Stockbroker Fraud Not Dischargeable

Closing the Loophole

The current scandals plaguing Wall Street finally brought the matter to the attention of Congress. Confronting the unsavory possibility that bankruptcy might offer escape for manipulative stockbrokers, even those found guilty of wrongful acts by the market's own self-regulatory bodies, lawmakers acted decisively to close the loophole once and for all. Congress added a new paragraph to Section 523, the statute classifying non-dischargeable debts. The amendment is found in the Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204 (July 30, 2002), ' 1, 116 Stat. 745, et seq. Within Sarbanes-Oxley is the Corporate and Criminal Fraud Accountability Act of 2002, a subdivision encompassing a related set of anti-fraud provisions. Sarbanes-Oxley at Title VIII, ' 801, 116 Stat. 800, et seq. (the CCFA). The CCFA adds a new subsection to Section 523, making non-dischargeable any debt for a violation of federal or statute securities laws. Sarbanes-Oxley at ' 803, 116 Stat. 801.

The new Section 523(a)(19) declares that a debt cannot be discharged in an individual bankruptcy if the indebtedness arises from a violation of any federal or state securities laws, or common law fraud or deceit in connection with the buying or selling of a security, and results from any judgment or order entered in any federal or state case or administrative proceeding. Most revolutionary of all, the reform proviso also makes non-dischargeable any debt resulting the settlement of any such litigation. For the first time, Congress has declared that a settlement accord, not a judicial decree, resulting from a charge of securities fraud will create a non-dischargeable debt. With this legislative revision, any debt arising from the settlement of a claimed securities law violation shall be incapable of discharge.

Baptism by Fire

It did not take long for the new law to be tested in court. Appropriately enough, the baptism of fire was in the bankruptcy court for the Southern District of New York, a mere two blocks from Wall Street, the financial epicenter this very amendment was designed to target. In Smith v. Gibbons (In re Gibbons), 289 B.R. 588 (Bankr. S.D.N.Y. 2003), Smith was an elderly widow who entrusted her retirement funds to stockbrokers at J.P. Gibbons & Co., where Foster Gibbons was chief legal and compliance officer and later president. The entirety of Smith's funds was lost, and in late 2000, a panel of arbitrators convened by the National Association of Securities Dealers (NASD), Wall Street's self-regulatory body, awarded the defrauded customer nearly $400,000 in damages to compensate for the fraud that led to her losses.

Foster Gibbons filed for Chapter 7 in July 2001, and received a discharge of debt in October of that same year. He argued that his debt to Smith was likewise discharged along with his general debts. Smith brought the instant adversary proceeding, and moved for summary judgment, contending that Congress intended retroactive effect for the new Section 523(b)(19), rendering the arbitration award non-dischargeable. Id. at 589-91.

Bankruptcy Judge Allan L. Gropper concisely framed the issue; if 523(a)(19) did in fact apply here, 'it unquestionably renders non-dischargeable [Smith's] debt, as the debt is based on a judgment enforcing an arbitral award for common law securities fraud.' With the same surefootedness, Judge Gropper announced that the new amendment did apply, Gibbons could not discharge the debt, and then the learned jurist explained why.

To understand Paragraph 19, the Gibbons court rightly started by examining its legislative history, unquestionably a task made all the easier by the newness of the reform legislation it sprang from. Sarbanes-Oxley, noted the court, was intended to address systemic weaknesses in the financial markets that had led to a breakdown in corporate financial and broker-dealer responsibility. The new amendments were specifically intended to enhance the prosecution and punishment of those who defrauded investors in the public stocks markets, including the prevention of the bankruptcy discharge of debts incurred in such wrongdoing. Id. at 591-92, citing S. Rep. No. 107-146, at 2 (2002), among others.

