The Impact of Bankruptcy on the S.E.C. Receivership

11.01 In General

After being sued by the S.E.C., it is not uncommon for defendants to file Chapter 7 or Chapter 11 Bankruptcy petitions to thwart the S.E.C. enforcement action. If defendants are placed in bankruptcy, the S.E.C. loses control over many aspects of the case which it can otherwise influence with a receiver. Moreover, bankruptcies are not an efficient way to run the estate. As Judge Posner noted in the decision of Scholes v. Lehmann, 56 F.3d 750, 755 (7th Cir. 1995), “[c]orporate bankruptcy proceedings are not famous for expedition . . . and whatever advantages they may have over receiverships in a case such as this–if any, and none has been pointed out to us–are not ones that the defendants in these fraudulent conveyance claims should be heard to trumpet.” As a result, both investors and the S.E.C. are better served through the use of a receiver.

The receivership court may enjoin third parties from filing involuntary bankruptcy petitions against the subject of the receivership. S.E.C. v. Byers, 609 F.3d 87 (2d Cir. 2010).

11.02 The Bankruptcy Code

Under the Bankruptcy Code, a debtor may be placed into bankruptcy in one of two ways, voluntarily34 or involuntarily.35 However, in order to place a debtor into aninvoluntary bankruptcy, three creditors whose claims are not contingent as to liability or subject to a bona fide dispute, with claims totaling $15,325.00 must join in the petition. Very often, creditors’ claims against defendants in S.E.C. enforcement actions are hotly disputed. Even more restrictive is the fact that, although the S.E.C. has filed an enforcement action against a particular individual or entity, it does not mean that the S.E.C. has a claim against that person since the S.E.C.’s claim has not yet been liquidated as to amount. As a result, the S.E.C. typically cannot properly petition to have the defendant in an S.E.C. enforcement action placed into involuntary bankruptcy. Furthermore, 11 U.S.C. §303(i) provides that, if the bankruptcy court ultimately dismisses a bankruptcy case, the petitioning creditors could be subject to costs, attorneys’ fees, or damages caused by the filing and/or punitive damages. As a result, even if the S.E.C.’s claim against a particular defendant were liquidated and not contingent, like any other creditor facing possible exposure to damages for an improperly filed petition, the S.E.C. may very well be reluctant to join in an involuntary bankruptcy petition with other creditors whose claims may ultimately fail.

In addition, it is often unclear whether the defendant in an S.E.C. enforcement action is actually insolvent. Quite often the schemes engineered by the defendants are masterful in that the liabilities incurred by the perpetuation of the scheme, outside of the S.E.C. enforcement action itself, are by companies and individuals that are not controlled or otherwise directly related to the actual wrong-doer. In many circumstances, the claims of investors or defrauded individuals are actually against multiple shell companies controlled by marketers which are generally created to issue fraudulent notes and/or bonds to investors and are engineered to create a separation between the wrong-doer and the actual unlawful activity. This is particularly true in Ponzi scheme situations in which these marketer companies are simply shell companies who only have a true bankruptcy-recognized claim against the company above it in the Ponzi scheme.

Assuming, arguendo, that the threshold issue of placing a defendant in a securities enforcement action into bankruptcy could be overcome, there are still many practical problems posed by a bankruptcy in a securities enforcement action.

First, 28 U.S.C. §1408 requires that a bankruptcy petition be filed in the judicial district were the defendant has resided for 180 days prior to the filing. In many S.E.C. enforcement actions, there are numerous individual and corporate defendants residing or doing business in more than one district. As a result, to put such defendants into bankruptcy would require that a separate bankruptcy case be commenced in each judicial district in which a corporate or individual defendant resided in or primarily did business resulting in numerous bankruptcy judges and bankruptcy trustees hearing often incomplete yet, in many cases, duplicative testimony. Additionally, such a situation would create a strong possibility of inconsistent rulings between the bankruptcy judges in the various different proceedings.

Second, the multiplicity of litigations in various courts would also destroy the administrative synergies often available in receivership cases. In particular, in situations where the defendant in an S.E.C. enforcement action has property or has diverted funds off-shore, a receiver can seek to be appointed as receiver or liquidator in those foreign jurisdictions where significant assets or valuable information are located. If a bankruptcy proceeding were utilized instead of a receivership, or a multiplicity of bankruptcies in numerous jurisdictions with different trustees, the bankruptcy would result in little or no opportunity for meaningful synergies to emerge. A receiver appointed in an S.E.C. enforcement action has greater nationwide powers to recover assets or pursue individuals or causes of action than a bankruptcy trustee is statutorily equipped to pursue.

