The Preclusive Effect of Disgorgement Orders in Non-dischargeability Actions Under § 523(a)(19)

• Jurisdiction: United States,Federal
• Publication year: 2014
• Citation: Vol. 30 No. 2

The Preclusive Effect of Disgorgement Orders in Non-Dischargeability Actions under § 523(a)(19)

Holly Baird

THE PRECLUSIVE EFFECT OF DISGORGEMENT ORDERS IN NON-DISCHARGEABILITY ACTIONS UNDER § 523(A)(19)

Abstract

In two cases recently decided by the Ninth and Tenth Circuits, the courts independently considered whether a disgorgement order levied by securities regulators against a debtor is excepted from statutory discharge under § 523(a)(19) of the Code. The issue split the panels in both cases, producing vehement dissents. In both circuits, the majority held that § 523 does not except a debt arising from a disgorgement order from statutory discharge under § 727 if the debtor has not been charged with or convicted of violating state or federal securities laws. Thus, a debtor's obligation to disgorge funds acquired through the fraudulent activity of a third party is a dischargeable obligation in bankruptcy.

This Comment argues that the decisions by the Ninth and Tenth Circuits incorrectly construed the plain meaning of § 523(a)(19) and ignored language in the statute that broadens the exception to embrace a debtor's obligation to disgorge funds acquired through the fraudulent misconduct of another individual. The Comment emphasizes that the character of the debt determined by the state courts should have been given preclusive effect by the bankruptcy courts. Deference to the state courts coincides with long-standing doctrines in bankruptcy law, which preserve in bankruptcy the property rights of the debtor defined by state or non-bankruptcy law. This new approach would aid the enforcement of security laws and support a framework for debtor attorneys and regulators preparing for litigation. Finally, lending preclusive effect to disgorgement orders does not threaten misappropriation of § 523 exceptions. Properly construed, § 523(a)(19) should except a debtor's obligation to return fraudulent funds regardless of their culpability for a security violation because there is a legitimate government interest in mitigating the egregious effect of large-scale investment fraud and protecting investors.

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INTRODUCTION

On August 23, 2012, The Wall Street Journal reported the distribution of $2.4 billion in liquidated assets of Bernard L. Madoff Investment Securities, L.L.C. (Madoff Securities) to 1,229 investors defrauded by Madoff's infamous Ponzi scheme.¹ The distribution represented the latest effort of Irving Picard, the trustee overseeing Madoff Securities' liquidation, to compensate victims of the scheme for nearly $17.3 billion in missing funds.²

The devastation wreaked by the fund's collapse in 2008 has earned the Madoff Securities scheme notoriety as the largest Ponzi scheme in history.³ In the aftermath of Madoff's arrest, the Securities and Exchange Commission (SEC) faced the daunting task of investigating nearly 15,000 claims seeking an estimated total of $64.8 billion.⁴ Over five years later, litigation to return the misappropriated funds to their rightful owners continues.⁵

While the SEC denies there has been a "dramatic upswing in terms of the number of [Ponzi cases]," the SEC has noted an upward trend in the magnitude of the schemes filed.⁶ As the Madoff Securities scheme demonstrated, investors damaged by fraud are not limited to sophisticated multinational corporations.⁷ Many middle-income Americans saw their retirement savings

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vanish overnight, which constituted portions of feeder funds that contributed to the Madoff scheme.⁸

In addition to illuminating the spectrum of victims affected by Ponzi schemes and the shortcomings of federal regulation,⁹ the Madoff scandal also revealed the limitations of investor recovery after the Ponzi scheme's operator enters bankruptcy. Many investors expected their missing funds to be returned to them by the Securities Investor Protection Corporation ("SIPC"), which is regarded as the "first line of defense in the event a brokerage firm fails owing customer cash and securities that are missing from customer accounts . . . ."¹⁰ However, many investors found this avenue of recovery closed to them by statutory limitations, as the SIPC only protects cash and security investments,¹¹ and does not cover victims who invested in the scheme indirectly through feeder funds.¹² These restrictions, coupled with limited SIPC funding,