The new Paragraph 19 amended the Bankruptcy Code to ensure that both judgments and settlements based upon securities law violations were non-dischargeable debts, thereby 'protecting victims' ability to recover their losses.' Id. at 592, quoting 148 Cong. Rec. S1787 (daily ed. March 12, 2002) (statement of Senator Leahy). The lawmakers recognized that the current bankruptcy scheme of non-dischargeability might permit wrongdoers to discharge debts from judgments or settlements arising from securities law violations. Judge Gropper quoted the legislative history's candid declaration that '[t]his loophole in the law should be closed to help defrauded investors recoup their losses and to hold accountable those who violate securities laws after a government unit or private suit results in a judgment or settlement against the wrongdoer.' Id. at 592, quoting S. Rep. No. 107-146 (2002).

Vital to the instant analysis, the Gibbons court concluded the legislative history also demonstrated Congress' intention to apply the new Paragraph 19 'as broadly as possible in pending bankruptcy cases.' Id. at 593. Indeed, commentary from the bill's architects contained explicit statements that, to the maximum extent possible, the new non-dischargeability statute should be applied to pending bankruptcies, declaring '[t]he provision applies to all judgments, and settlements arising from state and federal securities laws violations entered in the future regardless of when the [bankruptcy] case was filed.' This would met the legislators' mandate that malefactors be prevented from 'using the bankruptcy laws as a shield and to allow the defrauded investors to recover as much as possible.' Id. at 593, quoting 148 Cong. Rec. S7418 (daily ed. July 26, 2002) (statement of Senator Leahy). Parenthetically, the bankruptcy judge noted it was also evident that Congress intended the new Paragraph 19 to apply where the securities fraud action had been commenced prior to the proviso becoming law, but was still pending on the date of its codification. Id. at 593 n. 8.

'Temporal Application'

The bankruptcy court next addressed the 'temporal application' of the new Section 523(a)(19). All of the CCFA of Sarbanes-Oxley was explicitly made effective as of July 30, 2002, noted Judge Gropper. See Pub. L. No. 107-204, 116 Stat. 745 (2002). To be sure, there was no expression direction of its temporal reach of the reform act. Id. at 594. Nonetheless, Congress amply demonstrated within Sarbanes-Oxley that it could limit the effectiveness of a specific reform if it wished to.

For this comparison, the court turned to the immediately following section of the amendments, which enacted a new, uniform 2 years from discovery/5 years from the fraud statute of limitations for federal securities law actions. Yet, by its own terms, the revised limitary period was made inapplicable to lawsuits pending on the date of the amendment. Id. at 594. See Sarbanes-Oxley at ' 804, 116 Stat. 801-02. 'The fact that Congress has explicitly ruled that another section of a given statute not be applied in pending cases is evidence that Congress intended the remainder of the statute to apply thereto,' opined the bankruptcy court. Id. at 594.

Next, and '[b]eyond the express words of the statute,' the legislative history indicated Paragraph 19 should be applied to prior conduct. The Congressional Record, noted the court, insists that the new proviso apply to the maximum extent possible in existing bankruptcies.' Id. Also, there was nothing to contradict the foregoing proposition in the remainder of the legislative history. Id. at 595.

For these reasons, the Gibbons court concluded that the lawmakers did in fact consider retroactive application of the remedial statute, and determined that 'any potential unfairness was an acceptable price to pay for the countervailing benefits.' When considering the statutory text, the legislative history, and the public policy behind enacting the new Section 523(a)(19), there was no doubt that Congress had acted with the 'requisite clarity' of purpose to extend the temporal reach of the new paragraph retroactively to pending bankruptcy cases. Id. at 595.

Examining this case of first impression, Gibbons is an important step in ensuring that justice is done under the Bankruptcy Code. For too long, manipulative stockbrokers had the opportunity to take awards or settlements rendered by courts or stock market regulators, and then discharge the liability as ordinary debt in a bankruptcy filing. Present day reforms to the securities industry would be meaningless if this loophole was allowed to remain available.

The new Section 523(a)(19) forecloses this possibility, once and for all. Any judgment, award or settlement is now automatically deemed non-dischargeable, and cannot be discharged by the insolvent wrongdoer. The clear statutory text of the new proviso does not allow for any other outcome, and thus reserves bankruptcy for the honest debtor, not the miscreant stockbroker.

