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Bankruptcy Update

Bankruptcy Alternatives: Receiverships and Assignment

Monday, June 16, 2008

For secured creditors, a federal receivership can offer the quickest and most cost-effective method of gaining control over a borrower’s collateral upon default. A federal receivership maintains the value of the collateral by allowing the business to continue to operate. The receiver will preserve and protect the collateral as well as the financial integrity of the business as a going concern. In addition, the receiver may be able to stabilize the operations to mitigate further potential losses.

Foreclosure actions are generally brought in the county in which the property is located, while state receivership actions are brought in the state in which the property is located. These remedies present logistical issues when the collateral is located in multiple counties or states. Federal receivership actions commence in the federal district of the state where the property is located or in the state of the borrower’s principal place of business.

Although federal receiverships are grounded in federal common law, several federal statutes govern such receiverships.

Appointment of a Receiver

Federal Jurisdiction

To initiate an action in the federal court, the federal court must have jurisdiction. Because a secured party’s enforcement of its rights is not usually based upon a federal question (although federal district courts may appoint receivers in cases initiated by governmental entities for violation of federal laws), diversity and the minimum amount in controversy under § 1332 of Title 28 of the U.S. Code must exist to invoke the jurisdiction of a federal district court. Once jurisdiction is established, the court has ancillary jurisdiction to appoint a receiver, as well as ancillary subject matter jurisdiction over every suit the receiver may subsequently initiate.

Procedurally, to have a receiver appointed, the secured creditor will first file suit against the borrower for breach of contract. Once the suit is filed, the secured creditor will then file a motion to appoint a receiver, supported by an affidavit alleging the basis for the relief requested. In many states, including Michigan, a suit for breach of contract cannot be combined with a count for foreclosure; the secured party must decide whether to initiate the suit or begin foreclosure.

The act of appointing a receiver is analogous to the entry of an injunction; it is an extraordinary remedy that lies in the discretion of the court and should be employed with the utmost caution and granted only in cases of clear necessity to protect a plaintiff’s interest in property.

The following factors are usually weighed by the court to determine whether a receiver should be appointed:

  • the existence of a valid claim by the moving party
  • fraudulent conduct on the part of the defendant
  • imminent danger that property may be lost, concealed, injured, diminished in value, or squandered
  • an inadequacy of the available legal remedies
  • the probability that harm to plaintiff by denial of the appointment is greater than the injury to the parties opposing appointment
  • plaintiff’s probable success in the action
  • possibility of irreparable injury to plaintiff’s interest in the property.

Role of the Receiver

Once appointed by the federal court, the receiver becomes an officer of the court who manages and operates the property according to the laws of the state where the property is located.

In addition, the receiver may be sued with respect to any of the acts taken or transactions engaged in while carrying on the business as a receiver, according to 28 U.S.C §959(a). An action for possession of property held by the receiver, however, is outside the scope of the section. Generally, the decision of whether to allow a third-party action to be brought in a separate action is within the discretion of the court appointing the receiver.

The court has broad powers and wide discretion to determine appropriate relief in an equity receivership. These broad powers enable the court to effectively supervise a receivership and protect the interests of its beneficiaries. As courts of equity, they have authority in appropriate circumstances to impose broad stays of all actions against the entities in receivership, except by leave of the receivership court. Receivership law has no inherent limitation regarding the amount of control that a receiver may wield over the receivership entity.

Effect of Appointment of a Receiver

Control over receivership property. Once appointed, the receiver is required to post a bond, which vests the receiver with complete jurisdiction over all property, personal and real, covered by the receivership order, with the right to take possession of such property.

The jurisdiction of the court appointing the receiver, however, appears to have some limitations, including limiting the jurisdiction to federal districts in which real and personal property are located and to districts in which those asserting rights in such property are located.

Jurisdiction of courts not appointing the receiver. 28 U.S.C. §1692 allows nationwide service in a federal receivership, and the territorial jurisdiction of the appointing court extends to any judicial district in which receivership property is found. At least one court has held that 28 U.S.C. §754 is broad enough to include actions initiated by a receiver appointed outside the United States.

Filing Requirements for Extraterritorial Jurisdiction.

28 U.S.C. §754 states that within 10 days after entry of the appointment order, a receiver must file a copy of the complaint and the order appointing the receiver in each district in which property is located. The statute further provides that failure to file such copies in any district divests the receiver of jurisdiction and control over any property located in that district.

The majority of courts considering §754, however, have held that failure of a receiver to timely file the required documents is not fatal. The court will be vested with jurisdiction once the documents are properly filed.

Sales of Assets by a Receiver

The sale of assets by a receiver is governed by 28 U.S.C. §§ 2001, 2002, 2004. A 1996 Ninth Circuit case determined that the power of sale is within the scope of a receiver’s complete control over receivership assets under §754, a conclusion firmly rooted in the common law of equity receiverships. The statutory provisions governing the sale of assets are very specific with respect to certain requirements (e.g. notice provisions, appraisals), but are vague with respect to the procedures to be employed in the sales, thereby allowing for flexibility and creativity. In addition, under federal law(28 U.S.C. §2001(b)), there is no right of redemption from judicial sales.

