In this issue of The Institutional Risk Analyst, we return to the Lehman Brothers, Madoff and MF Global bankruptcies to talk about how the largest banks have wired US bankruptcy laws to their own advantage. Specifically, the 2005 changes to the bankruptcy code, combined with the traditional American caution regarding pre-judgement restraint on the parties surrounding a bankruptcy, has provided American banks with a free pass to facilitate fraud with no accountability.
On May 17th, IRA co-founder Christopher Whalen is making a presentation to the economic advisory committee of FINRA entitled "Policy issues regards customer account protection and bankruptcy." This edition of The IRA is meant as a background to that discussion, which unfortunately is closed to the public. In that regard, thanks to Max Keiser for the quotation from his kinsman William Wallace.
You may also read our earlier comment, "Should the Courts Appoint an Equitable Receiver for Bank of America?," where we argue that the degree of obvious fraud present in the operations at BAC and Countrywide justifies the appointment of a federal receiver now to run the bank.
But before we jump into this discussion, we just have to take a moment to note that Ally Financial has apparently received the blessing of the US Treasury to file a bankruptcy for the ResCap real estate unit, according to Dakin Campbell at Bloomberg News. This is a profoundly bad idea, as we have noted in past issues of The IRA. The subsidiaries of bank holding companies cannot default, especially when the sub has its own bond holders with a different agenda than the parent company creditors. Hello! Read Gretchen Morgenson in the Sunday NY Times: "Mortgage Unit Troubles Ally Financial"
Neither Secretary Geithner nor President Obama wants to deal with Ally before the election. The incompetence of Geithner in dealing with the portfolio investments of the US is a national scandal, but Ally is first among his failings because of the politics of GM and big labor. The obvious thing to do was sell the auto business back to GM and the servicing book to somebody a year or more ago, but the policy of "extend and pretend" continues in Washington. Sad thing is, though, that the business community is still abandoning the White House in droves despite or maybe because of such behavior.
The Case for Equitable Receivers in Bankruptcy
Article III of the US Constitution created the judicial branch of the American government and made it independent of the legislative and executive branches. District Courts, Courts of Appeal and the US Supreme Court are all authorized under this part of the Constitution and are thus known as "Article III" courts. The Supreme Court has ruled that only Article III courts may render final judgments in cases involving life, liberty, and private property rights, with limited exceptions.
Article I tribunals consist of certain federal courts and other forms of adjudicative bodies, including federal bankruptcy and administrative law courts, and many federal agencies such as the Fed, FDIC and OCC in the banking world. Article I, Section 8, Clause 4 authorizes Congress to enact "uniform Laws on the subject of Bankruptcies throughout the United States." These bodies are creatures of the Executive Branch and the decisions of these "adjunct" tribunals are subject to comprehensive review by the Article III courts, as noted above.
The historical separation between bankruptcy courts and the US judiciary is complex and reflects the imperfect, often conflicted nature of the governances structures of the American republic. The concept of checks and balances, after all, implies conflict, not the phony notion of consensus. The policy on bankruptcy evolves with the country.
When it comes to business insolvencies, both Congress and the Courts have tended to want to leave bankruptcy courts in the commercial realm, operating more like mediators for corporations and social welfare agencies for individual, than as "equity courts" in the ancient sense. Out of this tradition has grown a great reluctance on the part of US Article III courts to allow the bankruptcy courts to operate outside the narrow confines of the interests of the estate of the failed individual or entity.
In the 1920s and 1930s, when financial fraud reached an apex, the Courts were not afraid to empower bankruptcy trustees also as receivers in order to protect the public from various types of criminality in existence at that time. In the landmark 1925 case Benedict v. Ratner, where Justice Louis Brandeis laid down the law on collateralized borrowing, the bankruptcy trustee in the underlying case was also appointed as a receiver.
The difference between a trustee and receiver is very significant. The trustee in a bankruptcy represents the estate and has no power to pursue other parties nor to make decisions affecting equity. The bankruptcy of the Madoff firm, for example, shows how the trustee in unable to act on behalf of the victims of the fraud. Irving Picard may only represent the interests of the failed broker dealer. Under the bankruptcy code, the trustee may only pursue money's owed to the estate and may not pursue third parties for their actions against the victims of the fraud.
