Three financial instutions holding $21 million in claims against  Boy Band Promoter Lou Pearlman and his company, Transcontinental Airlines, Inc., filed an involuntary bankruptcy this week against Pearlman and Transcontinental. 

Pearlman, who best known for promoting "boy bands" N-SYNC and Back Street Boys, has been alleged to have bilked investors out of $317 million in a Ponzi Scheme.  The State of Florida Office of Financial Regulation filed an action against Pearlman and his myriad companies and caused a receiver to be appointed.  Pearlman is reportedly overseas in Germany. If an order for relief in the involuntary bankruptcy is granted, some or all of the state court receiver's activities will come to a halt.

The filing of an involuntary bankruptcy is not always the best move in the wake of a fraud such as Pearlman's.  Under the bankruptcy laws, all creditors are required to stay their collection activities and instead seek recovery as a creditor in the bankruptcy.  Unless the bankruptcy court lifts the automatic stay, only the trustee in bankruptcy can pursue claims on behalf of the creditors. 

The trustee, however, owes a duty to all creditors, and all creditors share pro rata in whatever assets the trustee may recover. Unless there is money in the estate, the trustee will need to be funded, usually by the larger, financial institution-type creditors.  Thus, it is likely that the creditors who filed the involuntary bankruptcy will have to fund the trustee's activities, but have no control over the trustee.  Moroever, whatever funds are recovered will be shared with other creditors.

In contrast, if these  creditors had aggressively pursued their own asset recovery investigation, any assets they would recover, they could keep for themselves. 

This comment is not meant as a criticism of the creditors who filed the Pearlman bankrupcty; there are surely many complex issues and concerns that lead to their decision.  I just offer this comment to demonstrate that the conventional step--filing a bankrupcty--may not be the best one.

A large number of Cayman island companies are incorporated as special purpose vehicles or as holding companies for foreign shareholders' assets and conduct no other actual business. Are those companies' assets beyond a creditor's reach? The Grand Court of the Cayman Islands recently granted a Mareva Injuction against such assets.

In KYH Capital v. China One, et. al., the sole purpose of the Cayman Island Company was to act as a conduit for the repatriation of its shareholders' indirect investment in a distressed debt portfolio. It was argued that the distribution of dividends to the shareholders was in the ordinary course of the Company's business and not subject to a Mareva injunction since that Injunction cannot be used to impede or interfere with a defendant's ordinary bona fide business transactions. The Grand Court disagreed, finding that the distribution of dividends was not the company's ordinary course of business, but merely the means by which the company distributed profits from its business operations. The Company's actual business was investing in another enterprise. The Grand Court held that  "Restraining a company by Mareva Injunction from distributing dividends does not prejudice the operations of the company itself and neither does it affect the company's business as such."  The Court reasoned that "The schemes which a debtor may devise for divesting himself of assets are legion" and the provison for disallowing an Injunction for ordinary business expenses should not allow the defendant "to bring (its) business to an end and (distribute) all of its assets, by way of dividends, at a time before its legal rights and obligations have been finally determined".

The message from the KYH Capital decision is that Cayman Island companies will not be beyond the reach of asset preservation orders if the company's assets are not genuinely used for ordinary and usual business purposes. There is a clear distinction between ordinary business purposes and activites designed to benefit shareholders rather than the company itself. A Mareva Injunction is a proper remedy where assets are in vehicles that are merely established to benefit the shareholders or officers.

If recovering money is your goal, throwing a judgment debtor in jail may not be the best strategy.  According to the Miami Herald, Stephan Jay Lawrence was released from jail on December 13, 2006 after spending more than six years in a federal detention center for failure to comply with a bankruptcy court order requiring him to turnover millions of dollars held in an offshore trust.  Dan Christensen, Debtor Who Defied Judge On Funds Leaves Jail At Last, Miami Herald, Dec. 22, 2006, at 1C.  Though it is unclear what other efforts were made to seize the offshore money in the Lawrence case, seeking the repatriation of funds through a United States court is not the only option.  Often, a better strategy is to seek turnover of the assets directly in the foreign jurisdiction where they are located.  This is especially true in the post 9/11 environment.  Since 9/11, the laws in many asset protection havens have become more creditor friendly as part of the effort to combat money laundering and the funding of terrorist activities.  For this reason, the seizing of assets abroad should be fully explored as part of any asset recovery effort.