Securities and Exchange Commission v. Wealth Management, LLC, et al., 628 F.3d 323 (7th Cir. 2011)  

CASE SNAPSHOT

The principal officers of a small group of related investment funds had invested money in impermissible investments, received kickbacks, and inflated investment results, to the extent that the funds eventually had to be closed down. The SEC filed an enforcement action for fraud, requested that the court freeze the firm’s assets, appoint a receiver to perform an accounting, and design a plan to distribute the recoverable assets. The District Court, over some investor objections, approved the receiver’s plan of pro rata distribution. This decision was appealed. The Circuit Court of Appeals affirmed, and, in a case of first impression, held that reviewing the interlocutory order approving the receiver’s plan was reviewable, under the collateral-order doctrine.

FACTUAL BACKGROUND

For more than 20 years, Wealth Management, LLC managed funds for hundreds of clients. Most clients were conservative investors, and Wealth Management invested accordingly, in low-risk securities. In 2003, Wealth Management established six unregistered funds, and began investing heavily in unconventional, illiquid and risky securities, in contravention to the stated investment parameters of these funds. These six funds were organized either as limited liability companies or limited partnerships; Wealth Management was the general partner or managing member for each of these funds. Two Wealth Management executive officers had complete authority to manage these funds.

The express language in the offering documents of these funds provided that the funds would invest only in “investment-grade” debt securities. In fact, these funds were operated more along the lines of high-risk hedge funds, investing in life-insurance premium financing funds, real-estate financing funds and a water park. Monthly reports issued to investors falsely indicated that the funds were performing well. The situation began to unravel in February 2008, when the funds notified investors that there was not enough money to pay redemptions in full, and that redemptions would be limited to 2 percent per quarter of the value of each investor’s investment.

In June 2008, the two principal officers responsible for managing these funds informed Wealth Management’s board of directors that they had mismanaged the funds and had received kickbacks for investing in certain securities. Investors learned at this time that the SEC was investigating Wealth Management, the funds and the officers. In December 2008, Wealth Management notified investors of its decision to completely close down.

In May 2009, the SEC commenced its enforcement action against Wealth Management and the two principal officers. The court granted the SEC’s request to freeze the firm’s assets, and appoint a receiver for the firm and its assets. In September 2009, the receiver filed her report. Roughly $102 million had been invested in these six funds. The receiver, however, was able to recover little more than $6 million. The receiver determined that no investors were creditors of the firm, and that the fairest approach was to treat all investors equally as equity holders, regardless of whether a redemption request had been made. Thus, the receiver proposed to distribute the $6.3 million to investors on a pro rata basis. The receiver also selected May 31, 2008 as a “redemption cutoff date.” Redemption distributions received after this cutoff date would be offset against the investor’s total distributions; redemption distributions received prior to this date would not be offset. The receiver selected this date because news of the SEC investigation became public in June 2008, causing a spike in redemption requests.

Two investors are involved in this appeal. Both had, after receiving the 2008 letter limiting redemptions to 2 percent, placed redemption orders for the full amount of their investments, before May 1, 2008. These redemption requests were in Wealth Management’s records, and each investor had received partial redemptions in accordance with the 2 percent limitation. These objecting investors argued that their redemption requests required that they be treated as creditors, entitled to priority over non-redeeming investors. The District Court disagreed, holding that the investors were not creditors, that the receiver’s plan was fair and reasonable, as was the redemption cutoff date. The receiver distributed more than $4 million to investors after this decision, then moved to dismiss the investors’ appeal or in the alternative, to affirm the plan.  

COURT ANALYSIS

Collateral-Order Doctrine

The Court of Appeals first addressed its jurisdiction to review the appeal. The appeal regarding the receiver’s plan was interlocutory; no final determination on the merits of the SEC enforcement action had been made. The question therefore was whether this issue was ripe for appeal. The Court of Appeals, as a matter of first impression in the Seventh Circuit, determined that it did have jurisdiction to review the decision under the collateral-order doctrine.

