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In re Bayou Group

February 2, 2007

IN RE BAYOU GROUP, L.L.C., ET AL., DEBTORS.
DIANA G. ADAMS, ACTING UNITED STATES TRUSTEE,
v.
JEFF J. MARWIL, RECEIVER, AND OFFICIAL COMMITTEE OF UNSECURED CREDITORS, APPELLEES.



On Appeal from the Appellant, United States Bankruptcy Court for the Southern District of New York.

The opinion of the court was delivered by: McMahon, J.

DECISION AND ORDER

AFFIRMING THE BANKRUPTCY COURT'S DENIAL OF THE UNITED STATES TRUSTEE'S MOTION TO APPOINT CHAPTER 11 TRUSTEE

Appellant Diana G. Adams, Acting United States Trustee ("U.S. Trustee"), asks this court to overturn an order of the United States Bankruptcy Court (Adlai S. Hardin, B.J.), dated June 30, 2006, which denied the U.S. Trustee's motion for the appointment of a Chapter 11 trustee for Bayou Group, L.L.C. and its related entities ("Bayou" or "Bayou On-Shore Entities"). On April 28, 2006, prior to the filing in bankruptcy by any Bayou On-Shore (i.e., U.S.-based) entity, this court appointed Jeff J. Marwil, Esq. ("Marwil") as receiver and "exclusive managing member" of the Bayou On-Shore Entities, at the behest of a group of Bayou creditors calling themselves "The Unofficial On-Shore Creditors' Committee of the Bayou Family of Companies ("Unofficial Committee")." The relief sought by the Unofficial Committee and granted by this Court -- in effect, the appointment of an equity receiver -- paralleled relief sought and obtained by the creditors of certain Off-Shore Bayou entities in the Grand Court of the Cayman Islands.

On May 30, 2006, each of the Bayou On-Shore Entities filed separate voluntary petitions for relief under Chapter 11 of the Bankruptcy Code. As exclusive managing member, Marwil continued to administer the Bayou On-Shore Entities, which operated as debtors-in-possession. When the U.S. Trustee learned about this arrangement, she moved for appointment of a Chapter 11 trustee to administer the estate. It is, of course, the prerogative of the U.S. Trustee (or a party in interest) to request who that bankruptcy trustee would be.

Appellant claims that, because Marwil is a receiver appointed in a pre-bankruptcy proceeding, he became a "custodian" within the meaning of § 543 of the United States Bankruptcy Code as soon as the Bayou On-Shore Entities filed their Chapter 11 petitions. Pursuant to the Code, any such "custodian" is prohibited from taking any action in respect of the debtor's property in his possession (except insofar as is necessary to preserve the property) and is required to immediately turn over all of the debtor's property in his possession to a duly appointed Chapter 11 trustee. Appellees argued that this court's order appointing Marwil as "exclusive managing partner" of the Bayou On-Shore Entities made Marwil more than simply a receiver; rather, the order provided for the ongoing corporate governance of the Bayou On-Shore Entities at a time when their prior management was disabled from acting (due to the guilty pleas of Bayou's principals). The U.S. Trustee countered that any corporate management powers Marwil had been given were derivative of his receivership and disappeared the moment the entities filed in bankruptcy. The Official Creditors Committee, appointed in the Bankruptcy Court by the U.S. Trustee, adamantly opposed the U.S. Trustee's motion.

The bankruptcy court denied the U.S. Trustee's motion. Judge Hardin concluded that granting the motion would be tantamount to overturning this court's April 28 Order, something he did not have the power to do. Judge Hardin further ruled that, if he did have the power to appoint a Chapter 11 Trustee, he would decline to do so, because there was no need for any such trustee. He concluded that this court's April 28 Order had set up corporate management for each of the Bayou On-Shore Entities, which allowed them to operate as debtors-in-possession and obviated the need for a Chapter 11 trustee.

As should be obvious, this court has (quite unintentionally) set off a turf war between the Office of the United States Trustee and groups of sophisticated creditors for control over Bayou's estate in bankruptcy. The issue raised by this appeal is one of first impression and can be stated succinctly: have Bayou's creditors managed to find a loophole in the Bankruptcy Code that permits them to control the appointment of the person who will administer a bankruptcy estate?