Sale of Real Property

A receiver may use a public sale or a private sale to sell real property. A public sale must occur in the district where the receiver was appointed, unless the court permits it to occur in another district. The terms and conditions of the sale will be as directed by the court. Notice of a public sale must be approved by the court and published at least once a week for four weeks before the sale, in at least one newspaper in general circulation in the county, state or judicial district where the property is located.

A private sale may occur if the court determines that it is in the best interest of the estate. As with a public sale, the terms and conditions of the sale will be as directed by the court. In a private sale, however, the court must appoint three disinterested appraisers to appraise each parcel of property. The originally proposed offer will not be confirmed by the court unless the sales price is two-thirds of the appraised value, or if another offer of at least 10 percent over the original offer is received. Notice of the private sale also must be approved by the court and published in a newspaper of general circulation at least 10 days before the hearing on the confirmation of the sale.

Sale of Personal Property

The sale of personal property is governed by the same rules as that for the sale of real property, unless the court orders otherwise. 28 U.S.C. §2004 gives the district court discretion as to whether appraisals are required to sell personal property.

Application of the Statutes by the Courts

Courts are generally liberal with respect to receivership sales. Courts have stated that a judicial sale made with notice and in the manner prescribed by law will not be denied confirmation or set aside for mere inadequacy in price, unless the price is so grossly inadequate as to shock the conscience of the court, coupled with additional circumstances indicating unfairness, such as chilled bidding.

Appeals

28 U.S.C. §1292(a)(2) governs the types of orders entered in a receivership proceeding which are appealable. Courts considering the issue of the appealability of orders have strictly interpreted this statutory provision. The order appointing a receiver is appealable. Likewise an order directing a sale of receivership assets and an order confirming such a sale are appealable. The majority of the courts, however, have limited the statute to orders refusing to direct action.

Interplay Between Bankruptcy and Receiverships

The various legal and practical differences between receiverships and bankruptcy proceedings may be significant in certain situations. Some district courts have enacted local rules specifically pertaining to receiverships. Busy district judges may refer receivership proceedings to magistrate judges. This presents the issue of the parties’ willingness to consent to having the magistrate judge hear the case and order entry of judgment, pursuant to 28 U.S.C. §636(c), or merely make recommendations to the district judge after hearing the merits.

The receiver’s ability to pursue certain causes of action on behalf of the estate also needs to be considered. A receiver has no authority to avoid and recover preferential transfers. Nor does a receiver have statutory authority to employ the “strong arm” powers of 11 U.S.C. §544 to avoid unperfected liens. Equity receivers have standing to assert state fraudulent conveyance theories to recover property for the receivership estate. In addition, a receiver may be able to bring certain actions against third parties that a bankruptcy trustee, debtor in possession or committee cannot.

By contrast, several circuits, including the Third Circuit, have held that bankruptcy trustees (and other bankruptcy estate representatives) are subject to the in pari delicto defense. This is based on the language of 11 U.S.C. §541, which defines property of the estate as it exists as of the commencement of the bankruptcy.

On a practical level, district courts tend to be far less experienced than bankruptcy judges in dealing with sales and other estate administration matters. They are often receptive to suggestions as to procedures to be employed on these issues. The district courts also will often rely on analogous provisions of the Bankruptcy Code and Bankruptcy Rules for guidance where appropriate, although they are not bound to follow them. In addition, a district court presiding over a receivership is less likely to share the view of many bankruptcy courts that it should not permit a case to go forward (or authorize a sale) if the sole beneficiaries of the sale are secured creditors.

Alternatives to Federal Receivership

When federal jurisdiction does not exist, e.g., because there is no diversity of citizenship between the parties, the secured creditor should consider state law alternatives for controlling and liquidating the collateral. The availability of such alternatives varies greatly from state to state, as do the rules governing such procedures. However, most states offer some form of state receivership or assignment for benefit of creditors that can be useful for secured creditors.

State Court Receivership

The courts of most states have the authority to appoint receivers, either by statute or under their general equitable authority. The remedy can be invoked not only to oversee the liquidation of an insolvent debtor, but also to resolve shareholder disputes and management deadlocks.

Receivership is a potential remedy available under the Uniform Fraudulent Transfer Act adopted by the National Conference of Commissioners on Uniform State Laws in 1984 and subsequently enacted by most of the states. If a creditor prevails on a claim under the UFTA, the statute empowers the court to appoint a receiver to take charge of the transferred asset or other property of the transferee.

State court receivers may be granted the power to operate the debtor’s business, although more typically, they are empowered only to liquidate the assets and distribute the proceeds. The court and/or the governing statute prescribe the procedures for filing claims and sharing in the distribution. The priority of claims are determined by applicable state law, which means the first-lien creditor has the right to first proceeds after the receiver’s costs of administration.

