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[Legislative Updates] [ABI Logo]

Web posted and Copyright © September 1, 2002, American Bankruptcy Institute.

Accounting Reform Law Adds Broad Securities Fraud Discharge Exception

Written by:
Prof. G. Ray Warner
ABI Robert M. Zinman Resident Scholar
warnerg@umkc.edu

The Corporate and Criminal Fraud Accountability Act of 2002, signed into law by President Bush on July 30, adds a new broadly worded exception to discharge for securities claims. The law amends §523 of the Bankruptcy Code to create a new subsection—§523(a)(19)—that renders non-dischargeable those debts relating to violations of federal or state securities laws, or common-law fraud, deceit or manipulation in connection with the purchase or sale of any security. The amendment requires that the debt must result from either a settlement agreement or from a judicial or administrative judgment or order.

The new section reads:

(a) A discharge under §727, 1141, 1228(a), 1228(b) or 1328(b) of this title does not discharge an individual debtor from any debt—
(19) that—
(A) is for—
(i) the violation of any of the federal securities laws (as that term is defined in §3(a)(47) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(47)), any state securities laws, or any regulation or order issued under such federal or state securities laws; or
(ii) common law fraud, deceit or manipulation in connection with the purchase or sale of any security; and
(B) results from—
(i) any judgment, order, consent order or decree entered in any federal or state judicial or administrative proceeding;
(ii) any settlement agreement entered into by the debtor; or
(iii) any court or administrative order for any damages, fine, penalty, citation, restitutionary payment, disgorgement payment, attorney fee, cost or other payment owed by the debtor.

Effective Date Unclear

The act fails to specify an effective date for the amendment. Since, unlike the pending bankruptcy reform legislation, there is no provision delaying the amendment's application, the new exception should apply to bankruptcy cases filed after it was signed into law. However, the failure to include an explicit effective date provision makes it unclear whether the new exception to discharge applies retroactively to cases pending on the effective date. The Supreme Court has been inconsistent in its application of legislation to pending cases in situations where Congress is silent. See Landgraf v. USI Film Products, 511 U.S. 244, 272-80, 114 S.Ct. 1483, 1500-05, 128 L.Ed.2d 229 (1994) (discussing conflict); compare Bradley v. Richmond School Board, 416 U.S. 696, 711, 94 S.Ct. 2006, 2016, 40 L.Ed.2d 476 (1974) (court must apply law in effect at time of decision) with Bowen v. Georgetown Univ. Hosp., 488 U.S. 204, 208, 109 S.Ct. 468, 471, 102 L.Ed.2d 493 (1988) (retroactivity is not favored). In the bankruptcy discharge context, cases applying the §523(a)(8) "student loan" exception to discharge disagreed as to whether the controlling law was that in effect at the time of filing or at the time of decision. Compare In re James, 4 B.R. 115, 117-18 (Bankr. W.D. Pa. 1980) (time of filing) with In re Amadori, 5 Bankr. Ct. Dec. (CRR) 187, 20 CBC 523 (Bankr. W.D.N.Y. 1979) (time of entry of order); see, also, In re Shearer, 167 B.R. 153, 155 (Bankr. W.D. Mo. 1994) (§532(a)(9) case discussing conflicting lines of Supreme Court authority).

Non-fraudulent Debts Covered

In addition to the uncertainty regarding the amendment's effective date, the wording of the new exception will give rise to a number of interpretive issues. Note that §523 already excepted from discharge debts that were fraudulently incurred (§523(a)(2)), debts arising from breach of fiduciary duty (§523(a)(4)) and debts arising from intentional torts (§523(a)(6)). These provisions blocked the discharge of most securities fraud claims that involved intentional wrongdoing. The new provision appears to expand the class of non-dischargeable securities-related debts in a number of ways.

First, non-dischargeability could now be premised on a mere violation of state or federal securities laws, without the need to establish all of the elements of §523(a)(1), such as justifiable reliance, fraudulent intent or even falsity. For example, securities law doctrines such as the "fraud on the market" theory may relax the reliance requirement for a claim for securities fraud under Rule 10b-5 to a level lower than the bankruptcy standard for justifiable reliance. Further, some securities law violations, such as a company director's liability for registration statement errors under §11 and liability for misleading statements under §12(a)(2) of the Securities Act of 1933, do not require a showing of fraudulent intent, but may be based on the failure to exercise due diligence. In addition, securities-related liability could be based on technical violations of disclosure and filing rules where the debtor had no fraudulent intent. For example, some state securities laws impose liability for negligence and in some cases impose strict liability. See In re Goldbronn, 263 B.R. 347, 361 (Bankr. M.D. Fla. 2001) (negligence or strict liability standard under state law); In re Tam, 136 B.R. 281, 286 (Bankr. D. Kan. 1992) (negligence standard under state law). The new section would render debts based on such claims non-dischargeable. Also, the provision's inclusion of violations of regulations or orders issued under securities laws could result in non-dischargeability in some cases where there was no fraudulent intent.

