It is often the case that bankruptcy laws find themselves in conflict with other federal statutes or with state law. In many instances, the public policy supporting the rehabilitation of a debtor and the equality of distribution among creditors dictates that the provisions of the Bankruptcy Code prevail. Yet, in others, bankruptcy courts - and the Bankruptcy Code itself - defer to state law.

Recently, the 2nd U.S. Circuit Court of Appeals was faced with a possible conflict between the priority of treatment given to creditors under the Bankruptcy Code and the discretion afforded to the Securities and Exchange Commission under the Sarbanes-Oxley Act of 2002 to distribute civil penalties which the SEC collects.

In Official Committee of Unsecured Creditors of WorldCom Inc. v. SEC, the court of appeals held that the Official Committee of Unsecured Creditors of WorldCom Inc. had nonparty standing to appeal a lower court's order approving a plan developed by the SEC for distribution of civil penalties, but it rejected the committee's claim that the lower court abused its discretion in approving that plan.

On June 26, 2002, the SEC filed a civil complaint against WorldCom Inc. in the U.S. District Court for the Southern District of New York alleging, inter alia, that WorldCom had overstated its income by $9 billion between 1999 and the first quarter of 2002 and thus, violated various federal securities laws by defrauding its investors. Less than one month later, on July 21, WorldCom filed for bankruptcy protection in the U.S. Bankruptcy Court for the Southern District of New York.

Approximately a year after Worldcom's bankruptcy filing, the SEC and WorldCom entered into a settlement agreement resolving the civil action pursuant to which WorldCom agreed to pay a civil penalty of $750 million. The settlement agreement also provided for a nominal disgorgement of $1 (together with the penalty, the fund). This $1 disgorgement triggered the applicability of the Fair Fund provisions of Sarbanes-Oxley, which allowed the civil penalty of $750 million to be added to the disgorged amount and to be distributed to defrauded investors.

As part of the settlement agreement, the SEC had to propose a plan to distribute the fund. The district court and the bankruptcy court each approved the settlement agreement. Although the committee's support was reflected on the record in both instances, the committee was not formally a party to the proceedings or a signatory to the settlement.

After WorldCom emerged from bankruptcy, the SEC sought the district court's approval of its plan to distribute the fund. Because the amount of the fund was less than the total amount of losses suffered by WorldCom's investors, the SEC plan excluded certain investors, including the following: those who recovered 36 percent or more under WorldCom's reorganization plan or through the sale of their securities; and those who made a net profit on their combined purchases or sales of WorldCom securities during the period in which the fraud occurred.

The committee voiced its objections to the SEC plan during the district court hearing, but it did not actually intervene in the civil action, and the district court approved the SEC plan. The committee then appealed the district court's order approving the SEC plan, challenging the exclusions set forth in the SEC plan and arguing that the district court had inappropriately afforded "heightened deference" to the SEC.

In reviewing its jurisdiction, the court looked to whether the committee had standing to bring the appeal and whether the committee was acting within its authority in doing so. As to the standing issue, the SEC argued that the committee did not have standing because it was not a party to the civil action and did not meet the requisites to appeal as a nonparty. As a preliminary matter, the circuit court noted that only parties to a lawsuit may appeal an adverse judgment, generally, and the committee's objection to the SEC plan at the district court level was not enough to make the committee a party to the civil action.

The court then noted that there are two exceptions to the general rule prohibiting nonparty appeals: a nonparty may appeal a judgment by which it is bound; and a nonparty may appeal if it has an "interest affected by the . . . judgment."

Focusing on the second exception, the court stated that it is sufficient that a nonparty prove it have an interest that has been plausibly affected by the judgment. The SEC argued that the committee could not possibly have been affected by the judgment, because even were it successful on appeal, such success would only result in a reapportionment of a fixed amount of funds among the committee's constituents.

In fact, the SEC pointed out that if the committee was successful in its appeal, certain classes of investors that had been previously excluded from the SEC plan would now be included. As a result, the number of creditors receiving a distribution would increase and the amount distributed to each creditor would correspondingly decrease.

However, citing the complexity of the SEC plan and the limited record before it, the court of appeals stated it was unable to determine how a successful committee appeal would affect distribution. As such, the court of appeals could not conclude that the committee's asserted interest was absolutely not affected. Accordingly, the court held that the committee had standing to appeal as a nonparty.

