receivership, claims may then be separated into separate groups with claims against certain pools of recovered assets. Appropriate claim amounts may be limited to out-of-pocket losses, excluding promised profits, where the recovery is limited. In re Tedlock Cattle Co., Inc., 552 F.2d 1351 (9th Cir. 1977).
Even such normally venerable principles as prorating of distributions within a trust class may be markedly unfair in a regulatory receivership. For example, estimating and paying claims according to the length of time the invested funds were subject to embezzlement may be necessary in order to avoid a late-in-time investor’s losses exceeding all the embezzlement that occurred after his or her investment was made. See SEC v. Qualified Pensions, Inc., supra.
Early partial payments can be critically important to the victims who are not typically commercial creditors. The subject fund may be some victims’ primary source for meeting every day living expenses. For that reason, even when a general partial distribution cannot be made, hardship exceptions may be important to consider. Full payment of small claims will reduce administrative expenses and may also lessen victims’ hardship.
Claimants sometimes are not considered parties to regulatory enforcement actions and, in some courts, must first intervene if they want to be heard. In the U.S. District Court for the Central District of California, Local Civil Rules 25.7 and 7 anticipate notice to creditors.
In conclusion, regulatory receiverships are replete with profoundly
personal concerns that, fortunately, benefit from the flexibility afforded
by their not being strictly subject to the rigid and necessarily lengthy
liquidation process under the Bankruptcy Code.