Exceptions to Dischargeability

On Wall Street, misconduct by individual brokers responsible for handling customer accounts and liability of their supervisors is commonly known. Litigations alleging insider trading, mishandling of discretionary accounts, suitability, churning, failure to supervise, SEC Rule 10b-5 and similar claims existed long before the current stock market swoon. As the securities industry is heavily regulated there are laws and rules addressing virtually all aspects of the business. Thus there are endless possibilities for 'securities violations.' In many securities litigations the broker, supervisor or employee is charged with negligence or other unintentional misdeeds.

While there have been record numbers of Chapter 7 and 13 filings over the past several years (more than 1.5 million in 2002), only a small percentage of such filings have been made by business and financial executives and Wall Streeters. Most filings sail through the bankruptcy discharge process without much notice.

Before addressing some of the consequences to dischargeability for public company executives and Wall Streeters arising from the Sarbanes-Oxley Act, we briefly examine historical dischargeability issues. At the conclusion we look at a quirk in the legislation that may offer refuge to some individuals.

Dischargeability of Debts Before Sarbanes-Oxley

Historically, a principal purpose of the bankruptcy laws has been to provide the 'honest but unfortunate' debtor with a 'fresh start.' But in some situations, Congress has determined that supervening non-bankruptcy policies justify the continuation of obligations despite the debtor's general bankruptcy discharge. For more than a century, in weighing the goal of a fresh start against these non-bankruptcy policies, Congress has carved out categories of non-dischargeable debt, or 'exceptions to discharge,' which are set forth in Section 523 of the Bankruptcy Code. Examples of exceptions include alimony and child support, student loan obligations, and personal and wrongful death claims resulting from the debtor's intoxication. Until July 30, 2002 Congress did not seek to create a broad exception for violations of securities laws. In re McGuire, 284 B.R. 481, 490 (Bankr.D.Colo. 2002).

The absence of a 'specific exception for violations of securities laws' did not mean that such debts were automatically discharged in bankruptcy. The more common financially based liabilities excepted from discharge are briefly described below.

Section 523(a)(2)(A) ' Fraud and False Pretenses

This subsection excepts from discharge debts 'for money ' obtained by ' (A) false pretenses, a false representation, or actual fraud.'

A violation of SEC Rule 10b-5 may give rise to the 'fraud' component. In Securities and Exchange Comm. v. Bilzerian (In re Bilzerian), 153 F.3d 1278 (11th Cir. 1998), the SEC sought to except from discharge a civil award requiring disgorgement of fraudulently obtained profits. The Eleventh Circuit Court of Appeals held that the SEC was owed a monetary debt and that the debtor was precluded from challenging the SEC's action. The legal question in Bilzerian was 'whether a criminal conviction for securities fraud, combined with a civil disgorgement judgment in favor of the SEC, satisfies the requirements of collateral estoppels for determining 'fraud' under ' 523(a)(2)(A).' The court answered that question in the affirmative.

Section 523(a)(4) ' Fraud or Defalcation of Fiduciary, Embezzlement or Larceny

Section 523(a)(4) provides that an individual debtor may not be discharged from any debt for fraud or defalcation while acting in a fiduciary capacity, embezzlement or larceny. Here, fraud has been interpreted to involve intentional deceit, rather than implied or constructive fraud. G.W. White & Son, Inc. v. Tripp (In re Tripp), 189 B.R. 29 (Bankr. N.D.N.Y. 1995). Some courts have required 'a showing of a positive intentional act involving moral turpitude.' Tripp, 189 B.R. at 36. But in a recent Second Circuit decision, it was sufficient that the fiduciary was an attorney to find that overpayment of a fee based on an invalid retainer agreement was nondischargeable. Andy Warhol Foundation for Visual Arts Inc. v. Hayes (In re Hayes) 183 F.3d 162 (2d Cir. 1999).