Another significant area of expansion involves fraudulent oral statements about the financial condition of a business. Under §523(a)(2)(B), false statements of financial condition respecting the debtor or an insider of the debtor do not bar discharge unless they were made in writing, with an intent to deceive, and were reasonably relied on by the creditor. In the case of a closely held corporation, the corporation would be an insider of the sole shareholder, and false oral statements made in connection with the sale of the business would not bar discharge of the shareholder's fraud debt. See Blackwell v. Dabney (In re Blackwell), 702 F.2d 490, 492 (4th Cir. 1983); In re Richey, 103 B.R. 25, 29 (Bankr. D. Conn. 1989). Under new subsection 523(a)(19), such debts would now be non-dischargeable.

A further area of expansion that will require judicial interpretation is the reference to "deceit" and "manipulation" in subsection 523(a)(19)(A)(ii). Presumably, these terms are based on the securities law's use of identical terms, and they may have the same meaning. However, since violation of the securities laws is already addressed in subsection 523(a)(19)(A)(i), it could be argued that these terms in subsection 523(a)(19)(A)(ii) must be given a broader interpretation. Under securities laws, both terms refer to conduct that does not necessarily rise to the level of fraud. For example, manipulation refers to conduct intended to affect the price of securities such as fictitious wash sales or matched orders, even if no fraudulent intent is involved. See generally, Hazen, Thomas L., The Law of Securities Regulation §12.1 (4th ed. 2002).

The new exception to discharge does not apply to the chapter 13 "super-discharge;" however, the chapter 13 debt limits of $290,525 in liquidated unsecured debt and $871,550 in liquidated secured debt will limit the availability of chapter 13 relief in most cases involving large securities claims. Since the debt limits do not apply to unliquidated claims, in some cases a debtor could discharge a large securities fraud claim by filing chapter 13 before a judgment is entered, as long as the other debts were within the chapter 13 caps. The debtor's lack of good faith in filing chapter 13 might result in dismissal of the case.

Non-public Securities Covered

Although the amendment was a response to the recent spate of accounting scandals involving major publicly traded corporations, the new exception to discharge is not limited to publicly traded securities. By its terms, it applies to any securities law violation and to common-law fraud, deceit or manipulation in connection with the purchase or sale of any security. The federal law definition of "security" is extremely broad and would include a variety of investment vehicles, non-public stock, limited-partnership interests and other equity or debt interests. In general, the "passive" nature of the investment brings it within the scope of the definition of "security." See Hazen, supra at §1.6. In addition, even the sale of a small business may result in a securities-law violation if the sale is accomplished by a transfer of stock. See Landreth Timber Co. v. Landreth, 471 U.S. 681, 105 S.Ct. 2297, 85 L.Ed.2d 692 (1985) (rejecting the "sale of a business" exception). Since, as discussed above, new §523(a)(19) dispenses with the §523(a) (2)(B) requirement of a written statement for financial condition fraud, the major impact of the new provision may be in the personal bankruptcy cases of former small business owners, rather than those of former Fortune 500 executives.

Claim Must Be Represented by a Judgment, Order or Settlement Agreement

In order for a securities fraud debt to be non-dischargeable under new §523(a)(19), it must "result from" some judgment, order, decree or settlement agreement. Virtually any type of judicial or administrative order that results in a claim is sufficient to meet this requirement. For example, the section specifically includes administrative as well as judicial orders. Unfortunately, it is not clear whether the judgment, order or settlement agreement must be entered pre-petition. If a pre-petition judgment, order or settlement agreement is required, the provision can easily be subverted by filing bankruptcy before any judgment is entered.

A similar requirement in the original version of the §523(a)(9) "drunk driving" exception to discharge was removed in 1990 by Congress precisely because of these interpretive problems. Nonetheless, most of the cases decided under the pre-1990 version of the drunk driving exception held that a post-petition judgment was sufficient. See In re Hudson, 859 F.2d 1418 (9th Cir. 1988); In re Anderson, 74 B.R. 463, 464 (Bankr. E.D. Wis. 1987) (citing cases); see generally, Kalevitch, Lawrence, "Cheers? The Drunk Driving Exception to Discharge," 63 Am. Bankr. L.J. 213 (1989). The courts often lifted the automatic stay and delayed discharge until a judgment could be obtained. See, e.g., Anderson, supra; accord, In re Harris, 135 B.R. 434, 436 (Bankr. S.D. Fla. 1992) (following §523(a)(9) cases and staying bankruptcy to allow suit to proceed to judgment under §523(a)(11)). However, the cases decided under former §523(a)(9) may no longer be good law. Those opinions were based on policy arguments and congressional intent and were decided before the "plain-language" approach to Bankruptcy Code interpretation had become as firmly entrenched as it is today. For example, the court in In re Richards, 59 B.R. 541, 543 (Bankr. N.D.N.Y. 1986), acknowledged that the plain language of former §523(a)(9) required a pre-petition judgment, but rejected that view because it would emasculate Congress's intent.