Gibbons Confirms the Law

Gibbons confirms the vitality of the new law, and then some. First, its unequivocal enforcement of the statute makes it beyond doubt that the statute has the scope Congress intended.

Second, the bankruptcy court's seminal decision ensures that the new Paragraph 19 is immediately available to pending bankruptcies. Gibbons correctly parses the text of not only the statute, but the contents of Sarbanes-Oxley as a whole, and comes to the correct conclusion that Congress knew precisely what it was doing in extending the temporal reach of this reform to existing cases. Indeed, the court's thorough reading of the significant legislative history verifies this was the lawmakers' intent. Thus, as of this moment, the bankruptcy court will not be a refuge for white-collar lawbreakers any longer.

Third, and admittedly a foregone conclusion, is that any and all bankruptcy cases initiated from the passage of Sarbanes-Oxley will undeniable be subject to the new Section 523(a)(19). It is now beyond peradventure that in today's and future bankruptcy cases, debts arising from an award or settlement of securities fraud charges are non-dischargeable.

Conclusion

In conclusion, the new Paragraph 19 and the Gibbons case provide certainty that defrauded investors no longer need worry that a stockbroker guilty of fraud will escape payment of a debt arising from their wrongdoing. Bankruptcy is a process reserved for honest debtors, and these developments make sure that is so.

A. Michael Sabino is an Associate Professor of Law, Tobin College of Business, St. John's University, and a partner in Sabino & Sabino, Mineola, NY.

It is a cornerstone of our nation's bankruptcy jurisprudence that the discharge of individual debt is reserved solely for the honest debtor. This encompasses rules that certain debts are non-dischargeable, notable among them debts obtained by fraud and other illegal acts.

Nevertheless, from time to time various lawbreakers still seek to manipulate the bankruptcy laws. One particular category encompasses stockbrokers brought up before stock market regulators on charges of fraud in connection with the buying or selling of securities, and then either settle for a sum certain with claimants or are found liable for damages and ordered to pay under an industry award or court decree.

Many of these avaricious types file for bankruptcy, and attempt to discharge what they owe under the allegation that the settlement or award is an ordinary debt. More often than not, the defrauded customer/creditor has had to resort to the expensive and time-consuming process of replicating in the bankruptcy court the original fraud case tried before the stock exchange regulators. Most disturbing, under the then-existing regime, there was no guarantee that a stockbroker's debt arising from wrongdoing would be held to be non-dischargeable.

Closing the Loophole

The current scandals plaguing Wall Street finally brought the matter to the attention of Congress. Confronting the unsavory possibility that bankruptcy might offer escape for manipulative stockbrokers, even those found guilty of wrongful acts by the market's own self-regulatory bodies, lawmakers acted decisively to close the loophole once and for all. Congress added a new paragraph to Section 523, the statute classifying non-dischargeable debts. The amendment is found in the Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204 (July 30, 2002), ' 1, 116 Stat. 745, et seq. Within Sarbanes-Oxley is the Corporate and Criminal Fraud Accountability Act of 2002, a subdivision encompassing a related set of anti-fraud provisions. Sarbanes-Oxley at Title VIII, ' 801, 116 Stat. 800, et seq. (the CCFA). The CCFA adds a new subsection to Section 523, making non-dischargeable any debt for a violation of federal or statute securities laws. Sarbanes-Oxley at ' 803, 116 Stat. 801.

The new Section 523(a)(19) declares that a debt cannot be discharged in an individual bankruptcy if the indebtedness arises from a violation of any federal or state securities laws, or common law fraud or deceit in connection with the buying or selling of a security, and results from any judgment or order entered in any federal or state case or administrative proceeding. Most revolutionary of all, the reform proviso also makes non-dischargeable any debt resulting the settlement of any such litigation. For the first time, Congress has declared that a settlement accord, not a judicial decree, resulting from a charge of securities fraud will create a non-dischargeable debt. With this legislative revision, any debt arising from the settlement of a claimed securities law violation shall be incapable of discharge.

