Receiverships v. Bankruptcies = The Wild West v. The Rule Of Law

By: Donald L Swanson

When comparing proceedings under the Bankruptcy Code with receivership proceedings under state law, there is a similarity:

• both require intensive court supervision.

And there is a huge difference:

• bankruptcy provides precise rules—lots of them—under an extensive Code and accompanying national and local rules and a massive amount of case law across the entire federal system construing those laws, which laws exist under the authority of the U.S. Constitution and its requirement that federal bankruptcy laws be “uniform” across the entire system, with the U.S. Supreme Court riding herd on maintaining uniformity, with the U.S. Trustee’s Office focused on preventing abuse, and with expert bankruptcy judges managing the caseload; whereas
• state receiverships are mostly unbounded by rules—state receivership statutes are commonly limited in scope (a few dozen sections or so) and leave much to the unbridled imagination of the receiver and the state judge who (i) appoints the receiver, and (ii) commonly has little expertise in such matters.

And so, if given a choice between receivership proceedings and a bankruptcy, I’d almost always favored the certainty of bankruptcy laws over the wild west of receiverships.

An Illustrative Case

I happened to have a client involved with a ponzi scheme receivership in another state.  My client was not an investor in that scheme—instead, was a garden variety creditor, having been caught in the middle with substantial out-of-pocket losses.

In that case, the Receiver simply ignored and distributed nothing on my client’s claim—and I still don’t understand why.

With the relative size of my client’s claim and the paltry distribution being proposed, hiring a local attorney in that distant locale to object in what would undoubtedly be a futile effort (the state court was obviously going to approve whatever the Receiver proposed) was out of the question.

In my mind, what happened to my client in that receivership was the very embodiment of “arbitrary” and “abusive.” 

Receiver’s Arguments in that Case

What follows is a summary of arguments from the “Legal Authority” portion of the “Receiver’s Proposed Plan of Distribution” in that case—which proposal was approved by the state court and, as noted above, returned nothing on my client’s claim!  

–Legal Standards for Distribution = Little to None

State courts presiding over equity receivership proceedings have broad powers and wide discretion to determine relief.  This discretion derives from the inherent powers of an equity court to fashion relief.

Such broad discretion applies to a state court’s review of a receiver’s proposed plan for distributing the assets of the receivership. As the Second Circuit explained:

• the decision of a district court as to the choice of distribution plan for a receivership estate is reviewed for abuse of discretion; and
• a district court has abused its discretion if it based its ruling on an erroneous view of the law or on a clearly erroneous assessment of the evidence, or rendered a decision that cannot be located within the range of permissible decisions.

–Distribution Scheme—Nearly Unbridled Receiver Discretion

Unlike a case arising under the Bankruptcy Code, there is no statutory mandate that prescribes how the assets recovered in a receivership should be distributed: 

• thus, it is within a receiver’s discretion to create a plan of distribution that classifies claims into different classes containing differing payment terms using equitable notions.

In deciding how the assets of a receivership estate should be paid out to aggrieved investors and other creditors, no specific distribution scheme is mandated so long as the distribution is “fair and equitable.” 

For purposes of distribution in an equity receivership, courts may ignore the separate identities of entities that are part of a unified scheme to defraud:

• the Fifth Circuit affirmed a district court’s approval of a consolidated distribution plan as being fair and equitable, even though the objecting investor’s funds could be traced to one specific investment vehicle which had not been commingled with the others used by the perpetrator.

–Distribution Method—Rising Tide v. Pro Rata

For claims by investors with a net loss, the Receiver proposes using what is often called the “Rising Tide” method for distributing the limited funds in the Estate to the investor victims because it will come closest to equalizing the recoveries for all investors:

• in summary, the Rising Tide method considers all payments received by investors from the Scheme and calculates a recovery percentage for each investor; and
• distributions under the Rising Tide method seek (to the greatest extent possible) to equalize the recovery percentage for each investor.

Rising tide appears to be the method most commonly used (and judicially approved) for apportioning receivership assets.

The primary alternative distribution methodology used in Ponzi scheme cases is the Pro Rata methodology. Under the Pro Rata method:

• each investor’s claim is determined by adding together all funds invested into the scheme and then subtracting all payments received from the scheme to determine a new net balance; and
• funds are then distributed from the Estate pro rata based on each investor’s percentage of the total loss.

In this case, the Pro Rata methodology would have the perverse effect of distributing substantial sums to the investors with the highest recovery percentages.  Therefore, the Receiver recommends that the Rising Tide method results in a more equitable distribution of funds from the Estate.

And the state receivership court approved the Receiver’s recommendation in full.

Conclusion

I’m still irritated by that receivership case.  It was a wild west of proceedings that rejected my client’s claim and any possible distribution thereon in what I considered to be an arbitrary and abusive manner.

In bankruptcy, my client’s claim would have been allowed and received its distribution share as provided in the Bankruptcy Code.

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