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Seventh Circuit Holds Federal Receiver Not Bound by State Law Priorities for Redeeming Investors

Commercial Bankruptcy / Appellate / Corporate Services Update Faye B. Feinstein, E. King Poor, Christopher Combest

At a time when billions of dollars of assets are under the supervision of federal receivers and bankruptcy trustees, the Court of Appeals for the Seventh Circuit recently ruled in favor of an equity receiver and held that in proposing her plan of distribution to investors, she was not bound by the requirements of state law when establishing priorities for and making distributions to investors.

In SEC v. Wealth Management LLC, - F.3d - 2010 WL 4862623 (7th Cir., Dec. 1, 2010), the court agreed with the federal equity receiver for six insolvent hedge funds that allocations of receivership property need only be fair and reasonable in the judgment of the supervising federal district court. The court held that such allocations are not controlled by state law, even if applicable state law would have required a different result. Therefore, in the event of insolvency investors cannot rely upon contractual rights to receive a priority for redemption payments.

In this case, the Securities and Exchange Commission filed a complaint in Wisconsin federal district court before Judge William C. Griesbach against Appleton, Wisconsin-based investment firm Wealth Management LLC and its principals, alleging, among other things, misrepresentation and fraud. At the SEC's request, the court appointed Faye B. Feinstein, a Quarles & Brady partner, as Receiver for Wealth Management and its six unregistered pooled investment funds (i.e., hedge funds).

Having determined that the hedge funds would be unable to repay investors more than a small fraction of the $102 million invested and outstanding at the time of her appointment, the Receiver proposed a plan to allocate the funds' assets pro rata to their respective investors, with no priority afforded to those investors who had requested, prior to the receivership, to redeem their investments in the funds. The funds' subscription agreements provided, as is typically the case, that upon a request for redemption and acceptance of the request by the managing member/general partner, investors would be treated as "creditors" and paid their requested redemptions before non-redeeming investors. In the Receiver's view, however, each investor's right to payment arose from the same underlying fact - that they had made equity investments in the funds, and, therefore, all investors should be treated equally. The district court approved the Receiver's plan.

Two investors appealed. Before the receivership, they had sought to withdraw their investments from the funds. They argued that, under their contracts with the relevant funds and under Wisconsin law (Delaware law, which governed others of the hedge funds, is substantially similar), their requests to redeem had transformed their ordinary equity investments into higher-priority debt, thereby making them creditors of the funds entitled to full payment before non-redeeming investors.

The investors also argued that they were entitled to priority under federal law (28 U.S.C. ยง959(b)), which provides that receivers and trustees must "manage and operate" property under their control in conformity with state law. Those investors argued that applicable Wisconsin law gives redeeming investors priority as creditors, and the Receiver had no discretion to modify that priority.

The Seventh Circuit unanimously affirmed the district court and held that federal receivers and trustees need not follow the requirements of state law when distributing assets under their control. Holding that "equality is equity," the court found that to give unpaid redemption requests the same priority as any other equity interest "promotes fairness by preventing a redeeming investor from jumping to the head of the line . . . while similarly situated non-redeeming investors receive substantially less."

For investors, there are lessons to be taken away from the Wealth Management decision: (a) actively monitor all investments; (b) ask questions and understand the substance of the documents executed and the discretion given to fund managers; and (c) even if a request to redeem and exit from a fund has been accepted by the fund manager, a court-appointed receiver or trustee for that fund will have the power to treat the redeeming investor as though it were still invested in the fund, with no greater rights than other investors.

Faye Feinstein argued the appeal; her appellate team consisted of E. King Poor, Christopher Combest and Shannon O'Boye.

If you have any questions regarding this client update, please contact Faye B. Feinstein at (312) 715-5069 /, E. King Poor at (312) 715-5143 /, Christopher Combest at (312) 715-5091 / or your Quarles & Brady attorney.