Potentially the greatest detriment in utilizing bankruptcy court administration of securities enforcement action defendants’ assets would be the successive layers of costs and fees incurred by each of the separate bankruptcy trustees and their respective counsels. For example, assuming as in the case of the typical Ponzi scheme, a number of investors provide capital to shell corporation A in Estate #1 in return for fraudulent promissory notes or bonds. Shell corporation A then forwards those funds to shell corporation B in Estate #2 in return for corresponding notes or bonds. Shell corporation B then forwards the funds on to shell corporation C in Estate #3, again for the same fraudulent notes or bonds, and then finally shell corporation C forwards the funds on to the originating defendant or operator of the scheme in Estate #4. Assuming for discussion sake that the mastermind of the scheme, and shell corporations A, B, and C were each put into bankruptcy, the cases would have to be filed in the four different districts were the four defendants resided. Since each filing would be a separate case, each case would have its own trustee and each trustee would retain its own legal counsel. who would presumably each retain their own legal counsel, accountants, experts, investors, etc. These multiple layers of administration expenses would likely cripple the collection estate and result in little or no return to investors.

We can best demonstrate the detriment to the creditors by further assuming that the only recoverable assets are held by the scheme mastermind and the only claim in each bankruptcy is the claim of the Shell corporation below them, or the claim of the original investors against Shell corporation A. If $100 in assets are recovered from the mastermind of the scheme, it is not unreasonable to expect that 25% of those assets will go simply to paying the trustee’s statutory commission, along with his or her attorneys’ fees. If shell corporation C was the only claimant against the scheme mastermind, only $75 of the original $100 recovered would then flow into the bankruptcy estate of Shell corporation C. Assuming the same 25% reduction of assets recovered for payment of that trustee along with his or her attorney, that means that only $56.25 flows to the bankruptcy estate of shell corporation B, and finally only $42.19 flows to the bankruptcy estate of shell corporation A, out of which the actual defrauded investors themselves would have their only legitimate claim in bankruptcy.

While this hypothetical has obviously been over-simplified, you can see where using the separate bankruptcies which would be required to administer the multiple layers of the typical Ponzi scheme, would result in a significant majority of the assets recovered actually being dissipated through administrative expenses, rather than being made available to be distributed as quasi-restitution to the defrauded investors. The single equity receivership obviously preserves those efficiencies by having one receiver (who, unlike a bankruptcy trustee, does not take any statutory commission based on a percentage of funds distributed), and one set of attorneys representing that receiver.

11.03 The Bankruptcy Court is not an Appropriate Venue for the S.E.C. to Conduct its Case.

It is commonplace for the S.E.C. in enforcement actions to find it necessary to resort to seeking contempt orders to force compliance with court orders. If the defendant has filed bankruptcy, the automatic stay of the bankruptcy court will chill the S.E.C.’s efforts to force the defendant to comply with its subpoenas, disgorgement orders, freeze orders, etc. Even assuming the bankruptcy court chose to cooperate in the S.E.C.’s enforcement action, bankruptcy courts, as non-Article III courts, do not have the same civil and criminal contempt powers that the district courts have to force compliance with court orders. As a result, in each matter where contempt actions are necessary, the bankruptcy court would need to forward a referral and recommendation for a finding of contempt to the United States District Court for resolution. Compare this with the ability of the court to take immediate action for citations for not only civil, but also criminal contempt: see Commodity Futures Trading Comm’n v. Lake Shore Asset Mgmt. Ltd., 07 C 3598, 2007 WL 4591005 (N.D. Ill. Dec. 21, 2007).

Where there are claims to be asserted on behalf of the estate, another major problem arises: a bankruptcy trustee may be unable to assert such claims under the doctrine ofin pari delicto. However, under the weight of authority, a receiver may bring actions without being subject to a “clean hands” or “in pari delicto” defense. See Chapter 5.

11.04 The SEC’s Tool Against Bankruptcy; Withdrawal Of Reference

Under 28 U.S.C. §157, the district courts refer cases arising under Title 11 to bankruptcy judges. However, on proper motion by a party, the district court is required to withdraw reference to the bankruptcy court to the extent resolution of the case requires consideration of both Title 11 and other laws of the United States regulating organizations or activities effecting interstate commerce. Since cases instituted by the S.E.C. involve laws of the United States effecting interstate commerce, in all likelihood the district court would be required to withdraw reference of these cases from the bankruptcy court. Where the S.E.C. has already commenced an enforcement action, it should be able to successfully petition the district court to withdraw reference to the bankruptcy court, especially where a receiver has been appointed to conduct a claims process and pursue estate assets.


34 11 USC §301.


35 11 USC §303.