The circuit court then addressed the issue of the committee's statutory authority to pursue the appeal. In particular, the SEC argued that the appeal was beyond the powers granted to the committee under the Bankruptcy Code, as the committee had initiated a proceeding outside the bankruptcy court, and the committee had neither sought nor obtained bankruptcy court approval to file an appeal.

In reviewing the general authority given to the committee pursuant to 11 U.S.C. Section 1103(c)(5) to "perform such other services as are in the interest of those represented," the court noted that this authority was not without limits, particularly in cases in which creditors' committees have attempted to act entirely outside of bankruptcy proceedings. Specifically, the court noted that in previous cases, when a committee has sought an appeal as a nonparty, it has generally sought authority from the bankruptcy court to do so.

However, as the committee did not seek such authority in this case, the court noted the bankruptcy court would have an opportunity to address the issue in the context of that court's review of the fee application, if any, that the committee might file seeking reimbursement of its fees and expenses. Stating, "(t)here is, in short, a serious question regarding what legal action, if any, the committee is authorized by statute to pursue outside of the [bankruptcy court]" and that the committee did not claim to have sought the bankruptcy court's authorization to initiate this appeal, the court declined to reach the question as to the committee's statutory authority to pursue this appeal. Instead, it exercised its "hypothetical jurisdiction" because it was satisfied that the committee had Article III standing and otherwise possessed standing to appeal as a nonparty.

As to the committee's challenges to the SEC's proposed distribution under the Fair Fund provisions of Sarbanes-Oxley, the court reviewed the historical development of SEC disgorgement actions. It noted that, statutorily, the SEC originally only had the power to seek disgorgement of profits, and the primary purpose of this power was to deter violations; compensation of fraud victims was only a secondary goal. Thereafter, through the passage of the Securities Enforcement Remedies Act and Penny Stock Reform Act of 1990, the SEC was given additional authority to seek civil penalties which were payable to the U.S. Department of Treasury. Sarbanes-Oxley then provided the SEC with the power to impose civil penalties and distribute them to defrauded investors.

The appellate court then noted that in reviewing decisions of the SEC regarding distribution of funds, the 2nd Circuit has typically deferred to the SEC's experience and expertise. It also concluded that Sarbanes-Oxley did not limit the SEC's role in distributing funds to injured investors, but actually expanded it. Thus, the court held that the "fair and reasonable" standard that is applied to review the SEC's distribution of disgorged profits also applies to the SEC's distribution of civil penalties under Sarbanes-Oxley's Fair Fund provisions.

Accordingly, the appellate court's review of the district court's decision was limited to whether the district court had abused its discretion. Reviewing the committee's objection to the exclusion of certain creditors from distribution under the SEC Plan, the court of appeals stated that regarding the exclusion of investors whose aggregated sales and purchases of WorldCom securities resulted in a net profit, the SEC had considered carefully how to best apportion the limited funds: the court noted that it had approved a similar exclusion in another case.

Regarding the exclusion of creditors who recovered more than $0.36 on the dollar, the court pointed out that there is no mandate in the Fair Fund provisions that the SEC follow the Bankruptcy Code's claim priorities when developing a distribution plan. Thus, the court held that the district court had not abused its discretion in determining that the SEC plan fairly and reasonably distributed the fund among the potential claimants. Accordingly, the court affirmed the decision of the district court.

While the court noted that a committee's authority is not boundless, it did allow the committee to pursue this appeal under the theory of "hypothetical jurisdiction." The question as to the authority of the committee could have been avoided had the committee sought and obtained the approval of the bankruptcy court to file an appeal.

However, in addition to issues surrounding the bankruptcy court's timing on such a determination, there is the obvious risk to the committee that the bankruptcy court would not have approved its involvement in and/or appeal of the civil action. In fact, there is still the risk that the bankruptcy court will not approve a fee application, if any, filed by the committee for its fees and expenses associated with this appeal. Nonetheless, this case demonstrates that there are situations in which not all funds recovered from a debtor's estate will be distributed in accordance with the priorities set forth in the Bankruptcy Code.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.

Wendy M. Simkulak is an associate in the business reorganization and financial restructuring practice group of Duane Morris, representing liquidating trustees, secured creditors, large unsecured creditors, and insurers in all aspects of a bankruptcy case. Simkulak assisted in the representation of the liquidating trustee in the case of In re Trico Steel Company in the District of Delaware and was the coordinating associate in the firm's representation of the liquidating trustee in the case of In re Durango Georgia Paper Company in the Southern District of Georgia. She also serves as a representative to the firm's associates' committee and recruitment and retention committee.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.