The elements of a fiduciary's fraud, identical to those set forth in Section 523(a)(2), are as follows: 1) that the debtor made a representation; 2) that he or she knew that the representation was false at the time that it was made; 3) that the representation was made with the intention and purpose of deceiving the creditor; 4) that the creditor relied on the representation; and (5) loss by the creditor as a result of the false representation. In re Houtman, 568 F.2d 651 (9th Cir. 1978).

Defalcation has been defined as 'a willful neglect of duty, even if not accompanied by fraud or embezzlement.' Matter of Schwager, 121. F.3d 177, 182 (5th Cir. 1997). 'Mere negligence, without some element of intentional wrongdoing, breach of fiduciary duty or other identifiable misconduct, does not constitute a 'defalcation' within the meaning of section 523(a)(4).' In re Ellenbogen, 218 B.R. 709, 716 (Bankr. S.D.N.Y. 1998).

'Defalcation refers to a failure to produce funds entrusted to a fiduciary and applies to conduct that does not necessarily reach the level of fraud.' Gentry v. Kovler (In re Kovler), 249 B.R. 238, 264 (Bankr. S.D.N.Y. 2000). Brokers have been held to be fiduciaries. See BAII Banking Corp. v. UPG, Inc., 985 F.2d 685 (2d Cir. 1993). Some cases have held that '[f]or purposes of section 523(a)(4), the term 'defalcation' requires at least some element of wrongdoing on the part of the debtor/fiduciary, and ' innocent or merely negligent conduct, even if held actionable in a state court, is not within the scope of the statutory exception to dischargeability ' ' In re Kovler, 249 B.R. at 264.

Section 523(a)(7) 'Government Fines, Penalties and Forfeitures

Section 523(a)(7) provides that a debt is non-dischargeable 'to the extent such debt is for a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit, and is not compensation for actual pecuniary loss ' '

In Securities and Exchange Comm. v. Telsey (In re Telsey), 144 B.R. 563 (Bankr.S.D.Fla.1992), Mr. Telsey had been barred by the SEC in February 1972 from associating with any broker, dealer, investment advisor or investment company. In March 1991 he was found to have been in violation of the bar order. The district court ordered him to ”disgorge to the United States Treasury the sums received by him ” as a result of his associations in violation of the SEC order.' In analyzing Section 523(a)(7), the question was whether a debt arising from violation of an order was a 'fine, penalty or forfeiture' within the meaning of the statute.

In Telsey, the court noted that the Supreme Court had found that ' 523(a)(7) created a 'broad exception for all penal sanctions ' ' Because the disgorgement order that served as the basis of the debt was designed as a deterrent, the resulting debt was found to be a 'fine, penalty, or forfeiture' within the meaning of Section 523(a)(7). As such, the debt was excepted from discharge.

In sum, prior to the Sarbanes-Oxley Act, for a financial executive or Wall Streeter to have a business-related debt declared non-dischargeable, he or she would have to intentionally do a prohibited act. Inadvertent or negligent performance would not ordinarily result in nondischargeability of debt.

Dischargeability under the Sarbanes-Oxley Act of 2002

Title VIII of the Sarbanes-Oxley Act is entitled 'Corporate and Criminal Fraud Accountability' and provides in Section 803 for the amendment of Section 523 of the Bankruptcy Code to include a new provision for the nondischargeability of debts if incurred in violation of securities laws. This new subdivision states as follows:

Section 523 ' Exceptions to Discharge

A discharge under section 727, 1141 ' of this title does not discharge an individual from any debt ' (19)'that ' (A) is for ' (i) the violation of any the Federal securities laws (as that term is defined in section 3(a)(47) of the Securities Exchange Act of 1934), 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 from:

• Any judgment, order, consent order, or decree entered in any Federal or State judicial or administrative proceeding;
• Any settlement agreement entered into by the debtor; or
• 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.

' 803 Sarbanes-Oxley Act.

This amendment to Section 523 eliminates the loophole identified in McGuire by creating a specific claim of non-dischargeability for violations of securities laws, whether intentional or negligent. As amended by Section 803 of the Sarbanes-Oxley Act, new Section 523(19) disallows the discharge of debts under Chapter 7 or 11 for debts arising from federal or state securities law violations.

