Preventing Securities Law Violators from Discharging their Debts in Bankruptcy

The following article appeared in the April 15, 2011 issue of Michigan’s Lawyers Weekly.

Although 11 U.S.C. § 523(a)(19) is not new, it may be underutilized.  The subsection was added to the Bankruptcy Code almost a decade ago as part of the Sarbanes-Oxley Act and was designed to make it easier to prevent the discharge of certain debts related to securities law violations.  With the recent downturn in the economy and the resulting problems in the stock market, the subsection is particularly relevant today as more fraudulent schemes involving securities violations come to light.

However, despite its relevance and despite the fact that it has been around for awhile, as anyone who has researched 11 U.S.C § 523(a)(19) will attest, there is not an overwhelming amount of case law regarding its application.  Because it stretches across several subsections, 11 U.S.C. § 523(a)(19) is cumbersome to quote and difficult to succinctly paraphrase.   In general, however, § 523(a)(19) provides that a debt is not dischargeable in bankruptcy if (A) the debt is for a violation of federal or state securities law and (B) if the debt “results, before, on or after the date on which the petition was filed, from” the following:

(i) any judgment order, consent order, or decree entered in any Federal or State judicial or administrative proceeding;

(ii) any settlement agreement entered 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.

In other words, the debtor’s violation of securities law is not enough.  The debt must also result from some resolution in a judicial or administrative proceeding or from a binding settlement agreement.  When these requirements are met, § 523(a)(19) makes avoiding discharge easy.  There is no need for a long adversary proceeding that is bogged down by protracted discovery and an expensive trial.  Because nondischargeablity is established by the underlying judgment, order, or settlement agreement, the creditor can usually prevail in the adversary hearing on the pleadings.

It is this relative ease in its application that makes § 523(a)(19) so useful.  While the Bankruptcy Code has long excepted from discharge those debts arising from the debtor’s fraudulent conduct, proving fraud is often problematic.  Moreover, there are securities law violations that do not even necessarily involve acts of fraud.  For example, MCL 451.2301 generally prohibits the sale of unregistered securities.  In these situations, a plaintiff in an adversary proceeding seeking to prevent the discharge of the debt resulting from the securities violation may not be able to rely on the exceptions that specifically apply to fraud – e.g., 11 U.S.C. § 523(a)(2).   Thus, § 523(a)(19) may be the simpler way to go.

However, meeting the requirements of § 523(a)(19) can be difficult.  Unfortunately, many of those who violate securities laws use the bankruptcy courts to seek protection from the claims against them.  Given that the automatic stay will be imposed if the violator declares bankruptcy, meeting the requirements of § 523(a)(19) may be problematic.  Consequently, at least to a certain extent, “the stars must align” before § 523(a)(19) becomes available to a creditor.

Nevertheless, any attorney bringing a claim for a securities law violation in state or federal court will want to keep § 523(a)(19) in mind.  By remembering what § 523(a)(19) requires, the attorney will be better positioned to ensure that any resulting judgment or settlement agreement is protected from discharge.  In addition, the bankruptcy attorney representing the creditor in a subsequent adversary proceeding will want to fully understand § 523(a)(19) and take full advantage of it.

In this regard, perhaps the most flexible subsection in 523(a)(19) is (B)(iii).  At first blush, its requirement for “any court or administrative order for any damages” may seem to require some type of final adjudication.  However, at least one district court in the Sixth Circuit has applied the subsection more liberally.  See In re Civiello, 348 B.R. 459, 463 (N.D. Ohio, 2006)

In Civiello, the debt that the plaintiffs sought to have excepted from discharge resulted from an administrative agency’s cease and desist order, which required the defendant to stop selling unregistered securities.  Although the cease and desist order was not a final judgment, the court nonetheless held that § 523(a)(19)(B)(iii) applied.  The court held that while subsection (i) applies to final adjudications, subsection (iii) presents a “clear distinction” and applies to non-final orders.  Id. at 465.  Furthermore, even though the cease and desist order did not expressly address any remedies or damages which would inure to the plaintiffs, the court found that the debt “resulted from” the order because state law afforded the plaintiffs the right of rescission.  Id. at 466.

This holding may be helpful to a creditor who is unable to obtain final judgment against a defendant for securities law violations before the defendant files for bankruptcy.  Take the scenario where the plaintiff files a state court action in Michigan alleging that the defendant violated Michigan’s Uniform Securities Act, MCL 451.2101, et. seq.  The plaintiff then moves for summary disposition on the issue of liability only, leaving for the issue of damages for another day.  If the court grants the motion, the defendant may seek bankruptcy protection before damages are assessed.  However, because MCL 451.2509(2) affords the plaintiff the right “to recover the consideration paid for the security,” under the reasoning of Civiello and other cases like it, the resulting order granting summary judgment on liability alone may be enough for the plaintiff to then utilize § 523(a)(19).

What if the defendant files for bankruptcy before the lawsuit for securities violations can even be filed?  In this scenario, the creditor may have a more difficult time.  Still, all might not be lost.  Some courts have held that the bankruptcy court itself can conduct a federal judicial proceeding and enter an order for damages under § 529(a)(19).  See In re Jansma, Case No. 09-AP-00444, 2010 WL 282511 (Bankr N.D. Ill, Jan. 21, 2010).  Under this approach, the underlying securities law violation may be tried in the adversary proceeding.  Other courts have permitted the automatic stay to be lifted to allow the creditor to continue with the underlying court action to establish the securities law violation.  See In re Zimmerman, 341 B.R. 77, 80 (Bankr N.D. Ga, 2006).  However, not all courts agree with these approaches.  See e.g. In re Chan, 355 B.R. 494, 504 (Bankr. E.D. Penn, 2006).  Ultimately, because the issue has not yet been addressed by the Sixth Circuit, the parties will be left to their best arguments.

In the final analysis, although § 529(a)(19) is not frequently used by creditors, it is a potentially an effective and relatively inexpensive method to deny discharge.  Certainly, those who have had the chance to use § 529(a)(19) to prevent the discharge of a debt know how well it can work.  If the underlying securities violation can be reduced to an appropriate judgment, order, or settlement agreement, the issue of nondischargability is easily decided.  At the end of the day, that is a nice result for any creditor’s attorney.

For more information, please contact Gary Rogers or Ryan Kauffman at Fraser Trebilcock, 800.748.0436.