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Bankruptcy and Non-Dischargeable Debts in Securities-Related Matters

This article discusses non-dischargeable debts in securities-related matters under 11 U.S.C. § 523(a), including subsections (2), (4), (6) and (19).

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.
Section 523(a) governs exemptions of debts from dischargeability in bankruptcy. Discharge provisions are “strictly construed against the creditor and liberally construed in favor of the debtor.” In re Chivers , 275 B.R. 606, 613 (Bankr. Utah 2002). See also In re Stone , 91 B.R. 589, 591 (D. Utah 1988) (“A central purpose of bankruptcy legislation is to provide the debtor with comprehensive relief from the burden of his debts by discharging virtually all financial obligations . . .[t]herefore, courts have narrowly construed exceptions to discharge in favor of the debtor in order to not frustrate this fundamental policy of promoting the debtor’s fresh start.”).

I. Non-Dischargeable Debts under 11 U.S.C. § 523(a)(2).

Section 523(a)(2) exempts from bankruptcy dischargeability debt:
[F]or 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 ...
The standard of proof for the dischargeability exceptions in 11 U.S.C. § 523(a)(2) is a preponderance of the evidence. See Grogan v. Garner, 498 U.S. 279, 291 (1991); In re Chivers , 275 B.R. at 619; In re Perkins, 298 B.R. 778, 787 (Bankr. Utah 2003).

Debtors may try to argue that the representations they made to the creditors had to do with their financial condition, and therefore their related debts are dischargeable under 11 U.S.C. § 523(a)(2)(A). Chivers v. Skull Valley Band of Goshute Indians, 2004 U.S. Dist. LEXIS 12270, at *10 (D. Utah 2004). Statements related to financial condition:
[A]re those that purport to present a picture of the debtor’s overall financial health. Statements that present a picture of a debtor’s overall financial health include those analogous to balance sheets, income statements, statements of changes in overall financial position, or income and debt statements that present the debtor or insider’s net worth, overall financial health, or equation of assets and liabilities. However, such statements need not carry the formality of a balance sheet, income statement, statement of changes in financial position, or income and debt statement. What is important is not the formality of the statement, but the information contained within it – information as to the debtor’s or insider’s overall net worth or overall income flow.
In re Joelson, 427 F.3d 700, 714 (10th Cir. 2005).

A plaintiff must show the following five elements for a claim under 11 U.S.C. § 523(a)(2)(A): “(a) the defendant made a false representation; (b) the defendant made that representation with intent to deceive the creditor; (c) the creditor relied on the representation; (d) the creditor’s reliance was justifiable; and (e) the debtor’s representation caused the creditor to sustain a loss.” In re Young , 91 F.3d 1367 (10th Cir. 1996); see also In re Pewtress , 2010 Bankr. LEXIS 4544, at *10-11 (Bankr. D. Utah Dec. 9, 2010) (same); In re Maloney , 2010 Bankr. LEXIS 4541, at *18 (Bankr. D. Utah Dec. 7, 2010) (same); In re Lusk , 2009 Bankr. LEXIS 2953, at *25-26 (Bankr. D. Utah Sept. 14, 2009) (same). This test is based on the Restatement (Second) of Torts § 535’s definition of a “misrepresentation” as “[o]ne who fraudulently makes a misrepresentation of fact, opinion, intention or law for the purpose of inducing another to act or to refrain from action in reliance upon it, is subject to liability to the other in deceit for pecuniary loss caused to him by his justifiable reliance upon the misrepresentation.” See In re Jahke , 2006 Bankr. LEXIS 4419, at * 11-12 (Bankr. D. Utah Oct. 10, 2006).

The first requirement, a false representation, can relate to a future event “if when the representation was made the debtor had no intention of performing as promised.” In re Pewtress , 2010 Bankr. LEXIS 4544 at *12-13. False representations or pretenses can also include the failure to disclose information (i.e., omission) or an implied misrepresentation. In re Jeppesen , 2007 Bankr. LEXIS 3478 at *4 (Bankr. D. Utah June 27, 2007). See, e.g., In re Young , 91 F.3d at 1373 (“Mr. Young’s first false misrepresentation was that he failed to inform Fowler Brothers of information that the New Mexico Rules of Professional Conduct required him to disclose.”).

