United States: SEC Temporary Asset Freeze Not Barred By Automatic Stay Provisions

In an effort to protect the property of a bankruptcy estate, Section 362(a) of the U.S. Bankruptcy Code imposes an automatic stay on most proceedings against a debtor in bankruptcy. The policy of this section is to grant relief to a debtor from creditors, and to prevent a "disorganized" dissipation of the debtor's assets. (See, e.g., U.S. Securities and Exchange Commission v. Brennan, 230 F.3d 65, 70 (2d Cir. 2000).) However, the scope of the automatic stay is not all-encompassing. For example, Section 362(b) provides several exceptions, including one for "the commencement or continuation of an action or proceeding by a governmental unit ... to enforce such governmental unit's ... police and regulatory power." This rather straightforward exception to the automatic stay is nevertheless qualified by a carve-out—often referred to as "the exception to the exception"—that maintains the automatic stay where such governmental police action occurs in connection with the enforcement of a money judgment. In Securities and Exchange Commission v. Wyly, 2014 U.S. Dist. LEXIS 155382 (S.D.N.Y. 2014), the U.S. District Court for the Southern District of New York considered whether a temporary asset freeze sought by the U.S. Securities and Exchange Commission was excepted from the automatic stay as a governmental exercise of police powers, or whether such action was within the "exception to the exception" and thus barred by the automatic stay.

Wyly involved a civil enforcement action brought by the SEC against Sam Wyly and the estate of his late brother, Charles Wyly, arising from a fraudulent offshore securities scheme. In early October 2014, the SEC requested that the district court enter a pretrial order for a temporary asset freeze, financial discovery, and an accounting of the Wyly brothers' assets in order to preserve the SEC's ability to enforce a final judgment, which the SEC was pursuing but had yet to secure. Sam Wyly and Charles Wyly's estate representative, along with various other Wyly family members, opposed the SEC's request. Later that month, however, while the SEC's application to the district court was still pending, Sam Wyly filed for Chapter 11 bankruptcy protection in the U.S. Bankruptcy Court for the Northern District of Texas. Charles Wyly's widow and primary estate beneficiary filed a similar petition for relief four days later.

As a result of the bankruptcy filings, the Wylys claimed that the SEC was barred from freezing any assets belonging to the debtors' respective bankruptcy estates. The SEC disagreed, arguing that the two bankruptcy filings had no impact on its attempt to freeze the assets of the Wyly debtors. In resolving this dispute, the district court concluded that because the SEC was acting within its police and regulatory powers, the automatic stay did not apply to bar the freezing of the debtors' assets.

The district court supported its conclusion by distinguishing precedent established by the U.S. Court of Appeals for the Second Circuit in Brennan. There, the Second Circuit held that the SEC's attempt to repatriate a bankruptcy debtor's offshore trusts constituted an effort to enforce a money judgment, and was thus precluded by the automatic stay. The court of appeals reasoned that while the entry of a monetary judgment in favor of a governmental unit exercising its police or regulatory powers would not constitute a violation of the automatic stay, "anything beyond the mere entry of a money judgment against a debtor is prohibited by the automatic stay including steps preparatory to money collection." The appellate court explained that "the collection of a money judgment after entry is not authorized and requires a separate application to the bankruptcy court." Notably, the court of appeals drew a distinction between a governmental unit's exercise of police and regulatory powers on the one hand, and the governmental unit's enforcement of a money judgment on the other hand: "Up to the moment when liability is definitively fixed by entry of judgment, the government is acting in its police or regulatory capacity. However, once liability is fixed and a money judgment has been entered, the government necessarily acts only to vindicate its own interest in collecting its judgment."

In Wyly, the district court was presented with the SEC's request to impose a temporary asset freeze after a bankruptcy filing, but before the entry of a money judgment, a circumstance the district court considered an issue of first impression. Comparing the facts of Wyly to those of the Brennan case, the district court recognized that Brennan "explicitly drew the line at entry of judgment, and explained that all actions taken by the government 'up to the moment' when judgment is entered are actions within the government's police or regulatory capacity." Because the SEC was not yet seeking to enforce a money judgment—but instead was merely working to obtain such a judgment—the district court concluded that the SEC was acting within its police and regulatory capacity.

The district court also rejected the Wylys' argument that because the SEC was seeking to control property of the bankruptcy estates, the requested asset freeze fell within the Section 362(b)(4) "exception to the exception" and was therefore stayed. The district court held that "no asset here will be modified in any way" by the requested temporary asset freeze. Noting that the "SEC seeks to preserve the status quo in anticipation of a final judgment," the district court concluded that "preserving assets in anticipation of a judgment is not equivalent to controlling those assets in an effort to enforce a judgment already entered." As a result, the district court granted the SEC's request and imposed a temporary freeze on the Wylys' assets.

Importantly, the district court departed from the traditional analysis applied by courts when determining whether government action is an exercise of police or regulatory power or is more appropriately characterized as a judgment collection effort. This traditional analysis considers (1) whether the government is pursuing a matter of public safety or welfare rather than its pecuniary interest (the pecuniary purpose test), and (2) whether the government action is designed to effectuate public policy rather than to adjudicate private rights (the public policy test). (See Berg v. Good Samaritan Hospital (In re Berg), 230 F.3d 1165 (9th Cir. 2000).) Because the SEC had not yet obtained a final judgment against the Wylys, the district court had no reason to reach this analysis. Instead, the district court concluded that the absence of a money judgment rendered the government's pretrial enforcement conduct within its police and regulatory capacity.

The district court in Wyly considered the scope of the "exception to the exception" in the unique circumstances where pre-judgment government action would directly affect assets of a debtor's bankruptcy estate. While this particular question presented the district court with an issue of apparent first impression, the ultimate holding is consistent with other cases that have considered similar scenarios. (See, e.g., SEC v. First Financial Group of Texas, 645 F.2d 429, 438 (5th Cir. 1981), holding that pretrial appointment of receiver was excepted from the automatic stay where "it [was] likely that, in the absence of a receiver to maintain the status quo, the corporate assets will be subject to diversion and waste.") Of course, had the SEC first obtained a final judgment against the Wylys and then sought to freeze the Wylys' assets in furtherance of such judgment, it is likely that the district court would have found the government's conduct to fall squarely within the "exception to the exception" and thus to be prohibited by the automatic stay.

Originally published by the Legal Intelligencer

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the Business Reorganization and Financial Restructuring. He concentrates his practice in the areas of commercial litigation and creditors' rights. Jarret P. Hitchings is an associate in the firm's Wilmington, Delaware office and practices in the area of business reorganization and financial restructuring.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.

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