The legislative history to the Sarbanes-Oxley Act dischargeability provisions targets not only securities fraud perpetrators but also all violators of the securities laws (federal or state), whether by determination of any tribunal (including a NASD proceeding) or by settlement of such claim. Thus for an employee who failed to maintain customer reserves under SEC Rule 15c3-3 or for a supervisor who negligently committed a 'securities violation' under state or federal law, non-dischargeability is now a strict liability matter.

Chapter 13 to the Rescue? The Super Discharge

When financial executives and Wall Streeters think of bankruptcy, they often envision a Chapter 7 liquidation or a Chapter 11 corporate reorganization. With the advent of the Sarbanes-Oxley Act, they may want to look at another Chapter of the Bankruptcy Code ' Chapter 13. Chapter 13 is known as a 'wage earner' bankruptcy. It is designed to allow an individual with a regular income to propose a plan by which a portion of the debt owed to the debtor's unsecured creditors will be repaid over a period of time (usually 3 to 5 years).

The qualifications for Chapter 13 are set forth in Section 109(e) of the Bankruptcy Code, and provide that only an individual with regular income that owes, matured, liquidated, unsecured debts of less than $290,525 and matured, liquidated, secured debts of less than $871,550. 11 U.S.C. ' 109(e). The key aspect of the qualification to file Chapter 13 is that noncontingent and liquidated unsecured debt is capped at $240,525. But if some debt includes large contingent or unliquidated claims, the individual may still qualify for Chapter 13. Thus, a Wall Streeter defending a $20 million lawsuit that is unproven may qualify for Chapter 13. The 'super discharge' under Section 1328 apparently releases debts excepted from discharge under the Sarbanes-Oxley Act, another reason that Chapter 13 may be advantageous.

Soon after a Chapter 13 filing, the debtor must propose a Chapter 13 plan, and even if the plan has not yet been confirmed, the debtor must begin making payments to the Chapter 13 trustee, who acts as disbursing agent for plan payments to creditors (though some payments to secured creditors are made outside of the plan). After a recommendation from the Chapter 13 trustee, the bankruptcy judge determines whether or not the plan is feasible and meets the standards for confirmation set forth in Sections 1324 and 1325. Creditors may object to confirmation, arguing that the plan is not proposed in good faith, that payments offered pursuant to the plan are less than creditors would receive in a Chapter 7 liquidation, or that the debtor's plan does not commit all of the debtor's projected disposable income to payments to creditors. Even before confirmation creditors or parties in interest may seek conversion of the Chapter 13 case to another Chapter of the Bankruptcy Code or dismissal claiming that the Chapter 13 is not filed in good faith.

The biggest potential stumbling block for a Wall Streeter Chapter 13 is the 'good faith' standard, which can serve as the basis for dismissal or conversion of the case or denial of Chapter 13 plan confirmation. Specifically, courts have held that 'a Chapter 13 plan which served no purpose other than to discharge an otherwise non-dischargeable debt evidences lack of good faith.' In re Fretwell, 281 B.R. 745, 752 (Bankr. M.D.Fla. 2002).

Thus, Chapter 13 may offer a financial executive of a public company or a Wall Streeter some refuge from the attack by a creditor alleging 'securities violations,' including violations of the Sarbanes-Oxley Act. Because this is uncharted territory fraught with litigation risks, Chapter 13 should be used only after all other options have been exhausted.

Chester B. Salomon is senior partner of Salomon Green & Ostrow, P.C., a New York law firm specializing in debtors' and creditors' rights.

For many years, financial or securities executives knew that if they had not committed a fraud or had not been fined by the Securities and Exchange Commission (SEC), they could get a discharge in bankruptcy by filing for Chapter 7 or 11. Negligently committing a securities violation would not preclude a bankruptcy discharge for the civil liability flowing therefrom.

The Sarbanes-Oxley Act of 2002 is commonly known for its sweeping reforms to combat corporate and accounting fraud, to establish a new accounting oversight board, and to impose new penalties and a variety of higher standards of corporate governance. Lesser known are the Act's draconian amendments that change bankruptcy law to deny dischargeability of debts incurred by reason of securities laws violations.

