Alert June 22, 2010

Second Circuit Upholds Provision in Receivership Order Prohibiting Commencement of Involuntary Bankruptcy Proceedings

The US Court of Appeals for the Second Circuit (the “Second Circuit”) affirmed an order of the United States District Court for the Southern District of New York (the “District Court”) enjoining creditors from filing involuntary bankruptcy petitions against several entities placed in an SEC receivership.  The Second Circuit’s decision arises out of an August 2008 complaint filed in the District Court in which the SEC alleged that Wextrust Capital, LLC and related entities (the “Wextrust Entities”), among other parties, perpetrated a Ponzi scheme defrauding investors of approximately $255 million.  In connection with the complaint, the SEC also sought a temporary restraining order freezing all of the Wextrust Entities’ assets and appointing a receiver.  The District Court’s order (the “Order”) placing the Wextrust Entities into the receivership (the “Receivership”) included an anti‑litigation provision which enjoined any person or entity, including creditors of the Wextrust Entities, from taking any action to “interfere with the taking control, possession, or management of the assets, including, but not limited to, the filing of any lawsuits, liens, or encumbrances, or bankruptcy cases to impact the property and assets subject to th[e] order.”  The District Court subsequently issued a preliminary injunction incorporating the Order’s anti-litigation provision.

After the entry of the injunction, an ad hoc group of creditors of the Wextrust Entities, filed a motion challenging the District Court’s authority to enjoin the filing of involuntary bankruptcy proceedings, contending that the Bankruptcy Code grants creditors an absolute right to commence an involuntary bankruptcy proceeding against a debtor.  The District Court denied the creditors’ motion but modified the injunction to allow a party to seek the court’s permission to file an involuntary bankruptcy petition on three days’ notice.

The Second Circuit, in affirming the District Court’s decision, held that there is no unwaivable right to file an involuntary bankruptcy petition under the Bankruptcy Code and, thus, although the power should be used sparingly, the federal district courts may issue injunctions including involuntary bankruptcy prohibitions to further the goals of maintaining control over and protecting the assets in a receivership.  In support of this holding, the Second Circuit cited, among other cases, the Ninth Circuit’s decision in SEC v. Wencke, 622 F.2d 1363 (9th Cir. 1980), in which the court held that a district court may stay litigation pending against a receivership entity as long as the affected parties may seek permission of the district court to continue the actions.  The Second Circuit’s decision does not explicitly address whether an anti-litigation injunction must contain a mechanism allowing creditors to seek court approval to file an involuntary bankruptcy.  In addition, the decision does not appear to be limited in terms of the type of receivership action to which it applies and could be applicable for other types of entities (such as investment funds) in receivership, depending on the scope of the receivership order.  (SEC v. Byers, Case No. 09‑0234 (2d Cir. June 15, 2010).)