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Note: In 2000, the U.S. Securities and Exchange Commission (SEC) charged First Choice Management Services, Inc. (Fraudster) with perpetrating a fraudulent investment scheme in violation of U.S. securities laws. Subsequently, the district court appointed Joseph Bradley (Receiver) as receiver to “locate, collect, and distribute [Fraudsters]’ assets among the victims of the [USD]31 million fraud”. When Receiver discovered that some of the defrauded assets were likely used to obtain oil and gas leases in Texas, Receiver requested that the district court freeze those assets, which it did. Subsequently, the district court “lifted a portion of the asset freeze so that those leases could be operated for the benefit of the defrauded investors” by ALCO Oil & Gas Company LLC (Receiver Agent). Receiver Agent was required to operate the property in compliance with state law pursuant to 28 U.S.C. § 959(b) and, as a result, the Railroad Commission of Texas (the Commission) required Receiver Agent to provide it with security pursuant to Texas law. Receiver Agent posted a USD 250,000 cash bond with Bank of America (Issuer) which in turn issued a letter of credit in favor of the Commission.

Receiver later claimed that the cash securing the LC was obtained as a result of the fraudulent scheme and requested that the Commission return the cash or LC pursuant to the district court’s original freeze order or a subsequent order approving Receiver’s “Verified Final Budget and Revised Plan for Closure of the Receivership”. When the Commission refused, Receiver moved for summary proceedings, civil contempt, disgorgement and other relief against the Commission. The district court denied the motion and Receiver appealed. The United States Court of Appeals for the Seventh Circuit, Rovner, Hamilton and Barrett, JJ., affirmed.

The appellate court reviewed the district court decision for abuse of discretion and noted that, to prevail, Receiver had to “establish by clear and convincing evidence that (1) there was an unambiguous command from the court; (2) the Commission violated that command; (3) the violation was significant, meaning that the Commission did not substantially comply; and (4) the Commission failed to take steps to reasonably and diligently comply with the command.”

Regarding the LC, the appellate court agreed with the Commission in citing In re Green, 210 B.R. 556, 558-59 (Bankr. N.D. Ill. 1997) that “Letters of credit payable to third parties are not receivership estate property, even if they are supported by estate property”.

The appellate court also noted that when the district court “lifted part of the freeze order to allow [Receiver Agent] to operate the oil leases, [it] may have extricated the bond from the order even if the bond had initially been subject to it.” The appellate court concluded that the district court did not abuse its discretion in denying Receiver’s motion noting the Commission’s valid basis for requiring security from Receiver Agent, the “state law obstacles to extracting a refund from the state treasury” and the Commission’s good faith negotiations that it would refund the cash collateral once it was paid for costs it incurred due to Receiver Agent’s poor operation of the leases.

[MJK]

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