Baptism by Fire

It did not take long for the new law to be tested in court. Appropriately enough, the baptism of fire was in the bankruptcy court for the Southern District of New York, a mere two blocks from Wall Street, the financial epicenter this very amendment was designed to target. In Smith v. Gibbons (In re Gibbons), 289 B.R. 588 (Bankr. S.D.N.Y. 2003), Smith was an elderly widow who entrusted her retirement funds to stockbrokers at J.P. Gibbons & Co., where Foster Gibbons was chief legal and compliance officer and later president. The entirety of Smith's funds was lost, and in late 2000, a panel of arbitrators convened by the National Association of Securities Dealers (NASD), Wall Street's self-regulatory body, awarded the defrauded customer nearly $400,000 in damages to compensate for the fraud that led to her losses.

Foster Gibbons filed for Chapter 7 in July 2001, and received a discharge of debt in October of that same year. He argued that his debt to Smith was likewise discharged along with his general debts. Smith brought the instant adversary proceeding, and moved for summary judgment, contending that Congress intended retroactive effect for the new Section 523(b)(19), rendering the arbitration award non-dischargeable. Id. at 589-91.

Bankruptcy Judge Allan L. Gropper concisely framed the issue; if 523(a)(19) did in fact apply here, 'it unquestionably renders non-dischargeable [Smith's] debt, as the debt is based on a judgment enforcing an arbitral award for common law securities fraud.' With the same surefootedness, Judge Gropper announced that the new amendment did apply, Gibbons could not discharge the debt, and then the learned jurist explained why.

To understand Paragraph 19, the Gibbons court rightly started by examining its legislative history, unquestionably a task made all the easier by the newness of the reform legislation it sprang from. Sarbanes-Oxley, noted the court, was intended to address systemic weaknesses in the financial markets that had led to a breakdown in corporate financial and broker-dealer responsibility. The new amendments were specifically intended to enhance the prosecution and punishment of those who defrauded investors in the public stocks markets, including the prevention of the bankruptcy discharge of debts incurred in such wrongdoing. Id. at 591-92, citing S. Rep. No. 107-146, at 2 (2002), among others.

The new Paragraph 19 amended the Bankruptcy Code to ensure that both judgments and settlements based upon securities law violations were non-dischargeable debts, thereby 'protecting victims' ability to recover their losses.' Id. at 592, quoting 148 Cong. Rec. S1787 (daily ed. March 12, 2002) (statement of Senator Leahy). The lawmakers recognized that the current bankruptcy scheme of non-dischargeability might permit wrongdoers to discharge debts from judgments or settlements arising from securities law violations. Judge Gropper quoted the legislative history's candid declaration that '[t]his loophole in the law should be closed to help defrauded investors recoup their losses and to hold accountable those who violate securities laws after a government unit or private suit results in a judgment or settlement against the wrongdoer.' Id. at 592, quoting S. Rep. No. 107-146 (2002).

Vital to the instant analysis, the Gibbons court concluded the legislative history also demonstrated Congress' intention to apply the new Paragraph 19 'as broadly as possible in pending bankruptcy cases.' Id. at 593. Indeed, commentary from the bill's architects contained explicit statements that, to the maximum extent possible, the new non-dischargeability statute should be applied to pending bankruptcies, declaring '[t]he provision applies to all judgments, and settlements arising from state and federal securities laws violations entered in the future regardless of when the [bankruptcy] case was filed.' This would met the legislators' mandate that malefactors be prevented from 'using the bankruptcy laws as a shield and to allow the defrauded investors to recover as much as possible.' Id. at 593, quoting 148 Cong. Rec. S7418 (daily ed. July 26, 2002) (statement of Senator Leahy). Parenthetically, the bankruptcy judge noted it was also evident that Congress intended the new Paragraph 19 to apply where the securities fraud action had been commenced prior to the proviso becoming law, but was still pending on the date of its codification. Id. at 593 n. 8.