For the reasons stated below, the bankruptcy court's denial of the United States Trustee's motion to appoint a Chapter 11 trustee for the Bayou entities is affirmed.

I. Background

Bayou is an affiliated group of legal entities based in Connecticut that created and managed private pooled investment funds, or hedge funds.*fn1 Bayou's principals, Samuel Israel III and Daniel E. Marino, operated Bayou as a fraudulent Ponzi scheme and, by August 2005, Bayou collapsed under the weight of this massive fraud. As would be expected, numerous civil and criminal investigations ensued, instigated by, among others, the United States Attorney for the Southern District of New York, the Securities and Exchange Commission ("SEC"), and the Commodity Futures Trading Commission ("CFTC").

On September 29, 2005, both Israel and Marino pled guilty to conspiracy to commit fraud, mail and wire fraud, and investment advisor fraud. They are presently awaiting sentencing.

A. The District Court Order and Bayou's Bankruptcy Filing

Following Bayou's collapse, the United States obtained forfeiture orders covering all of Bayou's tangible assets, and marshaled those assets. Bayou's only remaining assets were litigation claims.

A group of more than sixty Bayou creditors, holding more than $130 million in claims, organized themselves as the "Unofficial On-Shore Creditors' Committee of the Bayou Family of Companies" ("Unofficial Committee"). On March 27, 2006, they filed a lawsuit in this court, seeking the appointment of Jeff J. Marwil as "federal equity receiver" to pursue these litigation claims and thereby mitigate the massive losses suffered by the creditors and others. Unofficial On-Shore Creditors' Committee v. Bayou Group, L.L.C., 06-CV-2379 (CM). The appointment was sought pursuant to Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 thereunder, state law claims of fraud and breach of fiduciary duty, Federal Rule of Civil Procedure 66, 28 U.S.C. §§ 754 and 959, and this court's inherent authority. (See Unofficial On-Shore Creditors' Committee's Memorandum in Support of its Motion to Appoint a Receiver, p. 15, 06-CV-2379, Docket Entry No. 6; Proposed Order Granting The Unofficial On-Shore Creditors' Committee's Motion to Appoint a Receiver, p. 1-2, 06-CV-2379, Docket Entry No. 3.) The Unofficial Committee provided notice of this civil lawsuit to all known Bayou creditors, parties-in-interest, and the United States Department of Justice.

In filing this lawsuit, the Unofficial Committee essentially sought the same relief accorded Bayou's off-shore creditors by the Grand Court of the Cayman Islands. On September 1, 2005, seven Bayou Off-Shore Funds*fn2 petitioned the Cayman Islands court to appoint liquidators to wind down the Off-Shore Funds. (In re Bayou Off-Shore Master Fund, Ltd., et al., Nos. [2005] 397 etc. (Cayman Is. Grand Ct., Sept. 2, 2005) (Cayman Islands).) The Grand Court appointed Gordon I. Macrae and James G. Cleaver of Kroll (Cayman) Ltd. as the Off-Shore Funds liquidators, charging them with protecting the interests of the Bayou Off-Shore Funds' creditors, investors and shareholders. (See In re Petition of Macrae, No. 05-51154 (Bankr. D. Conn. Sept. 9, 2005), Docket Entry No. 3, Motion of Gordon I. Macrae and James G. Cleaver for Order Directing Joint Administration of Section 304 Cases, at ¶¶ 3, 6-7.)

Upon receiving the Unofficial Committee's complaint and motion for appointment of a receiver, this court consolidated their lawsuit (06-CV-2379) with In re Bayou Hedge Funds Investment Litigation (06-MD-1775), which had just been assigned to this court by the Judicial Panel for Multi-District Litigation. In the consolidation order, I noted, "What the Unofficial Committee seeks is very much akin to what occurs in a bankruptcy where there are numerous claimants -- a trustee is appointed, assets . . . are marshaled and pursued through subsidiary litigation, professional fees are apportioned and estates are settled." (See Appellate Record, D.E. 43, Ex. F at 3-4.)

