Debtor Does Not Have To Repatriate Offshore Trust: 2nd Circuit Ruled Lower Court´s Order Violated Automatic Stay Provision

This article originally appeared in the December 29 edition of The Legal Intelligencer

For a change, embattled securities dealer Robert E. Brennan, President of discount securities broker-dealer First Jersey Securities, Inc., has won a round in his long-running battle with the SEC. The U.S. District Court for the Southern District of New York, at the request of the SEC, directed Brennan, a chapter 11 debtor in a case pending in the U.S. Bankruptcy Court for the District of New Jersey, to repatriate the assets of an offshore asset protection trust and to deposit those assets in the registry of the district court. In Securities and Exchange Commission v. Brennan, 230 F.3rd 65 (2nd Cir. 2000), the appeals court vacated that order, holding that it violated the automatic stay provisions of Section 362(a) of the Bankruptcy Code.

In 1985, the SEC sued First Jersey Securities, Inc. and Brennan in the U.S. District Court for the Southern District of New York, alleging that they had perpetrated a massive fraud against their customers and realized millions in illegal profits. The case was finally heard in 1994 and, after a lengthy bench trial, the district court entered a judgment in the SEC’s favor in July 1995 (the "July 1995 Judgment"), directing Brennan and his company used to disgorge millions in ill-gotten gains and prejudgment interest.

Sometime during the 1994 trial and before the July 1995 Judgment, Brennan established an offshore asset protection trust, called the Cardinal Trust, in Gibraltar, funded with $5 million in municipal securities and naming Brennan’s three adult sons and the Robert E. Brennan Foundation, Inc. as beneficiaries. The SEC claimed that Brennan was using the trust to fund a lavish lifestyle.

Shortly after the July 1995 Judgment, Brennan filed a chapter 11 petition in the U.S. Bankruptcy Court for the District of New Jersey, eventually (but not initially) listing the Cardinal Trust as property of his estate. He valued his interest at $0. In June 1997, a trustee was appointed for Brennan’s chapter 11 case at the request of the SEC, based on a finding that Brennan, inter alia, was not providing adequate financial disclosure. In May 1998, the trustee, joined by the SEC, asked the Bankruptcy Court to require that Brennan repatriate the assets of the Cardinal Trust. The Bankruptcy Court declined to do so and its order was not appealed.

The Cardinal Trust contained a provision called a "flight clause" which required the trustee to relocate the trust upon the occurrence of an "event of duress," including any government action that would attempt to take control of the trust assets. Accordingly, the Cardinal Trust was relocated twice, first to Mauritius and then to Nevis. The bankruptcy trustee also brought an action in the High Court of St. Kitts and Nevis to recover the assets of the trust, but that action was dismissed for failure to state a claim under Nevis law.

The SEC then turned to the U.S. District Court for the Southern District of New York here it had obtained the July 1995 Judgment, and that court on April 7, 2000 entered an ex parte order requiring Brennan to appear for a contempt hearing and directing him, inter alia , to repatriate the assets of the Cardinal Trust (the "Repatriation Order"). Brennan appealed, arguing violation of the automatic stay (and also issue preclusion and lack of due process). The Second Circuit dealt only with the issue of the automatic stay, on which it ruled in Brennan’s favor.

The majority opinion, written by Judge Cabrenas, notes that Section 362(a) of the Bankruptcy Code stays the commencement or continuation of virtually all proceedings against a debtor, including enforcement of judgments, that were or could have been commenced before the debtor filed for bankruptcy. It provides that:

"(a) except as provided in subsection (b) of the section, a petition filed ...operates as a stay, applicable to all entities, of

He also noted that the general policy underlying Section 362 is, on the one hand, to give the debtor relief from his creditors and, on the other hand, to prevent dissipation of his assets before an orderly distribution to creditors can be effected.

However, he pointed out that Section 362(b) establishes several exceptions to the automatic stay, one of which was "at the heart of the dispute in this case." Section 362(b)(4) provides that the filing of a bankruptcy petition does not operate as a stay

"... under paragraph (1), (2), (3) ... of subsection (a) of this section, of the commencement or continuation of an action or proceeding by governmental unit ... to enforce such governmental unit’s ... police and regulatory power, including the enforcement of a judgment other than a money judgment, obtained in an action or proceeding by the governmental unit to enforce such governmental unit’s ... police or regulatory power."

Brennan argued and the majority agreed that Section 362(b)(4) contains both an exception to the automatic stay for actions to enforce a governmental unit’s police or regulatory power, and also an exception to that exception, namely, when such governmental enforcement action is the enforcement of a money judgment. In an apparent case of first impression, the majority stated that the question presented was whether the Repatriation Order falls within the governmental enforcement exception to the automatic stay, as the SEC contended, or, as Brennan contended, within the exception to that exception, as being enforcement of a money judgment, albeit in the course of enforcement of the government’s police and regulatory power.