While many people are confused by the fact that the Madoff trustee has been unable to recover billions in funds stolen from the customers of the Madoff firm from JP Morgan and other banks, this situation simply reflects US law and the Constitutional limitations imposed upon the bankruptcy process. The well-established general rule was that a judgment fixing a debt was necessary before a court in equity would interfere with the debtor's use of his property.
Thus in the case of Madoff, the bankruptcy trustee is unable to pursue claims against the third parties, in part because this "adjunct" tribunal lacks the authority to make such a final judgment. In addition, because the trustee's authority stems from his association with the estate of the bankrupt entity, the concept of "in pari delicto" blocks the trustee from acting. Two key concerns for investors and risk managers are illustrated by the Madoff and MF Global bankruptcies:
o Unequal legal status of segregated accounts in bankruptcy vis-à-vis other creditors due to "safe harbor" changes to bankruptcy laws in 2005.
o Inability of bankruptcy trustees to pursue third parties that cause losses to investors due to fraud, other bad acts.
As a result of these two defenses working in tandem, today financial institutions can aid frauds such as Madoff and MF Global, to mention just a few, without being brought to task in civil proceedings. Because the federal courts and other agencies still do not recognize fraud as the paramount problem facing the US economy, the victims of the fraud are left defenseless. And once the perpetrator of the fraud files for bankruptcy, the individual victims often are left without any means of seeking redress and the bad actors among management and other customers literally walk away. As Peter Henning wrote for The New York Times last month:
"Most investors lose almost all of their money once a Ponzi scheme collapses, and the trustees appointed to clean up the mess try to find any deep pocket available to recover something. Unfortunately for the trustees, the legal doctrine of "in pari delicto," Latin for "in equal fault," may block any recovery."
In a major 1920s case decided a few years before the Benedict v. Ratner decision, Brandeis famously precluded any right for unsecured creditors to seek a receiver, except the right to have freedom from fraud. This decision was upheld decades later in 1999 when Justice Antonin Scalia, writing for a unanimous Supreme Court in Grupo Mexicano de Dessarollo, S. A., et al, held that:
"This case presents the question whether, in an action for money damages, a United States District Court has the power to issue a preliminary injunction preventing the defendant from transferring assets in which no lien or equitable interest is claimed… [T]he English courts of equity did not actually exercise this [Mareva] power until 1975, and that federal courts in this country have traditionally applied the principle that courts of equity will not, as a general matter, interfere with the debtor's disposition of his property at the instance of a nonjudgment creditor. We think it incompatible with our traditionally cautious approach to equitable powers, which leaves any substantial expansion of past practice to Congress, to decree the elimination of this significant protection for debtors."
The problem with the prose used by Scalia in the unanimous Supreme Court opinion is that the justices still do not "get it" when it comes to fraud. While the decision in Grupo Mexicano was correct, the problem with the cases coming before the bankruptcy courts today such as Lehman Brothers, Madoff and MF Global is that fraud is once again the key problem. And many lawyers and judges, with all due respect, do not understand the fraud exemption to the general rule set forth by Brandeis, Scalia and many other members of the Supreme Court.
Bankrupt firms such as MF Global, Madoff and all of their officers and business counterparts deserve greater scrutiny that only an equitable receiver appointed and empowered by a federal District Court judge can provide. Unfortunately, many victims of fraud do not understand their rights and duties in such situations. Worse, their lawyers who've never read Brandeis or the brothers Learned and Augustus Hand on these core Constitutional issues often fail to appreciate that there is a way to demand the appointment of a receiver by a federal court in a bankruptcy where fraud is present.