This court initially refrained from granting the motion, stating that it was "reluctant to do anything as drastic as appoint a Receiver until I can get some idea of what the actions being transferred to this court for pre-trial coordination are all about, and solicit the views of those parties and their counsel." (Id. at 4.)

This court conducted hearings on April 18 and April 28, 2006 to consider the appointment of Marwil as a qualified manager for each of the Bayou entities. The United States Attorney for the Southern District of New York sent representatives from both the Criminal and Civil Divisions; representatives from the SEC and the CFTC were present as well. Absolutely no one objected to the appointment of Marwil as federal equity receiver.

During the two-day hearing, the court inquired why the Unofficial Committee (or any three creditors) had not simply put the Bayou On-Shore Entities into bankruptcy:

MR. KIRBY [attorney for the Unofficial Committee]: Because we believe that one of the things that the receiver may choose to do is file bankruptcy. One of the things that he might do as one of his powers is to file bankruptcy if he believes that's necessary to gain additional powers in order to pursue claims. But the question --

THE COURT: Why didn't you go to the bankruptcy judge in the first place, which is what the offshore creditors did?

MR. BADER [attorney for Samuel Israel]: They commenced proceedings under Cayman Islands law. How or why they made that choice I don't know. But it is our view that there needs to be a fiduciary responsible to get them into the bankruptcy if bankruptcy is to happen, and what forum will be the ultimate choice is something the receiver needs to make a choice about. But from the creditors' committee's perspective, it will be piecemeal effort to get the bankruptcy, if bankruptcy is the right choice, without a fiduciary to do that.

THE COURT: What entities are you talking about?

MR. KIRBY: . . . . Your honor, the entities -- there are so many of these entities, to get each one into bankruptcy in an organized fashion you need to have someone responsible for getting them in bankruptcies. And in the meantime, the decision by the committee was that it made the most sense to seek a fiduciary that would have the powers -- and in the proposed order specifically would have the powers to continue on in that capacity as receiver through bankruptcy under paragraph -- as set forth in one of its powers under Paragraph 7E of corporate governance, that he would have the powers to put them in bankruptcy if necessary. And that way it would be an efficient process to get a voluntary bankruptcy petition into the court the receiver believes is the appropriate forum for that. And whether that's Connecticut or New York is something the -- judgment that the receiver would have to make. (06-CV-2379, Apr. 18, 2006 Hearing Tr. at 33:7-34:20.)

In addition to Mr. Kirby's speech above, the subject of corporate governance was discussed again when counsel for the Unofficial Committee summarized the need for the receivership:

Your Honor, the committee believes that it is important to have a receiver as quickly as possible. The reason for that is that the receiver, there presently is nobody functioning for the On-Shore entities. We anticipate that there is likely to be a bankruptcy necessary for a number of the Bayou entities, and the choices as to what form that would take, Chapter 11 versus Chapter 7 and who would administer that bankruptcy, the creditors believe should be something that they choose. And, given the fact that the present people who administer the Bayou On-Shore entities are Mr. Israel and Marino, as we have set forth in our papers, we believe it is important that they be replaced by a person with responsibility for all of those entities . . . . There is still nobody to represent the Bayou entities in that process and we believe the simplest way to go forward is to have an equity receiver responsible for all the On-Shore entities, to have that person administer the bankruptcy. The proposed order, as we have set forth, gives him those powers to do that. If somebody feels that that's not appropriate during bankruptcy they can raise those issues before a bankruptcy judge. (06-CV-2379, Apr. 28, 2006 Hearing Tr. at 10:22-12:20.)

Immediately following the April 28 hearing, this court, without objection, entered an order appointing Marwil as "non-bankruptcy federal equity receiver and exclusive managing member" for each of the Bayou On-Shore Entities. (See Appellate Record, D.E. 35, Ex. A (hereinafter "Order") at ΒΆΒΆ 1, 7) (emphasis ...


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