With regard to the fourth requirement, justifiable reliance, one court observed that:
Justification is a matter of the qualities and characteristics of a particular plaintiff, and the circumstances of the particular case, rather than the application of a community standard of conduct in all cases . . . [a] party may justifiably rely on a misrepresentation even when a simple, inexpensive investigation would have ascertained the falsity of the misrepresentation.
Skull Valley, 2004 U.S. Dist. LEXIS 12270, at *11-12.

II. Non-Dischargeable Debts under 11 U.S.C. § 523(a)(4).

Section 523(a)(4) exempts from bankruptcy dischargeability debt “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.” The standard of proof for the dischargeability exceptions in 11 U.S.C. § 523(a)(4) is a preponderance of the evidence. See Grogan v. Garner , 498 U.S. 279, 291 (1991); In re Putvin , 332 B.R. 619, 627 (B.A.P. 10th Cir. 2005); In re Hatley , 227 B.R. 757, 760 (B.A.P. 10th Cir. 1998).

One court has said that for a plaintiff to prevail on the first part of this exemption, a plaintiff must prove that: “(1) the defendant was obligated to the plaintiff in a fiduciary capacity; (2) the defendant committed fraud or defalcation while acting in his fiduciary capacity; and (3) the plaintiff’s debt resulted from such fraud or defalcation.” In re Stone , 91 B.R. at 593 (D. Utah 1988). Defalcation is a “failure to account for funds entrusted to a fiduciary.” Storie v. Storie , 216 B.R. 283, 287 (B.A.P. 10th Cir. 1997).

The term “fiduciary” is construed narrowly in the federal context:
Courts have recognized that the federal definition of “fiduciary” is quite different from the traditional common law definition. In fact, it has been specifically noted that the general meaning of a fiduciary is too broad for the purposes of § 523(a)(4) . . . [c]onsequently, the term “fiduciary capacity,” as defined by federal law and for purposes of § 523(a)(4), applies only to technical trusts, express trusts, or statutorily imposed trusts and not to fiduciary relationships which arise from an equitable trusts, implied trusts, constructive trusts, or an agency relationship. Moreover, the “fiduciary relationship” of § 523(a)(4) has been specifically held to not encompass ordinary commercial relationships such as those of principal/agent or debtor/creditor . . . [f]inally, courts also require the trust or fiduciary duty to be in existence before the occurrence of the act from which the debt arose . . . [i]n other words, the debtor must have been a trustee or fiduciary before the wrong and not a trustee ex maleficio.
In re Stone , 91 B.R. at 593-94. Accord In re Maloney, 2010 Bankr. LEXIS 4541, at *22 (“neither a general fiduciary duty of confidence, trust, loyalty, and good faith . . . nor an inequality between the parties’ knowledge or bargaining power . . . is sufficient to establish a fiduciary relationship for the purposes of dischargeability.”). The elements of an express trust are “(1) a declaration of trust, (2) a clearly defined trust res, and (3) an intent to create a trust relationship.” In re Stone , 91 B.R. at 594.

However, in one Bankruptcy Court of the District of Utah case, the stringent federal concept of a fiduciary seems to have been relaxed. In re Norman stated:
The Court in In re Young found that while the existence of a fiduciary relationship is determined under federal law, state law is relevant to the inquiry . . .[i]n Utah, a fiduciary or confidential relationship will be found when one party, having gained the trust and confidence of another exercises extraordinary influence over the other party. In this case, it is clear that Dr. Love entrusted his assets with the Defendant, for whatever reason. It is also clear that after obtaining access to these assets, the Defendant defalcated them.
2005 Bankr. LEXIS 1471, at *36-37 (Bankr. D. Utah June 3, 2005). The court, therefore, found a fiduciary relationship. If plaintiffs can show that a defendant gained their trust and confidence and exerted extraordinary influence over them, say by his or her position within the community and professed success with investment portfolios, and that he or she was therefore in a fiduciary relationship to them, then the plaintiffs could perhaps have a non-dischargeable claim under the first part of 11 U.S.C. § 523(a)(4). If and when the investors can prove defendant owed them a fiduciary duty, then the burden shifts to the defendant to provide an accounting. Storie, 216 B.R. at 288.