The new exception to dischargeability under Section 523(a)(19) of the Bankruptcy Code came suddenly as Congress and the media piled-on against aggressive public companies, their chief executives and chief financial officers, the public accounting profession and the securities industry in the aftermath of bankruptcy filings by Enron, Global Crossing, WorldCom and other spectacular corporate collapses. But what are the consequences of the hasty discharge legislation? For financial executives and Wall Streeters, the consequences surely are not positive. Yet there may be an escape from the latest Congressional broadside.

On Wall Street, misconduct by individual brokers responsible for handling customer accounts and liability of their supervisors is commonly known. Litigations alleging insider trading, mishandling of discretionary accounts, suitability, churning, failure to supervise, SEC Rule 10b-5 and similar claims existed long before the current stock market swoon. As the securities industry is heavily regulated there are laws and rules addressing virtually all aspects of the business. Thus there are endless possibilities for 'securities violations.' In many securities litigations the broker, supervisor or employee is charged with negligence or other unintentional misdeeds.

While there have been record numbers of Chapter 7 and 13 filings over the past several years (more than 1.5 million in 2002), only a small percentage of such filings have been made by business and financial executives and Wall Streeters. Most filings sail through the bankruptcy discharge process without much notice.

Before addressing some of the consequences to dischargeability for public company executives and Wall Streeters arising from the Sarbanes-Oxley Act, we briefly examine historical dischargeability issues. At the conclusion we look at a quirk in the legislation that may offer refuge to some individuals.

Dischargeability of Debts Before Sarbanes-Oxley

Historically, a principal purpose of the bankruptcy laws has been to provide the 'honest but unfortunate' debtor with a 'fresh start.' But in some situations, Congress has determined that supervening non-bankruptcy policies justify the continuation of obligations despite the debtor's general bankruptcy discharge. For more than a century, in weighing the goal of a fresh start against these non-bankruptcy policies, Congress has carved out categories of non-dischargeable debt, or 'exceptions to discharge,' which are set forth in Section 523 of the Bankruptcy Code. Examples of exceptions include alimony and child support, student loan obligations, and personal and wrongful death claims resulting from the debtor's intoxication. Until July 30, 2002 Congress did not seek to create a broad exception for violations of securities laws. In re McGuire, 284 B.R. 481, 490 (Bankr.D.Colo. 2002).

The absence of a 'specific exception for violations of securities laws' did not mean that such debts were automatically discharged in bankruptcy. The more common financially based liabilities excepted from discharge are briefly described below.

Section 523(a)(2)(A) ' Fraud and False Pretenses

This subsection excepts from discharge debts 'for money ' obtained by ' (A) false pretenses, a false representation, or actual fraud.'

A violation of SEC Rule 10b-5 may give rise to the 'fraud' component. In Securities and Exchange Comm. v. Bilzerian (In re Bilzerian), 153 F.3d 1278 (11th Cir. 1998), the SEC sought to except from discharge a civil award requiring disgorgement of fraudulently obtained profits. The Eleventh Circuit Court of Appeals held that the SEC was owed a monetary debt and that the debtor was precluded from challenging the SEC's action. The legal question in Bilzerian was 'whether a criminal conviction for securities fraud, combined with a civil disgorgement judgment in favor of the SEC, satisfies the requirements of collateral estoppels for determining 'fraud' under ' 523(a)(2)(A).' The court answered that question in the affirmative.

Section 523(a)(4) ' Fraud or Defalcation of Fiduciary, Embezzlement or Larceny

Section 523(a)(4) provides that an individual debtor may not be discharged from any debt for fraud or defalcation while acting in a fiduciary capacity, embezzlement or larceny. Here, fraud has been interpreted to involve intentional deceit, rather than implied or constructive fraud. G.W. White & Son, Inc. v. Tripp (In re Tripp), 189 B.R. 29 (Bankr. N.D.N.Y. 1995). Some courts have required 'a showing of a positive intentional act involving moral turpitude.' Tripp, 189 B.R. at 36. But in a recent Second Circuit decision, it was sufficient that the fiduciary was an attorney to find that overpayment of a fee based on an invalid retainer agreement was nondischargeable. Andy Warhol Foundation for Visual Arts Inc. v. Hayes (In re Hayes) 183 F.3d 162 (2d Cir. 1999).