The unspoken truth of 2007 financial crisis is that fraud on and off Wall Street just as pervasive in 2005 as in the 1920s. Lehman Brothers, Madoff, and MF Global all featured systemic fraud. Congress and the Supreme Court took a decade from 1929 to 1938 to wake up to root cause of Great Depression, namely securities fraud of 1910s through 1929, and acted accordingly. But today we have come full circle. A servile Congress and federal Courts have precluded just about every means for controlling fraud by large banks and have destroyed investor confidence in the process.
In the Grupo Mexicano case, Scalia's opinion relies on (and favorably quotes) opinions of Brandeis for when a receiver is proper. That case is still good law and Scalia quotes that case as his primary authority. The facts of Grupo Mexicano involved only "preferences," not "fraudulent transfers" (because they discharged obligations to creditors) and were not direct or indirect transfers to insiders or shareholders.
So while the Scalia decision is technically correct, the way his language is being misused today in the Madoff and MF Global litigations is the problem. Brandeis would agree with Scalia on the Groupo Mexicano "holding" that simple preferences of creditors should never be the basis for appointing a receiver. But that also means the use of receivers is allowed when there is evidence of insider dealings and actual or constructive fraud and thus is consistent with the "ruling" of Grupo Mexicano (though perhaps not reading Scalia's prose). Scalia could rule in favor of receivers at any time he wants and wrap himself in the "garb" of Brandeis. Bottom line: The Grupo Mexicano case should never be used as a preclusion from use of a receiver whenever there is evidence of fraud on unsecured creditors in a bankruptcy.
There are a number of examples where a receiver function plays an important role in fighting fraud. In case of The Stanford Group, an Article III receiver was appointed by a federal District Court without any bankruptcy to pursue a wide ranging investigation, which included efforts to conserve customer funds and pursue third parties via criminal and civil means.
The FDIC is another excellent example of how receivership powers enable that bank agency to limit losses to the mutual insurance fund supported by insured banks and also pursue claims against bank officers, directors and other parties. Unlike a trustee in a bankruptcy, the FDIC acting as receiver has broad authority to seize assets, sue officers and directors, reject contracts and even make criminal referrals related to a failed bank.
The FDIC example is instructive for what a receiver's role should be. The first job of counsel to any FDIC receiver is by regulation and practice to pursue claims against officers, directors, auditors, appraisers and attorneys (and their respective insurers). That is because when a financial institution goes bust, those are the ONLY sources for recovery of losses by taxpayers. Financial institutions NEVER go bust when their assets (loans) exceed their liabilities (deposits and debts) and losses, therefore, are all a result of asset deficiencies.
So what can be done to fight fraud and restore investor confidence? There are two key changes that Congress must make in current law. First, there needs to be a requirement for referral (by any trustee in bankruptcy AND by all bankruptcy judges) to the related District Court for appointment of receiver in ANY case where:
1. "in pari delicto" is asserted as a defense or as a basis for not proceeding in an adversary proceeding against any third party that the trustee or bankruptcy judge believes to be liable to the estate and/or its creditors, or
2. the trustee, any creditors' committee or bankruptcy judge determines that "in pari delicto" is likely to restrain collection of an otherwise collectible sum, unless, after a hearing, the Bankruptcy Court rules that it is not in the interest of the estate to pursue such claim.
A trustee and/or any affected creditor can then appeal to the related District Court without limitation by reason of the bankruptcy stay.
It should then be up to the District Court to determine whether a separate limited receiver is to be appointed (like a "special master") with respect only to those claims or to appointment of a full receiver.
When a full receiver is appointed, the District Court should be allowed to elect the trustee as a receiver, in the event there is found to be no conflict of interest, or to merely add receivership authority to the role of the trustee appointed by the District Court.
Empowering Bankruptcy Courts to use receivers appointed and empowered by federal District Courts restores the faith of investors that fraud is NEVER a "defense" and overcomes the desire of trustees (and even some bankruptcy judges) to keep Article III courts out of bankruptcy issues.
Expanded use of receivers in bankruptcy is also consistent with centuries of law that fraud overcomes any discharge of debt in bankruptcy. So this proposal is not so much a "change of law" but rather a recognition that markets suffer whenever fraud is an effective "defense" in bankruptcy or other venues.
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