The court noted that the Fifth and Sixth Circuits had held that the collateralorder doctrine permits interlocutory review of a District Court’s order approving a receiver’s plan of distribution. The doctrine permits review of a small class of decisions that finally determine claims separable from, and collateral to, rights asserted in an underlying action. “To fall within the scope of this doctrine, the order must conclusively determine the disputed question, resolve an important question completely separate from the merits of the underlying action, and be effectively unreviewable on appeal from a final judgment.” The court found that all three requirements were met, and held that it had jurisdiction to decide this appeal. 

Receiver’s Motion to Dismiss

Following the filing of the appeal, the appellants filed a motion to stay distributions until the appeal had been resolved. This motion was denied, and the receiver made distributions under the fund. Following these distributions, the receiver moved to dismiss the appeal as moot, arguing that unwinding the distributions that had already been made would be inequitable to innocent investors, as well as an administrative headache. This argument, sometimes called “equitable mootness,” is based on an equitable principle in bankruptcy law. Acknowledging that the term can cause confusion (because there is no actual mootness involved), the court noted that the term derives from the equitable principle that a court, in determining equitable relief, must consider the effects of the relief on innocent parties. This equitable doctrine has been applied in other securities fraud/receiver cases, where courts have decided whether to unwind distributions.

The court stated that there were two key issues in resolving the receiver’s motion: the legitimate expectations engendered by the plan, and the difficulty of unwinding the distributions. The court looked to precedent, noting that the inquiry is fact-intensive, and “weighs the virtues of finality, the passage of time, whether the plan has been implemented and whether it has been substantially consummated, and whether there has been a comprehensive change in circumstances.” The court determined that unwinding the distributions of $4.2 million to some 300 investors would raise “serious equitable concerns,” and pose “administrative hurdles.” The court declined to analyze this equitable question further, however, because “we are affirming on the merits.”  

The Distribution Plan

In supervising an equitable receivership, the courts have broad equitable powers to ensure that the plan is fair and reasonable. In this case, since the recoverable funds were just a small fraction of the overall investments, the District Court agreed with the receiver that it was more reasonable to distribute the assets to investors on a pro rata basis, rather than trying to trace assets to specific investors. The District Court concluded that all investors were in the same boat, regardless of whether they’d been redeeming investors or not, and to give redeeming investors some priority over nonredeeming investors would impermissibly “elevate form over substance.”

In reviewing the lower court’s decision, the Court of Appeals began “with the principle that where investors’ assets are commingled and the recoverable assets in a receivership are insufficient to fully repay the investors, ‘equality is equity.’” Pro rata distribution ensures that substantively similar claims receive proportionately equal distributions. The court then likened receivership to equitable subordination in bankruptcy law, stating that the goal of liquidation bankruptcy and securities-fraud receiverships is identical – the fair distribution of the liquidated assets. “Equitable subordination promotes fairness by preventing a redeeming investor from jumping to the head of the line and recouping 100 percent of his investment by claiming creditor status while similarly situated nonredeeming investors receive substantially less.” The court held that the District Court faithfully applied these principles, and reasonably exercised its discretion, in approving pro rata distribution to all investors. The objecting investors argued that, under 28 U.S.C. section 959(b), they were entitled to be treated as creditors, not equity holders. This statute governs receiver conduct, and requires that a receiver “manage and operate” the subject property in accordance with the laws of the state in which the property is located. The court cited case law in support of its conclusion that this statute has no relevance in the liquidation context. Moreover, under Wisconsin law, the objecting investors failed to satisfy the conditions of becoming creditors of the investment fund. Finally, the court rejected the appellants’ argument that the cutoff date of May 31, 2008 was arbitrary and unfair, finding that, in light of the public notice of the SEC investigation in June and the ensuing spike in redemption requests, the receiver exercised discretion reasonably and equitably.

The Court of Appeals held that the lower court did not abuse its discretion in approving the receiver’s distribution plan.  

PRACTICAL CONSIDERATIONS

Unfortunately for investors, there will always be some segment of investment managers that succumbs to the temptation to benefit themselves at the expense of their investors. Receivership and forced liquidation is often the only possible remedy, and it is almost always far less than a complete remedy. This decision affirms the broad, equitable powers and discretion of receivers in fashioning the distribution plan that is as fair as possible to as many investors as possible – equality is equity.