Alert 10.15.24
Lenders Beware: The Ponzi Scheme Presumption Can Trap an Unwitting Lender
A recent Ninth Circuit Court decision highlights a risk for lenders caught up in a Ponzi scheme.
Alert
Alert
10.25.24
When disputes involving financially distressed real estate or other property cannot readily be resolved through foreclosure, deed-in-lieu, consensual out-of-court restructuring, or a cooperative bankruptcy filing, a lender/mortgagee (or other creditors or interest holders) can ask a court to appoint a receiver to take control of the property, its rents, and sometimes the borrower entity. Typical receivership orders often grant receivers broad authority to take actions with respect to property and receivership assets. The orders also typically grant broad injunctive relief barring creditors, managers, equity holders and others, from taking actions against the property.
In this alert, we examine the ability of a manager or managing member of a limited liability company (LLC) for which a receiver has been appointed to file a bankruptcy petition for the LLC. That was the issue in the recent case, In re 530 Donelson, LLC, No. 3:24-bk-00879-RSM, 2024 WL 1810790 (Bankr. M.D. Tenn. April 25, 2024) (“Donelson”).
Background
Courts hold that Article I, Section 8, clause 4 of the U.S. Constitution (the “Bankruptcy Clause”), which gives Congress the power to, among other things, establish “uniform Laws on the subject of Bankruptcies throughout the United States,” reflects a constitutional right of debtors to file for bankruptcy relief. See e.g, Donelson, Merritt v. Mt. Forest Fur Farms of Am., Inc. (In re Mt. Forest Fur Farms of Am., Inc.), 103 F.2d 69, 71 (6th Cir. 1938) (state court order barring debtor and management from filing bankruptcy was erroneously entered due to debtor’s constitutional right to file for bankruptcy), cert. denied, 308 U.S. 582 (1939).
It is well settled that a typical receivership order does not strip the subject entity of the legal right to be placed into bankruptcy. See e.g., Struthers Furnace Co. v. Grant, 30 F.2d 576, 577 (6th Cir. 1929) (“[T]he pendency of a receivership does not ordinarily prevent the filing of a voluntary petition,” nor does “the usual injunction against interference.”); Muffler v. Petticrew Real Est. Co., 132 F.2d 479, 481 (6th Cir. 1942) (same holding); In re Yaran Naval Stores Co., 214 F. 563 (6th Cir. 1914) (creditors are not barred from filing an involuntary bankruptcy petition against an enterprise subject to a receivership order).
The case law is sensibly consistent with Bankruptcy Code section 543, which, upon the entity’s bankruptcy filing (a) prohibits custodians (such as a receiver) from using assets of the bankruptcy estate (except “as is necessary to preserve such property”), and (b) requires custodians to turn over all assets to the trustee in bankruptcy (i.e., presumptively, the debtor in possession, the very management ousted by the receivership order). Section 543 would be superfluous if a typical receivership order prevented the subject entity from seeking bankruptcy protection.
In Donelson, the bankruptcy court analyzed and ruled upon the narrow issue of “whether, as a matter of law, the LLC members who filed the [bankruptcy] petition on behalf of the Debtor were precluded from taking such action under a state order appointing a receiver.” Donelson at *1. The debtor, an LLC with three individual members, was embroiled in state-court litigation that resulted in the appointment of a receiver for both the LLC and the real estate and other assets belonging to the LLC. There was no dispute that the two LLC members who filed the bankruptcy petition were managing members who possessed the legal authority to do so under the debtor’s operating agreement, apart from the receivership order. The third LLC member moved to dismiss, arguing that the petition violated the terms of the receivership order. The sole issue before the bankruptcy court was whether the receivership order altered the rights of the managing members to file a bankruptcy petition for the LLC. The court ruled that it did not.
Tennessee’s version of the Uniform Commercial Real Estate Receiver Act provides that “[a] court may grant any equitable relief it considers just and reasonable under the circumstances, may dissolve an LLC or may direct that the dissolved LLC be merged into another or new LLC or other entity, or otherwise terminated, on the terms and conditions the court deems equitable.” Tenn. Code Ann. § 48-249-616. Indeed, the receivership order in Donelson granted the receiver broad authority over the receivership estate, which, as noted above, included both the entity and its real estate. The order generally barred the members, creditors and others from taking actions relating to the assets of the receivership estate.
Nevertheless, the bankruptcy court found that the receivership order was “more or less plain vanilla … with nothing that would alter the structure of the LLC, formally remove members, or deal with the possibility of bankruptcy.” Donelson at *3. Furthermore, the bankruptcy court reasoned that the state court was well aware of its authority under receivership law “to make fundamental changes in the LLC but chose not to take those steps.” Donelson at *5. Finally, the bankruptcy court cited to and quoted from the official comment to section 14 of the Uniform Commercial Real Estate Receivership Act (on which the Tennessee statute was based), which makes clear that the “stay” contemplated by a receivership order does not bar stakeholders from placing the receivership entity into voluntary or involuntary bankruptcy. Donelson at *6.
In reaching its conclusion, the Donelson bankruptcy court noted that Yaran, supra could be read to suggest that a state-court receivership order containing a “specific declaration” manifesting the receivership court’s intention to override the constitutional right of an entity to seek bankruptcy relief might limit the ability of those otherwise authorized to do so to commence a bankruptcy for the entity. Donelson at *3-4. Because the receivership order at issue did not contain a provision expressly barring a bankruptcy filing, the bankruptcy court did not reach the issue whether a receivership order with such a limitation is constitutional.
Conclusion
The Donelson decision further cements the law, at least in Tennessee and the Sixth Circuit, that a typical receivership order does not enjoin anyone from seeking bankruptcy relief. The court made no ruling on the enforceability of a receivership order that expressly prohibits any particular person from making a bankruptcy filing. We note that a receivership order worded differently, or one that effectively removes management for cause, might call for a different analysis. See e.g., Sino Clean Energy, Inc. v. Seiden (In re Sino Clean Energy, Inc.), 901 F.3d 1139, 1140-41 (9th Cir. 2018) (holding that board of directors lacked authority to file a bankruptcy petition on behalf of an enterprise after the pre-bankruptcy receiver removed the board for “nonfeasance and gross mismanagement” id. at 1140).
(This is another in our series of client alerts related to the intersection of bankruptcy and issues affecting real estate. For additional alerts on the ability of stakeholders to prevent an entity from seeking bankruptcy relief see our previous client alert here.)