'Temporal Application'

The bankruptcy court next addressed the 'temporal application' of the new Section 523(a)(19). All of the CCFA of Sarbanes-Oxley was explicitly made effective as of July 30, 2002, noted Judge Gropper. See Pub. L. No. 107-204, 116 Stat. 745 (2002). To be sure, there was no expression direction of its temporal reach of the reform act. Id. at 594. Nonetheless, Congress amply demonstrated within Sarbanes-Oxley that it could limit the effectiveness of a specific reform if it wished to.

For this comparison, the court turned to the immediately following section of the amendments, which enacted a new, uniform 2 years from discovery/5 years from the fraud statute of limitations for federal securities law actions. Yet, by its own terms, the revised limitary period was made inapplicable to lawsuits pending on the date of the amendment. Id. at 594. See Sarbanes-Oxley at ' 804, 116 Stat. 801-02. 'The fact that Congress has explicitly ruled that another section of a given statute not be applied in pending cases is evidence that Congress intended the remainder of the statute to apply thereto,' opined the bankruptcy court. Id. at 594.

Next, and '[b]eyond the express words of the statute,' the legislative history indicated Paragraph 19 should be applied to prior conduct. The Congressional Record, noted the court, insists that the new proviso apply to the maximum extent possible in existing bankruptcies.' Id. Also, there was nothing to contradict the foregoing proposition in the remainder of the legislative history. Id. at 595.

For these reasons, the Gibbons court concluded that the lawmakers did in fact consider retroactive application of the remedial statute, and determined that 'any potential unfairness was an acceptable price to pay for the countervailing benefits.' When considering the statutory text, the legislative history, and the public policy behind enacting the new Section 523(a)(19), there was no doubt that Congress had acted with the 'requisite clarity' of purpose to extend the temporal reach of the new paragraph retroactively to pending bankruptcy cases. Id. at 595.

Examining this case of first impression, Gibbons is an important step in ensuring that justice is done under the Bankruptcy Code. For too long, manipulative stockbrokers had the opportunity to take awards or settlements rendered by courts or stock market regulators, and then discharge the liability as ordinary debt in a bankruptcy filing. Present day reforms to the securities industry would be meaningless if this loophole was allowed to remain available.

The new Section 523(a)(19) forecloses this possibility, once and for all. Any judgment, award or settlement is now automatically deemed non-dischargeable, and cannot be discharged by the insolvent wrongdoer. The clear statutory text of the new proviso does not allow for any other outcome, and thus reserves bankruptcy for the honest debtor, not the miscreant stockbroker.

Gibbons Confirms the Law

Gibbons confirms the vitality of the new law, and then some. First, its unequivocal enforcement of the statute makes it beyond doubt that the statute has the scope Congress intended.

Second, the bankruptcy court's seminal decision ensures that the new Paragraph 19 is immediately available to pending bankruptcies. Gibbons correctly parses the text of not only the statute, but the contents of Sarbanes-Oxley as a whole, and comes to the correct conclusion that Congress knew precisely what it was doing in extending the temporal reach of this reform to existing cases. Indeed, the court's thorough reading of the significant legislative history verifies this was the lawmakers' intent. Thus, as of this moment, the bankruptcy court will not be a refuge for white-collar lawbreakers any longer.

Third, and admittedly a foregone conclusion, is that any and all bankruptcy cases initiated from the passage of Sarbanes-Oxley will undeniable be subject to the new Section 523(a)(19). It is now beyond peradventure that in today's and future bankruptcy cases, debts arising from an award or settlement of securities fraud charges are non-dischargeable.

Conclusion

In conclusion, the new Paragraph 19 and the Gibbons case provide certainty that defrauded investors no longer need worry that a stockbroker guilty of fraud will escape payment of a debt arising from their wrongdoing. Bankruptcy is a process reserved for honest debtors, and these developments make sure that is so.

A. Michael Sabino is an Associate Professor of Law, Tobin College of Business, St. John's University, and a partner in Sabino & Sabino, Mineola, NY.