In those cases where a pre-petition judgment, order or settlement agreement has been entered, the effect of the requirement will likely be to give it preclusive effect on the discharge question. This is the interpretation that has been given to the similar language of the §523(a)(11) "depository institution fiduciary defalcation" exception to discharge. The Seventh Circuit interpreted §523(a)(11) to give preclusive effect to default judgments, administrative agency orders and consent decrees, even though collateral estoppel would not normally attach to such orders. Meyer v. Rigdon, 36 F.3d 1375 (7th Cir. 1994). As the court stated, "By enacting §523(a)(11), Congress intended to limit the bankruptcy court's ability to nullify regulatory victories through its independent power to determine dischargeability." Meyer, 36 F.3d at 1380-81. Indeed, under the Seventh Circuit's view, the bankruptcy court is required to enter a finding of non-dischargeabilty based on the judgment and may not consider additional evidence. Meyer, 36 F.3d at 1381; contra, Harris, 135 B.R. at 437 (bankruptcy court has discretion to consider other evidence). An example illustrates how the Seventh Circuit's preclusion doctrine might apply. Assume that a pre-petition lawsuit includes both securities fraud claims and other claims. The securities fraud claims are weak, but the entire suit is settled without any admission of liability. The resulting settlement debt would be non-dischargeable, and the bankruptcy court would not have the ability to consider whether the debtor had actually committed securities fraud. Query whether this result could be avoided by requiring that the securities fraud allegation first be dismissed before the settlement agreement is consummated.

One other effect of the section's reference to settlement agreements is to avoid a novation that might otherwise convert the non-dischargeable securities fraud debt into a dischargeable ordinary contract debt. The Supreme Court is currently considering whether the doctrine of novation operates to make a settlement obligation dischargeable in cases where the settlement releases the underlying §523(a)(2) fraud claim. See Archer v. Warner, No. 01-1418, ___ U.S. ___, 70 USLW 3616, 2002 WL 496658 (S.Ct. June 24, 2002).

New Crime of Destruction, Alteration or Falsification of Records In Bankruptcy

In addition to the new discharge exception, the Corporate and Criminal Fraud Accountability Act of 2002 amends title 18 to create a new federal felony for tampering with records in connection with a bankruptcy case. The new §1519 of title 18 provides:

Whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies or makes a false entry in any record, document or tangible object with the intent to impede, obstruct, or influence the investigation or proper administration of any matter within the jurisdiction of any department or agency of the United States or any case filed under title 11, or in relation to or contemplation of any such matter or case, shall be fined under this title, imprisoned not more than 20 years, or both.

The broad language of this provision makes it applicable to all bankruptcy cases, not just large business bankruptcy cases. The "in relation to or contemplation of any such...case" language expands the provision beyond actions occurring in the case itself and would apply to actions taken prior to filing. Although the primary focus of the legislation is on accounting practices, the language of the new criminal provision reaches farther and will criminalize document manipulation in any aspect of the bankruptcy case. For example, a consumer debtor who falsifies schedules could be prosecuted under this provision, as could a bankruptcy professional who inflates time entries.

Many of the actions covered by the new section are already crimes under current 18 U.S.C. §§152 and 157. In those instances, this section expands the prosecutor's options in several ways. Most significantly, the new section dramatically increases the maximum penalty to 20 years imprisonment. The maximum penalty under the existing bankruptcy crimes provisions is five years imprisonment. In addition, the new section gives the prosecutor the ability to charge multiple offenses based on the same conduct. Finally, the legal standards under the various provisions appear to be different. For example, §152 requires a fraudulent intent, but the new provision merely requires an intent to impede, obstruct or influence the administration of the case.

Enhanced civil claims might also be based on the new criminal provision. For example, the new section could be the basis for the predicate criminal acts needed to support a civil RICO claim. At least one court has suggested that a single fraudulent bankruptcy case can be a "RICO enterprise" and that civil RICO claims might be asserted against a bankruptcy attorney who assists the debtor. See Handeen v. Lemaire, 112 F.3d 1339, 1348-49 (8th Cir. 1997).


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