Accounting Reform Law Adds Broad Securities Fraud Discharge Exception
Prof. G. Ray Warner
ABI Robert M. Zinman Resident Scholar
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
(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
(B) results from
(ii) common law fraud, deceit or manipulation in connection with the
purchase or sale of any security; and
(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
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
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
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
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
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).