Bankrupt Billionaire and Family Find No Automatic Stay Protection From SEC's Asset Freeze

By Stephen W. Sather

Barron & Newburger, P.C.

Austin, TX

The Second Circuit has held that efforts by the SEC to temporarily freeze assets alleged to be ill-gotten gains from a securities fraud scheme were excepted from the automatic stay by the police powers exception of section 362(b)(4).   SEC v. Miller, 808 F.3d 623 (2nd Cir. 12/18/15).   The opinion can be found here.   

What Happened

Brothers Samuel and Charles Wyly were officers and directors of various publicly traded companies.   They transferred millions of stock options to trusts and subsidiary companies in the Isle of Man.   They used the trusts as a vehicle to trade in the stock without disclosing their beneficial ownership.

On July 29, 2010, the SEC brought an enforcement action against the wily Wylys.   In May 2014, after a six week jury trial, the jury returned a verdict against them.   In September 2014, the Court ordered disgorgement of nearly $300 million representing taxes avoided on trading profits and a portion of the profits themselves.   

The SEC then sought an asset freeze order against the Wylys and sixteen members of their extended family.   Samuel Wyly and Charles's widow, Caroline, both filed chapter 11 bankruptcy proceedings in the Northern District of Texas.   They claimed that the asset freeze request was an attempt to collect a debt and therefore subject to the automatic stay.   After the bankruptcy filings, the family members were formally made parties to the action as "relief defendants."  

The District Court for the Southern District of New York held several hearings after which it entered an order freezing any assets that were ever property of the Isle of Man entities as well as any assets received from the Wylys after January 1, 2005.  The freeze allowed the relief defendants to use any assets that did not come from the tainted sources, as well as an allowance of $15,000 per month plus medical expenses, educational costs, legal fees and bankruptcy related costs.  

The District Court's order indicated an intent to work with the bankruptcy court in Texas and stated that the asset freeze would expire once the frozen assets were under the Bankruptcy Court's control.   In other words, the assets were only frozen until such time as they could be recovered by the appropriate Debtor-in-Possession or subsequently appointed trustee.   

The District Court issued an opinion in which it found that the SEC's actions did not violate the automatic stay because they were exercised in connection with its police powers.    

Fifteen of the relief defendants appealed to the Second Circuit.   The sixteenth relief defendant, Caroline Wyly, asked the Texas Bankruptcy Court to hold that the stay applied.   The Bankruptcy Court held that the police powers exception defeated the automatic stay.   In re Wyly, 526 B.R. 194 (Bankr. N.D. Tex. 2015).

The Second Circuit's Ruling

The Second Circuit agreed with the District Court (and the Texas Bankruptcy Court) that the police powers exception applied.    It described the purpose behind the police powers exception thusly:

(T)he purpose of the governmental unit exception “is to prevent a debtor from ‘frustrating necessary governmental functions by seeking refuge in bankruptcy court.’”  As the legislative history makes plain, “where a governmental unit is suing a debtor to prevent or stop [a] violation [constituting] fraud . . . or attempting to fix damages for violation of such a law, the action or proceeding is not stayed under the automatic stay.”

Opinion, pp. 16-17.  

The parties agreed that the SEC's enforcement action fell within the general bounds of the police powers exception.   However, they argued that it fell within an exception to the exception.

In the instant case, all parties agree that the SEC’s regulatory enforcement action against the Wyly Brothers falls within the governmental unit exception.  The Relief Defendants assert, however, that this case falls under an exception to the governmental unit exception. This “exception to the exception” provides that actions to enforce money judgments are subject to the automatic stay, even if they were otherwise pursued by a governmental unit in furtherance of the government’s police or regulatory powers.  Accordingly, the Relief Defendants argue that the asset freeze order is subject to the automatic stay. The SEC counters that the asset freeze order does not fall within the money judgment “exception to the exception” and hence does not trigger the automatic stay.

Opinion, p. 17.

 The Court distinguished its prior decision in SEC v. Brennan, 230 F.3d 65 (2nd Cir. 2000) to find that the stay did not apply.   The Court based its ruling on factual, procedural and policy distinctions.

 Factually, the Court found that the asset freeze order was not an impermissible enforcement of a money judgment.

Here, the applicable order is merely an asset freeze, which, unlike the order in Brennan, neither transfers ownership, nor vests control over assets in the courts, nor—given its numerous exemptions for legal, medical, educational, and other uses, as well as generous living expenses—entirely deprives the Relief Defendants of their use. To be sure, the asset freeze order entered by the District Court does temporarily burden the use of certain assets. It does not, however, rise to the level of impermissible enforcement of a money judgment.  Unlike the repatriation and deposit order in Brennan, the asset freeze seeks not to modify or transfer assets in any way, but rather, merely to “preserve the status quo in anticipation of a final judgment.

Opinion, pp. 19-20.

The Court also found that procedurally, an asset freeze entered prior to judgment was not a naked attempt to collect a judgment.

In Brennan, we instructed that “the line between [unstayed] police or regulatory power on the one hand, and [stayed] enforcement of a money judgment on the other, [must] be drawn at entry of judgment.”  In other words, “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.

Opinion, p. 21.

Finally, and perhaps most importantly, the Court found that the asset freeze order complimented the bankruptcy court's jurisdiction rather than threatening it.

No conflict exists between the proceedings in the District Court and those in the Bankruptcy Court. This asset freeze order is narrowly framed to exclude assets in the bankruptcy proceeding and to be lifted as soon as the assets are clearly under the control of the Bankruptcy Court. Indeed, the Bankruptcy Court itself endorsed the freeze as “neatly avoiding duplication of judicial effort between the SEC Action and these bankruptcy cases.”  What is more, the Bankruptcy Court determined that enforcing the automatic stay “may ultimately accomplish little” since the SEC would likely seek relief from the stay to proceed against the Relief Defendants in its enforcement action.   Though it stopped short of deciding such a hypothetical motion, the Bankruptcy Court strongly indicated its own inclination to avoid extending the automatic stay to cover this case: “From the standpoint of judicial economy, it likely would make the most sense for the District Court, in one coordinated proceeding, to liquidate the amount of alleged ill‐gotten gains of the securities fraud that all relief defendants allegedly received and still possess.”

Under these circumstances, the entry of the asset freeze order here does not contravene the first policy of “centraliz[ing] all disputes concerning property of the debtor’s estate so that reorganization can proceed efficiently, unimpeded by uncoordinated proceedings in other arenas.”   Moreover, the asset freeze order is fully consistent with the second policy of “prevent[ing] a debtor from frustrating necessary governmental functions by seeking refuge in bankruptcy court.”   The Wylys initiated bankruptcy proceedings and invoked the automatic stay mere days after the SEC filed its then‐pending motion for an asset freeze. The timing speaks loudly for itself. 

Opinion, pp. 24-25.

As a result, the Court concluded that the automatic stay did not apply.

What It Means

At first blush, it seems counter-intuitive that an action by the SEC to freeze assets was not an attempt to enforce a money judgment.   However, upon further reflection, it seems clear that both the SEC and the District Court took a nuanced approach to preserve assets until they could be brought into the bankruptcy estate.  The SEC learned how to get the result it wanted while avoiding the result from the Brennan case.   The close coordination between the District Court and the Bankruptcy Court makes it clear that the two courts were working towards a common end rather than competing with each other.   Thus, the Second Circuit's ruling seems quite sensible.