Judge Cabrenas, stating that "the question is a close one", agreed with Brennan that the Repatriation Order violated the automatic stay. He reasoned that the exception in Section 362(b)(4), while permitting the "entry" of a money judgment against the debtor as part of enforcement of the governmental unit’s police or regulatory power, "prohibited anything beyond the mere entry of a money judgment", such as an attempt to collect the money judgment, without the permission of the Bankruptcy Court in which Brennan’s chapter 11 case was pending. He cited a number of lower court and one non-Second Circuit cases in support of his conclusion that enforcement actions "after entry" of the judgment would violate the stay, concluding that:

"Accordingly, up to the moment when liability is definitively fixed by entry of judgment, the government is acting in its police or regulatory capacity -- in the public interest, it is burdening certain conduct so as to deter it. However, once liability is fixed and a money judgment has been entered, the government necessarily acts only to vindicate its own interest in collecting the judgment. Except in an indirect and attenuated matter, it is no longer attempting to deter wrongful conduct. It is therefore no longer acting in its ‘police or regulatory’ capacity, and the exception to the exception does not apply [sic]". [He meant to say that the exception to the exception does apply, i.e. that the government’s enforcement of a money judgment is stayed.]

Judge Cabrenas found it significant that the SEC had sought the Repatriation Order because "Brennan has not complied with the [July 1995 Judgment]" and that it had unsuccessfully deposed him (he invoked the Fifth Amendment) pursuant to Fed. R. Civ. P. 69(a) which governs discovery in proceedings in aid of a judgment or execution.

The SEC pointed out that the Repatriation Order sought only to bring the Cardinal Trust within the jurisdiction of the district court and that the SEC, as a creditor in bankruptcy, would seek only its pro rata share of the trust assets. It also argued that Section 362(a)(3) gave governmental units "unqualified" authority to seek to recover estate property outside the bankruptcy proceedings, so that the enforcement of a money judgment "exception to the exception" did not apply. Judge Cabranes characterized this as an attempt to create an exception to the exception to the exception" which would "virtually swallow whole" the exception to the exception.

Judge Cabrenas suggested that the SEC should have sought repatriation of the offshore trust before the bankruptcy court in New Jersey, and having done so unsuccessfully should have appealed that result to the U.S. District Court for the District of New Jersey, rather than returning for a repatriation order to the U.S. District Court for the South District of New York.

Judge Calabresi began by dismissing the cases cited by the majority for the proposition that enforcement of a money judgment after the money judgment has been entered is prohibited, by pointing out that none of the cases cited were binding on the Second Circuit and that the only one entered at a circuit court level was EEOC v. Rath Packing Co., 787 F.2d 318, 326 (8th Cir. 1986), a case in which the EEOC sought installment payments with respect to a money judgment which would be paid directly to itself and to no one else, which the SEC did not seek here.

He argued that the Repatriation Order did not amount to collection of the SEC’s judgment, but merely placed assets in the registry of the district court, to which the SEC and other creditors would not have access except through proceedings in the bankruptcy case. In short, he characterized the Repatriation Order as falling "somewhere in between the entry of a judgment and its collection".

Alternatively, Judge Calabresi argued that the fact that Brennan stands to lose control of the assets in the Cardinal Trust under the Repatriation Order "does not in itself transform the District Court’s order into an enforcement of a money judgment," since, he argued, the enforcement prohibited by Section 362(b)(4) occurs "at the time of collection" and only if the enforcement of the money judgment would have the effect of benefiting the government at the expense of other creditors. The majority opinion, responding to the latter argument, pointed out that there was no legislative history to support such an analysis of Section 362(b)(4), and that such a view would allow the government to enforce a money judgment against a debtor in any forum the government chose "so long as the government bound itself ex ante to distribute the proceeds thus collected to other creditors on a pro rata basis." This would give the government as creditor a privilege no other creditor has (i.e. forum shopping) and would be inimical to centralization of adjudication of the bankruptcy case.

A decision in which Judges Cabrenas and Calabresi joust with each other can be a good read. That is the case here. However, as they each endeavored to define the scope of the governmental unit’s exception to the automatic stay, and the further exception thereto for money judgments, it would appear that Judge Cabrenas and the majority reached the better-reasoned result. The Repatriation Order was unquestionably a significant step in an overall attempt by the SEC to collect (at least its pro rata creditor’s share of) the Cardinal Trust assets, even though the repatriation step fell short of actual collection of its share. Furthermore, as Judge Cabrenas pointed out, drawing the line of government’s permissible enforcement of its public and regulatory power with the entry of the money judgment itself "is the most logical place for it."

This article is reprinted with permission from the December 29, 2000 issue of The Legal Intelligencer © 2000 NLP IP Company.