Securities Law and Financial Fraud Violations Not Dischargeable in Bankruptcy

Securities Law and Financial Fraud Violations Not Dischargeable In Bankruptcy

Under the Bankruptcy Code (“Code”), any debt incurred by an individual debtor from a violation of a federal securities law, state securities law, or respective regulation or order is non-dischargeable through bankruptcy. This article will analyze the relevant provisions of the Code regarding non-dischargeable debt due to a securities violation.

Please note that, while this article accurately describes applicable law on the subject covered at the time of its writing, the law continues to develop with the passage of time. Accordingly, before relying upon this article, care should be taken to verify that the law described herein has not changed.

I. Background.

The Code provides exceptions for 19 non-dischargeable debts of an “individual debtor” in a bankruptcy action. Depending on the circumstances, several of these exceptions may apply to debt incurred through a securities violation. Specifically, Section 523(a)(19) provides an express exception for securities laws violations, while Sections 523(a)(2), (4), and (6) exempt similar misconduct.

In 2002, Congress enacted Section 523(a)(19) as part of the Sarbanes–Oxley Act in an effort to “close a ‘loophole’ which allowed debtors convicted of securities fraud or other securities violations to discharge the debt owed to their victims.” In re Lichtman, 388 B.R. 396, 409 (Bankr. M.D. Fla. 2008) (quoting In re Presto, 376 B.R. 554, 592 (Bankr. S.D. Tex. 2007). By enacting Section 523(a)(19), Congress intended to “amend the federal bankruptcy code to make judgments and settlements arising from state and federal securities law violations brought by state or federal regulators and private individuals non-dischargeable.” In re McClung, 304 B.R. 419, 424 (Bankr. D. Idaho 2004) (quoting S. Rep. No. 107–146, at 11 (2002)). In short, Section 523(a)(19) was designed to “enhance the ability of government regulators to prevent fraudulent practices and to assist the victims of securities fraud in recouping their losses.” Id. at 425.

II. Non-Dischargeable Debt under Section 523(a)(19).

Under Section 523(a)(19), an individual debtor cannot obtain a discharge of any debt that:

(A) is for–

(i) the violation of any of the Federal securities laws (as that term is defined in section 3(a)(47) of the Securities Exchange Act of 1934 [15 USCS § 78c(a)(47)]), any of the 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, before, on, or after the date on which the petition was filed, 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.

As interpreted, Section 523(a)(19) is divided into two main subsections. First, subsection A describes the underlying conduct required to preclude the debt from discharge and the general scope of the section. Based on subsection A, Section 523(a)(19) embraces a broad range of federal violations, including any violation involving the Securities Act of 1933, the Securities Exchange Act of 1934, the Public Utility Holding Company Act of 1935, the Trust Indenture Act of 1939, the Investment Company Act of 1940, the Investment Advisers Act of 1940, and the Securities Investor Protection Act of 1970. Next, subsection B requires the debt be presented in a judgment, order, consent order, decree, or settlement agreement “before, on, or after the date on which the petition was filed.” While interpretation of subsection A has been relatively straightforward, subsection B has led to divisive judicial interpretation and substantial discussion amongst commentators.