The elements of a fiduciary's fraud, identical to those set forth in Section 523(a)(2), are as follows: 1) that the debtor made a representation; 2) that he or she knew that the representation was false at the time that it was made; 3) that the representation was made with the intention and purpose of deceiving the creditor; 4) that the creditor relied on the representation; and (5) loss by the creditor as a result of the false representation. In re Houtman, 568 F.2d 651 (9th Cir. 1978).

Defalcation has been defined as 'a willful neglect of duty, even if not accompanied by fraud or embezzlement.' Matter of Schwager, 121. F.3d 177, 182 (5th Cir. 1997). 'Mere negligence, without some element of intentional wrongdoing, breach of fiduciary duty or other identifiable misconduct, does not constitute a 'defalcation' within the meaning of section 523(a)(4).' In re Ellenbogen, 218 B.R. 709, 716 (Bankr. S.D.N.Y. 1998).

'Defalcation refers to a failure to produce funds entrusted to a fiduciary and applies to conduct that does not necessarily reach the level of fraud.' Gentry v. Kovler (In re Kovler), 249 B.R. 238, 264 (Bankr. S.D.N.Y. 2000). Brokers have been held to be fiduciaries. See BAII Banking Corp. v. UPG, Inc. , 985 F.2d 685 (2d Cir. 1993). Some cases have held that '[f]or purposes of section 523(a)(4), the term 'defalcation' requires at least some element of wrongdoing on the part of the debtor/fiduciary, and ' innocent or merely negligent conduct, even if held actionable in a state court, is not within the scope of the statutory exception to dischargeability ' ' In re Kovler, 249 B.R. at 264.

Section 523(a)(7) 'Government Fines, Penalties and Forfeitures

Section 523(a)(7) provides that a debt is non-dischargeable 'to the extent such debt is for a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit, and is not compensation for actual pecuniary loss ' '

In Securities and Exchange Comm. v. Telsey (In re Telsey), 144 B.R. 563 (Bankr.S.D.Fla.1992), Mr. Telsey had been barred by the SEC in February 1972 from associating with any broker, dealer, investment advisor or investment company. In March 1991 he was found to have been in violation of the bar order. The district court ordered him to ”disgorge to the United States Treasury the sums received by him ” as a result of his associations in violation of the SEC order.' In analyzing Section 523(a)(7), the question was whether a debt arising from violation of an order was a 'fine, penalty or forfeiture' within the meaning of the statute.

In Telsey, the court noted that the Supreme Court had found that ' 523(a)(7) created a 'broad exception for all penal sanctions ' ' Because the disgorgement order that served as the basis of the debt was designed as a deterrent, the resulting debt was found to be a 'fine, penalty, or forfeiture' within the meaning of Section 523(a)(7). As such, the debt was excepted from discharge.

In sum, prior to the Sarbanes-Oxley Act, for a financial executive or Wall Streeter to have a business-related debt declared non-dischargeable, he or she would have to intentionally do a prohibited act. Inadvertent or negligent performance would not ordinarily result in nondischargeability of debt.

Dischargeability under the Sarbanes-Oxley Act of 2002

Title VIII of the Sarbanes-Oxley Act is entitled 'Corporate and Criminal Fraud Accountability' and provides in Section 803 for the amendment of Section 523 of the Bankruptcy Code to include a new provision for the nondischargeability of debts if incurred in violation of securities laws. This new subdivision states as follows:

Section 523 ' Exceptions to Discharge

A discharge under section 727, 1141 ' of this title does not discharge an individual from any debt ' (19)'that ' (A) is for ' (i) the violation of any the Federal securities laws (as that term is defined in section 3(a)(47) of the Securities Exchange Act of 1934), 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 from:

• Any judgment, order, consent order, or decree entered in any Federal or State judicial or administrative proceeding;
• Any settlement agreement entered into by the debtor; or
• 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.