State Court Receivership – the Delaware Example

State court receivership laws and procedures vary greatly from jurisdiction to jurisdiction. One state that offers a potentially attractive environment for an insolvency-based receivership proceeding is Delaware.

A Delaware proceeding may be of interest to a party seeking to put an entity into receivership because: (a) Delaware receivership procedures are fairly detailed (perhaps more detailed than the procedures applying to a federal court receivership), yet offer a great degree of flexibility; (b) Delaware receivership proceedings may provide the receiver with certain powers that many believe are only available in federal bankruptcy court proceedings; (c) by filing a receivership proceeding in Delaware, the creditor and receiver can avail themselves of the expertise of the Delaware Court of Chancery, one of the more renowned and respected courts in the country, and Delaware law, which is likely the most well-developed corporate law in the nation; and (d) jurisdiction should lie for the receivership proceeding if the entity is formed under Delaware law - and many entities are.

Under Delaware law, any creditor or shareholder has the power to file a complaint seeking the appointment of a receiver of an insolvent corporation. 8 Del. C. § 291. Insolvency in this context means “either: 1) ‘a deficiency of assets below liabilities with no reasonable prospect that the business can be successfully continued in the face thereof,’ or 2) ‘an inability to meet maturing obligations as they fall due in the ordinary course of business.’” Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772, 782 (Del. Ch. 2004) (quoting Siple v. S&K Plumbing and Heating, Inc., 1982 WL 8789 at *2 (Del. Ch. Apr. 13, 1982)). Even where the debtor is insolvent, however, the appointment of a receiver is only granted where urgent circumstances are present other than the mere collection of a debt and where some truly beneficial purpose will be served by the receivership proceeding. Production Resources, 863 A.2d at 784.

Once the receiver is appointed, it will have jurisdiction over all property of the entity in receivership with the exception of real property located outside of Delaware. As in a bankruptcy case, receivers are generally required to file lists of assets and liabilities, creditors are entitled to file claims, and the receiver has the power to object to claims, if it so chooses. In addition, as in a bankruptcy, notice must typically be provided to creditors of a sale or disposition of the assets of the debtor. Also, like a trustee in bankruptcy, a receiver has the power to prosecute and defend lawsuits on behalf of the entity in receivership.

The Delaware Court of Chancery can be flexible in administering a receivership proceeding. Particularly, under Delaware Court of Chancery Rule 148, the court has the power to relieve the receiver from “complying with all or any of the duties and procedures” set forth in the Court of Chancery Rules. Unlike bankruptcy cases, where parties must rigorously comply with a fairly exhaustive set of reporting requirements and procedures, the Court of Chancery may tailor the rules to the realities of the case and needs of the parties-in-interest. This can produce great savings in the cost of administering a receivership case as compared to the cost of administering a bankruptcy case.

A Delaware receiver also may exercise certain powers typically seen only in a bankruptcy case. For example, as in a bankruptcy case, it appears that a receiver has the power to disavow (or, in bankruptcy parlance, “reject”) executory contracts. Dupont v. Standard Arms Co., 81 A. 1089 (Del. Ch. 1912); Conover v. Sterling Stores Co., 120 A. 740 (Del. Ch. 1923). This is a particularly useful power where the receiver wishes to limit the administrative costs and expenses associated with the receivership. It is clear that, where a property is encumbered by a lien that is subject to dispute and the property subject to the lien is of the type that will deteriorate in value, the receiver has the power to sell property free and clear of all liens and pay the proceeds to the court. 8 Del. C. §297 (apparently, the net proceeds of sale are paid to the lienholder if its underlying lien and claim are deemed to be valid). Although the receivership laws do not address whether the receiver generally has the right to sell property free and clear of liens, Section 297 arguably seems to imply as much.

Assignment for Benefit of Creditors

When the value of the collateral exceeds the secured debt, such that there should be a recovery for unsecured creditors or even a return on equity, an assignment for the benefit of creditors often is a cost-efficient alternative to a receivership. Typically, the debtor reaches an agreement with creditors to assign all of its assets voluntarily to an assignee for purposes of liquidation and distribution.

The assignee must be someone unaffiliated with the debtor and is usually selected by the creditors. He or she has the duty to investigate the debtor’s assets, collect accounts receivable, prosecute any claims, and manage an orderly liquidation and distribution. The assignee is entitled to appropriate compensation, which the assignment document or the court can establish.

In some states, the assignment and distribution proceeds entirely out of court, the so-called “common-law consignment.” Other states mandate a court proceeding, and the assignee is required to report the status of the liquidation to the court, with the court monitoring the distributions to the creditors.

Kay Standridge Kress and Bonnie MacDougal Kistler

Written by

Kay Standridge Kress
Phone: 248.359.7365
Fax: 248.359.7700
kressk@pepperlaw.com



Bonnie MacDougal Kistler

The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

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