The main substantive dispute regarding Section 523(a)(19)(B) involves determining whether the provision permits a bankruptcy court to adjudicate and determine the actual injury from the securities violation underlying a Section 523(a)(19) claim. In re Hill, 495 B.R. 646, 655 (Bankr. D.N.J. 2013). This problem arose when Congress amended subsection B in 2005 to include post-petition securities judgments within the scope of the section. With minimal, if any, district or appellate court guidance, bankruptcy courts have been left to interpret the somewhat vague provision. Some courts deny the bankruptcy court jurisdiction to adjudicate liability and damages for violation of securities law. Under this narrow view of jurisdiction, bankruptcy courts are required to apply issue preclusion in the Section 523(a)(19) claims brought before it. See, e.g., In re Jafari, 401 B.R. 494, 499–500 (Bankr. D. Colo. 2009) (“[A]bsent a settlement agreement or other consensual determination of liability, Subsection B evidences a conscious choice to have the liability determinations occur outside of the bankruptcy forum, whether it occurs pre- or post-bankruptcy.”); In re Anderson, 2012 WL 3133827, at *4 (Bankr. D. Idaho Aug. 1, 2012) (denying motion for summary judgment for damages from securities violation because “[o]ne of the required elements of § 523(a)(19) is that a liability determination be made in a non-bankruptcy forum ‘before, on or after’ the date of the filing of a debtor’s petition”); In re Pujdak, 462 B.R. 560, 574 (Bankr. D.S.C. 2011) (“The inclusion of § 523(a)(19)(B) strips the bankruptcy court of its ability to determine whether the debtor did in fact violate the securities law.”). On the other hand, some bankruptcy courts hold that it has the power to fully adjudicate liability, damages, and exception to discharge in a Section 523(a)(19)-based adversary proceeding. See, e.g., In re Chan, 355 B.R. 494 (Bankr. E.D. Pa. 2006) (holding that a creditor ordinarily may seek a securities judgment in an adversary proceeding in bankruptcy court); In re Jansma, 2010 WL 282511, *5 (Bankr. N.D. Ill. Jan. 21, 2010) (denying the debtor’s motion to dismiss the complaint because even though the proffered state court judgment and state-issued Order of Prohibition were insufficient to prove a violation under § 523(a)(19)(A), “the bankruptcy court can satisfy the requirements of either § 523(a)(19)(B)(i) or (B)(iii) by conducting a federal judicial proceeding and issuing” the required judgment, order, or decree); In re Bricker, 348 B.R. 28, 35 (Bankr. W.D. Pa. 2006) (reasoning a bankruptcy court “could have ruled on the sale of unregistered securities claims” but permissively abstained under 28 U.S.C. § 1334(c)(1)).

Under either view, liability and damages will be determined by the bankruptcy court or another court of competent jurisdiction; however, the implications of this choice may lead to considerable differences in the time, cost, and manner of litigation for the alleged victim.

III. Other Non-Dischargeable Debts.

Three other sections of the Code can provide grounds for non-dischargeable debts arising from securities violations. Thus, depending on the circumstances, these sections may properly be observed and argued in conjunction with Section 523(a)(19). See In re Sherman, 441 F.3d 794, 817 (9th Cir. 2006) superseded by In re Sherman, 491 F.3d 948 (9th Cir. 2007) (“It appears that in many cases in which the SEC is attempting to ensure that a debtor in bankruptcy disgorges funds as required by the securities laws, it does so by invoking § 523(a)(2).”)

Codified in Section 523(a), these three provisions provide that an individual debtor cannot obtain a discharge of any debt:

(2) for money, property, services, or an extension, renewal, or refinancing of credit, to the extent

obtained, by–

(A) false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor’s or an insider’s financial condition;

(B) use of a statement in writing–

(i) that is materially false;

(ii) respecting the debtor’s or an insider’s financial condition;

(iii) on which the creditor to whom the debtor is liable for such money, property, services, or credit reasonably relied; and

(iv) that the debtor caused to be made or published with intent to deceive; or ...

(4) for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny; ...

(6) for willful and malicious injury by the debtor to another entity or to the property of another entity; ...

As noted by In re Chan, there are important differences between Section 523(a)(19) and Sections 523(a)(2), (4), and (6). First, “the elements of liability and dischargeability are co-extensive under § 523(a)(19), but are distinct in (a)(2), (4), and (6).” Jordan Factor, Making Crooks Pay: The Path to Nondischargeable Securities Judgments, Colo. Law., at 47 (March 2012) (citing In re Chan, 355 B.R. at 503 n. 18). Thus, when determining non-dischargeability under Section 523(a)(19), “a court does not interpret and apply elements unique to bankruptcy statutes; rather, a court merely determines the elements of liability under federal or state securities statutes or common law fraud.” Id. Further, due to Section 523(a)(19)(B), a bankruptcy court may not have exclusive jurisdiction to determine non-dischargeability under Section 523(a)(19), as other courts may have concurrent jurisdiction over the action. Id. (citing In re Chan, supra).

IV. Conclusion.

In summary, debts arising from securities law violations are not dischargeable in bankruptcy. As a whole, the non-dischargeable debt provisions of Section 523(a) of the Code clearly show Congress’ desire to assist victims of securities fraud by excluding several types of debts from bankruptcy, including an explicit exception for securities violations.
If you have questions regarding a possible securities law matter, or to arrange for a consultation concerning your legal matter, please contact Robert Mitchell at or at (602) 452-2730.
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