Some Added Security: Applying Lessons from Bankruptcy Law to Strengthen the Collection of Consumer Fraud Penalties.

• Author: Florio, Nicolas A.

TABLE OF CONTENTS I. INTRODUCTION 252 II. BACKGROUND 254 A. The General Framework of Corporate Bankruptcy Law 254 1. The Mechanics of Chapter 11 Reorganization 254 2. 11 U.S.C. [section] 523 Exceptions to Discharge 258 B. The In re Fusion Connect Saga 260 C. Causes for Concern 262 1. Looming Concerns over Liability Offloading in Corporate Bankruptcy 262 2. Mass Market Consumer Fraud in the Telecommunications Industry 263 III. ANALYSIS 265 A. A Two-Pronged Legal Solution 265 B. Addressing Offloading Concerns 266 C. Addressing Discharge Concerns 268 IV. CONCLUSION 271 A government agency's ability to collect fines is a telling indicator of whether an agency is more bark than bite. If an agency cannot practically collect its fines, its constituency takes notice. A constituent's cost of punishment suddenly becomes a predictable metric that can be strategically mitigated, and the agency loses its leverage as a regulator and enforcer over time, while the constituency's maligned behaviors persist. One need only look to the current state of the telecommunications industry to see a potential microcosm of this dynamic.

The Federal Communications Commission ("FCC") infamously struggles to practically collect the civil penalties it imposes on its constituents for consumer fraud. (1) Despite enforcement assistance from the Federal Trade Commission ("FTC"), (2) the FCC's shortcomings have conditioned a telecommunications industry that no longer blinks at the announcement of enormous consumer fraud penalties. (3) Sensational headlines often trumpet massive fines against the industry's largest corporations, but they do not capture reality. (4) In truth, these penalties might go uncollected for several years. (5) As a former Director of Research at the Consumer Federation of America once lamented: "When the lion roars, the gazelles run. The problem is that if the lion roars too much and never eats a meal, the gazelles will stop running." (6)

Indeed, the gazelles of the telecommunications industry have stopped running, but there is greater cause for concern on the horizon. An unresolved disagreement amongst federal courts over a particular section of the United States Bankruptcy Code ("the Code") might offer telecommunications companies a way to completely erase their consumer fraud penalties through Chapter 11 reorganization, further upsetting the FCC and FTC's practical ability to collect their fines. (7) While the United States' bankruptcy system is not intended as a means for corporate debtors to escape accountability for consumer fraud, a general understanding of the corporate bankruptcy process reveals how such an opportunity can arise.

When a distressed corporation files for relief under Chapter 11 of the Code, the corporation becomes a federally protected debtor. (8) In turn, the government can no longer collect its penalty claims against the debtor corporation. (9) This gives the corporation time to implement a plan of reorganization that restructures its capital arrangements and permits it to exit as a solvent entity. (10) Any creditor whose claim against the corporation is not backed by collateral is classified as an unsecured creditor (11) and ranks low within the creditor hierarchy without any guarantee of recovery. (12) Consumer fraud penalties levied by the FCC and FTC fall under unsecured status. (13) If the debtor corporation seeks to discharge the penalty in its plan of reorganization, it may very well succeed in doing so, despite the fact that that debt was the consequence of fraud. (14) For the FCC and FTC, this is the worst case scenario.

A recent case in the United States Bankruptcy Court for the Southern District of New York brought this exact fear to light. In 2019, Fusion Connect, Inc., a telecommunications provider, filed for bankruptcy and nearly discharged a $2.1 million FCC consumer fraud penalty levied via consent decree. (15) The bankruptcy judge ruled that where the government itself is not an injured victim of the fraudulent scheme, the penalty is dischargeable. (16) But on appeal, the bankruptcy court's ruling was reversed, (17) rekindling an awareness within the federal judiciary of disagreement. (18) And it has significant potential side effects.

Practitioners fear that the In re Fusion Connect saga serves as a precursor to what will soon become common practice in the telecommunications industry. (19) Telecommunications companies may begin to test courts with bankruptcy spinoffs. (20) Here, they may offload their consumer fraud penalties into subsidiaries solely for the purpose of discharging them in bankruptcy. (21) And this will not only perpetuate the FCC and FTC's struggles to collect their penalties, but also the agencies' ability to curb mass market consumer fraud. To address these problems, this Note argues that by modifying the way the FCC and FTC issue their consumer fraud penalties, the agencies can not only protect their claims in bankruptcy but strengthen their overall ability to collect their fines and disincentivize default.