Even if the plaintiffs cannot prove a fiduciary relationship, they can still have a non-dischargeable claim under 11 U.S.C.S. § 523(a)(4) by showing that the defendants committed embezzlement or larceny. “Under 523(a)(4), embezzlement will have occurred when there is a fraudulent appropriation of property by a person to whom such property has been entrusted, or into whose hands it has lawfully come, and it requires fraud in fact, involving moral turpitude or intentional wrong, rather than implied or constructive fraud.” In re Norman, 2005 Bankr. LEXIS 1471, at * 37 (citing In re Wallace, 840 F.2d 762 (10th Cir. 1988)). Larceny is “the taking of property without the owner’s consent, but without force or violence.” In re Tucker, 346 B.R. 844, 852 (Bankr. E.D. Okla. 2006).

III. Non-Dischargeable Debts under 11 U.S.C. § 523(a)(6).

Section 523(a)(6) exempts from bankruptcy dischargeability debt “for willful and malicious injury by the debtor to another entity or to the property of another entity.”

IV. Non-Dischargeable Debts under 11 U.S. § 523(a)(19).

Section 523(a)(19) exempts from bankruptcy dischargeability debt that:
(A) is for (i) the violation of any of the Federal securities laws . . . 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 of administrative order for any damages, fine, penalty, citation, restitutionary payment, disgorgement payment, attorney fee, cost, or other payment owed by the debtor.
The standard of proof of the dischargeability exception in 11 U.S.C. § 523(a)(19) is a preponderance of the evidence. See Grogan v. Garner, 498 U.S. 279, 291 (1991); In re Lichtman, 388 B.R. 396, 409 (Bankr. Fla. 2008); In re Lewandowski, 325 B.R. 700, 708 (Bankr. Pa. 2005). “[T]he merits of the § 523(a)(19) discharge exception are indistinguishable from the merits of the underlying legal claim,” i.e., the underlying violations of federal and state securities law and common law fraud. In re Chan, 355 B.R. 494, 503 (E.D. Pa. 2006) (“Thus, to determine whether a claim arising under the Securities Exchange Act of 1934 is dischargeable under § 523(a)(19), it may be necessary for a court to try the merits of the underlying claim.”).

One Utah Bankruptcy Court held that while the plaintiffs had met their burden under 11 U.S.C. § 523(a)(19)(A), they failed to meet their burden under 11 U.S.C. § 523(a)(19)(B) as no order or judgment had been ordered. Jeppesen, 2007 Bankr. LEXIS 3478, at *4-5. The court however, anticipating an order being entered in the future against the defendants by the Utah Division of Securities concerning the same violations, tolled the statute of limitation and stated that it would enter a separate order if such an order regarding dischargeability under 11 U.S.C. § 523(a)(19) came down from the State. Id. at *6-7. See also In re Jafari, 401 B.R. 494 (Bankr. D. Colo. 2009) (adopting same type of analysis and conclusion).

However, one could argue that this requirement limits possible recovery to individuals who have been the victims of violations of securities laws and/or securities fraud, in direct contradiction with the broad remedial purpose of 11 U.S.C. § 523(a)(19). See Okla. Dep’t of Sec. v. Mathews, 423 B.R. 684, 689 (W.D. Okla. 2010) (“the § 523(a)(19) exception has an express purpose and is broadly construed to achieve that purpose. The exception is designed to be broadly applied because the purpose of that exception is to protect investors and hold accountable those who violate securities laws.”). See also In re Chan, 355 B.R. at 504 (“section 523(a)(19) is indistinguishable from the other discharge exceptions determinations which are not committed to the exclusive jurisdiction of the bankruptcy court by 11 U.S.C. § 523(c)(1). Based on the concurrent jurisdiction which exists, it is perfectly appropriate for either the bankruptcy court or another court to make a dischargeability determination under § 523(a)(19)."
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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