' 803 Sarbanes-Oxley Act.

This amendment to Section 523 eliminates the loophole identified in McGuire by creating a specific claim of non-dischargeability for violations of securities laws, whether intentional or negligent. As amended by Section 803 of the Sarbanes-Oxley Act, new Section 523(19) disallows the discharge of debts under Chapter 7 or 11 for debts arising from federal or state securities law violations.

The legislative history to the Sarbanes-Oxley Act dischargeability provisions targets not only securities fraud perpetrators but also all violators of the securities laws (federal or state), whether by determination of any tribunal (including a NASD proceeding) or by settlement of such claim. Thus for an employee who failed to maintain customer reserves under SEC Rule 15c3-3 or for a supervisor who negligently committed a 'securities violation' under state or federal law, non-dischargeability is now a strict liability matter.

Chapter 13 to the Rescue? The Super Discharge

When financial executives and Wall Streeters think of bankruptcy, they often envision a Chapter 7 liquidation or a Chapter 11 corporate reorganization. With the advent of the Sarbanes-Oxley Act, they may want to look at another Chapter of the Bankruptcy Code ' Chapter 13. Chapter 13 is known as a 'wage earner' bankruptcy. It is designed to allow an individual with a regular income to propose a plan by which a portion of the debt owed to the debtor's unsecured creditors will be repaid over a period of time (usually 3 to 5 years).

The qualifications for Chapter 13 are set forth in Section 109(e) of the Bankruptcy Code, and provide that only an individual with regular income that owes, matured, liquidated, unsecured debts of less than $290,525 and matured, liquidated, secured debts of less than $871,550. 11 U.S.C. ' 109(e). The key aspect of the qualification to file Chapter 13 is that noncontingent and liquidated unsecured debt is capped at $240,525. But if some debt includes large contingent or unliquidated claims, the individual may still qualify for Chapter 13. Thus, a Wall Streeter defending a $20 million lawsuit that is unproven may qualify for Chapter 13. The 'super discharge' under Section 1328 apparently releases debts excepted from discharge under the Sarbanes-Oxley Act, another reason that Chapter 13 may be advantageous.

Soon after a Chapter 13 filing, the debtor must propose a Chapter 13 plan, and even if the plan has not yet been confirmed, the debtor must begin making payments to the Chapter 13 trustee, who acts as disbursing agent for plan payments to creditors (though some payments to secured creditors are made outside of the plan). After a recommendation from the Chapter 13 trustee, the bankruptcy judge determines whether or not the plan is feasible and meets the standards for confirmation set forth in Sections 1324 and 1325. Creditors may object to confirmation, arguing that the plan is not proposed in good faith, that payments offered pursuant to the plan are less than creditors would receive in a Chapter 7 liquidation, or that the debtor's plan does not commit all of the debtor's projected disposable income to payments to creditors. Even before confirmation creditors or parties in interest may seek conversion of the Chapter 13 case to another Chapter of the Bankruptcy Code or dismissal claiming that the Chapter 13 is not filed in good faith.

The biggest potential stumbling block for a Wall Streeter Chapter 13 is the 'good faith' standard, which can serve as the basis for dismissal or conversion of the case or denial of Chapter 13 plan confirmation. Specifically, courts have held that 'a Chapter 13 plan which served no purpose other than to discharge an otherwise non-dischargeable debt evidences lack of good faith.' In re Fretwell, 281 B.R. 745, 752 (Bankr. M.D.Fla. 2002).

Thus, Chapter 13 may offer a financial executive of a public company or a Wall Streeter some refuge from the attack by a creditor alleging 'securities violations,' including violations of the Sarbanes-Oxley Act. Because this is uncharted territory fraught with litigation risks, Chapter 13 should be used only after all other options have been exhausted.

Chester B. Salomon is senior partner of Salomon Green & Ostrow, P.C., a New York law firm specializing in debtors' and creditors' rights.