Dena Kaufman | Bloomberg Law Sherman v. SEC, No. 09-55880, 2011 BL 238983 (9th Cir. Sept. 19, 2011) The United States Court of Appeals for the Ninth Circuit reversed the district court's holding that a debt was excepted from discharge pursuant to 11 U.S.C. § 523(a)(19) for violation of securities laws despite the fact that the debtor was not found guilty of any securities law violations. In so ruling, the Ninth Circuit held that 11 U.S.C. § 523(a)(19) prevents the discharge of a debt for securities law violations only in instances where the debtor is found liable for the securities violation creating such debt.
Debtor's Bankruptcy FilingRichard Sherman ("Debtor") was an attorney who represented certain companies in an enforcement action initiated by the Securities and Exchange Commission (the "SEC") in 1997, which led to the appointment of a receiver. During the enforcement action, the receiver ordered Debtor to disgorge certain amounts that Debtor had received and retained in a separate contingency case, as such amounts exceeded the amount Debtor actually earned. Under the California Rules of Professional Conduct, Debtor was required to return sums obtained in excess of Debtor's final fee. Notably, the SEC determined that Debtor had not committed any securities violations. A few days prior to the hearing on disgorgement, Debtor, together with his wife, filed a voluntary petition under chapter 7 of the United States Code (the "Bankruptcy Code").
The Lower Courts' RulingsIn response to Debtor's bankruptcy filing, the SEC filed a motion to dismiss the bankruptcy case. The bankruptcy court's order denying the motion was reversed by the district court on appeal. During the pendency of the appeal to the district court, Debtor was granted a discharge under 11 U.S.C. § 727. On appeal, the Ninth Circuit reversed the district court's order, holding that there was not sufficient "cause" to warrant a dismissal for bad faith under 11 U.S.C. § 707(a). Issuing its order, the Ninth Circuit pointed out that the SEC was not time-barred from filing an adversary proceeding to except the disgorgement order debt from discharge under 11 U.S.C. §§ 523(a)(7) or (19), without concluding whether the SEC would prevail in such an adversary proceeding. Subsequently, Debtor filed an adversary proceeding seeking declaratory relief that the disgorgement order debt had been discharged despite the exception to discharge in § 523(a)(19). In granting summary judgment to Debtor, the bankruptcy court held that, as a matter of law, the disgorgement order debt did not arise out of any securities law violation and that § 523(a)(19) only applied to debtors who have committed securities law violations. On appeal, the district court reversed the bankruptcy court's ruling. Debtor appealed the district court's ruling to the Ninth Circuit.
Section 523(a)(19) Discharge Exception Is Only Applicable to Debt Where Debtor Himself Is Culpable for Securities Law ViolationThe Ninth Circuit began its analysis with a review of the plain language of the statute. The SEC argued that, since the text of the statute did not limit the discharge exception to debts for a violation of securities law explicitly by containing language such as "by the debtor," the statute should be interpreted as broadly as possible. Recognizing that the text of other discharge exceptions in § 523(a) did contain such limiting language, the Ninth Circuit mentioned that it would not be outside the principles of statutory interpretation to conclude that, by not including such limiting language in § 523(a)(19), Congress intended for such exception to extend to debt for securities violations by persons other than Debtor. However, the Ninth Circuit noted that in several of its previous cases it had restricted the application of other discharge exceptions that did not contain such limiting language by requiring that the debtor be responsible for the wrongdoing giving rise to the debt in order for the debt to be excepted from discharge, reasoning that extending such discharge exceptions to the "honest but unfortunate debtor" contravened the "fresh start" purpose of the Bankruptcy Code. Under the guidance of the Supreme Court and its own previous opinions, both of which the Ninth Circuit found to strongly favor the bankruptcy court's interpretation, the Ninth Circuit continued its analysis by pointing out the two main goals of the Bankruptcy Code: (1) distributing Debtor's assets in an equitable way and (2) providing Debtor with a "fresh start." The Ninth Circuit highlighted that, as excepting any debt from discharge would naturally prohibit a debtor from obtaining a true "fresh start," the Supreme Court has adopted a narrow interpretation of exceptions to discharge and that the Bankruptcy Code limits a "fresh start" to the "honest but unfortunate debtor." Considering these two points together, the Ninth Circuit reasoned that discharge exceptions should be limited to "dishonest debtors seeking to abuse the bankruptcy system in order to evade the consequences of their misconduct." The Ninth Circuit found further support for its conclusion in the legislative history of § 523(a)(19), noting that the discharge exception was only included to prevent a debtor from re-litigating a judgment against him for securities fraud or other securities violations based on the fact that the elements of fraud within the meaning of 11 U.S.C. § 523(a)(2)(A) may not be exactly the same as the elements of various securities law violations. Ultimately, the Ninth Circuit rejected the SEC's argument that the disgorgement order debt should be excepted from discharge under § 523(a)(19) on the basis that Debtor was essentially a constructive trustee of the funds and should not be able to avoid his obligation to return such funds held in trust through a bankruptcy filing. Moreover, the Ninth Circuit explained that the SEC might have prevailed on such theory if it had sought to except the debt from discharge under 11 U.S.C. § 523(a)(4), "for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny," which it was now time-barred from doing, but could not prevent the discharge of such debt under § 523(a)(19) when Debtor was not responsible for any securities law violations.
Ninth Circuit Reverses District Court RulingAccordingly, the Ninth Circuit reversed the ruling of the district court and Debtor's debt to the SEC was not excepted from discharge under § 523(a)(19). Disclaimer This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy. ©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.
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