This Note first requires an in-depth background discussion. Section II.A.1 elucidates the relevant framework of Chapter 11 bankruptcy reorganization. Section II.A.2 details the relevant statutes governing the nondischargeability of certain debts. Section II.B then illuminates the In re Fusion Connect saga's near successful exploitation of Section 523(a)(2)(A) of the Code. From here, Section II.C.1 explores why the FCC and FTC should heed the warnings identified in In re Fusion Connect, namely bankruptcy spinoffs and liability offloading. Section II.C.2 then concludes the background with an examination of consumer fraud in the telecommunications industry.

This Note then proposes a solution that focuses solely on those FCC and FTC penalties levied via consent decrees, as seen in In re Fusion Connect. Section III.A explains that the best resolution requires two modifications to the way these agencies draft their agreements. Section III.B suggests that consent decrees should first reduce offloading concerns by stipulating that their penalties cannot be assigned to subsidiaries, independent spinoffs, and other third parties. Section III.C then proposes that consent decrees should attach the corporations' FCC licenses to the penalties to create security interests that characterize the government as a secured creditor. Such a plan offers an effective means at addressing the issues rediscovered by the In re Fusion Connect saga and presents a sustainable solution grounded in undisputed bankruptcy law.

2. BACKGROUND

   1. The General Framework of Corporate Bankruptcy Law

      1. The Mechanics of Chapter 11 Reorganization

         Bankruptcy is a unique legal process codified under federal law that permits entities distressed by crippling debts the opportunity to seek relief from their obligations to creditors. (22) It is one of the few contexts where judicial intervention is not punitive, but rather seeks to secure a better outcome than would otherwise be received by all parties without the court's assistance. (23) This is especially the case in "reorganization" bankruptcies, such as those filed under Chapter 11 of the Code. (24) In many ways, a reorganization arguably transforms the court's role into that of a broker, always concerned about striking the deal. Reorganization bankruptcy involves a highly sophisticated framework of procedure, litigation, negotiated transactions, and business decisions. It employs its own terms of the trade to make sense of it all. Accordingly, this Note narrowly examines only a few points within that complex framework and walks through a typical Chapter 11 bankruptcy reorganization from beginning to end.

         A bankruptcy proceeding under Chapter 11 of the Code commences with the filing of a Chapter 11 petition in a federal bankruptcy court. (25) A bankruptcy court is a unit of the federal judiciary and is endowed with subject matter jurisdiction over most bankruptcy case matters under Article I of the United States Constitution. (26) Therefore, all bankruptcy law is federal law and subject to the review of federal appellate courts. (27) Bankruptcy appeals, however, have a unique process that, depending on the jurisdiction, may escalate via different paths. (28) For instance, decisions and orders issued by certain bankruptcy courts are generally appealed directly to their corresponding federal district courts. (29) As such, a decision by the United States Bankruptcy Court for the Southern District of New York is generally appealed to the United States District Court for the Southern District of New York. (30) However, the First, Sixth, Eighth, Ninth, and Tenth Circuits employ Bankruptcy Appellate Panels ("BAPs") to review bankruptcy court decisions. (31) Such panels are authorized under 28 U.S.C. [section] 158(b) and consist typically of three bankruptcy judges appointed by their respective circuit courts. (32) Bankruptcy appeals reviewed by the district court or BAPs may then be appealed up to the circuit courts and then to the United States Supreme Court, following the traditional path of federal appellate review. (33)

         A Chapter 11 bankruptcy petition contains itemized schedules of the distressed corporation's financial affairs. (34) This includes itemized schedules of the corporation's assets and liabilities. (35) Assets include tangible assets, as well as ownership interests, revenue contracts, and other non-trivial property that falls under the bankruptcy estate pursuant to 11 U.S.C. [section] 541. (36) Liabilities include any claims to money owed by the corporation to its creditors, which may be loans, bond payments, contractual obligations, lawsuit judgments, or government civil penalties. (37) This is where the relevant creditors to the bankruptcy petition become apparent, establishing a picture of the corporation's overall capital structure. (38) Here, the assets usable for the generation of funds toward the reorganization are set...