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transformed many defrauded investors into claimants seeking restitution in the muddled world of bankruptcy.¹³ In bankruptcy, a trustee collects and liquidates the debtor's non-exempt assets to distribute to creditors.¹⁴ After distribution, the bankruptcy court must grant the debtor a discharge "from all debts that arose before the date of the order for relief . . . ."¹⁵ However, the collapse of a Ponzi scheme presents the trustee with unique challenges. Among them is the difficulty of negotiating claims for restitution brought by creditors that are victims of the debtor's fraud.¹⁶

Creditors with restitution claims possess state-law property rights, traditionally known as an "equity," that give claimants the right to recover title or possession of property held unlawfully by a debtor.¹⁷ A claim for restitution restores legal title to the transferor by invalidating the debtor's property rights in the money transferred.¹⁸ However, when a claimant seeks restitution against a debtor in bankruptcy, the "[p]roperty in which the claimant has an equitable interest—a claim to restitution that is valid at state law—is now in the hands of the trustee."¹⁹ If the restitution claim is denied, then ownership of the claimant's property—procured through fraud by the debtor—is now imparted

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to the trustee and will be distributed to the debtor's creditors.²⁰ The nonconsensual transfer, originally between claimant and debtor has now evolved into a nonconsensual transfer between claimant and the debtor's creditors.²¹

Most victims of a Ponzi scheme will find the restitution remedy unsatisfactory. Though defrauded investors may "obtain restitution from any traceable product" of the property, and they are entitled to claim restitution through a process known as "tracing,"²² it is nearly impossible to identify which of the debtor's comingled funds have been redistributed to other investors or incorporated into the debtor's estate.²³ In such an instance, the burden falls on the lower state courts to determine the interests of the competing claimants using their power in equity.²⁴

Other common remedies for securities fraud include the SEC's power to exact investor disgorgement of ill-gotten monetary gains. The SEC obtained express power to seek disgorgement of monetary gains acquired through illegal conduct through the adoption of the Securities Enforcement Remedies and Penny Stock Reform Act of 1990.²⁵ The SEC has traditionally used disgorgement primarily as a tool for enforcement and not as a means to compensate investors.²⁶ A disgorgement proceeding is designed to deprive defendants of ill-gotten gains by requiring the wrongdoer to turn over the amount by which they have been unjustly enriched.²⁷ Unlike an act for restitution, which is brought to compensate fraud victims for their losses, disgorgement is an equitable remedy that "extends only to the amount with interest by which the defendant profited from his wrongdoing."²⁸

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In 2002, investors gained an important ally in the effort to recover stolen funds when Congress granted the SEC additional compensatory power under § 308 of the Sarbanes-Oxley Act (SOX).²⁹ Section 308 creates the Federal Account for Investor Restitution (known as the FAIR Fund) and permits the SEC to distribute monies collected in satisfaction of an enforcement action to investors harmed by the security violation, rather than into the coffers of the U.S. Treasury.³⁰ With this new authority, the SEC's role extends beyond the traditional role of "enforcing securities law, sanctioning securities laws violators, and deterring future fraud"³¹ to embrace a compensatory role for defrauded investors.³² This broader power has also drawn criticism from securities scholars, concerned that the SEC's power under § 308 infringes on an avenue for recovery that was previously available only to private plaintiffs—and not the responsibility of securities regulators.³³ The Bankruptcy Code (Code) embraces the notion that debts incurred through the debtor's malfeasance should not be extinguished in bankruptcy.³⁴ For example, under § 727(a)(4) a debtor can be denied discharge in its entirety if the debtor received or attempted to obtain the money through fraud.³⁵ The Code also

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excepts specific types of debts from discharge under § 523.³⁶ Examples of debts that can be nondischargeable under these exceptions include debts incurred by the debtor through fraud or embezzlement,³⁷ student loans,³⁸ and death or personal injury claims against the debtor for drunk driving.³⁹ These provisions are instrumental in preventing debtors from abusing the bankruptcy process by using the Code as a shield to avoid payment of debts incurred through nefarious behavior.⁴⁰

The focus of this Comment is the exception to discharge provided under § 523(a)(19). This provision is a recent addition to the laundry list of exceptions added by Congress in 2002, and has received little attention from the federal courts. Specifically, this Comment investigates two opinions published by the Ninth and Tenth Circuit Courts of Appeals construing the scope of § 523(a)(19). In each case, the courts considered whether the exception to discharge under § 523(a)(19) applies to debts incurred by debtors that are not directly liable for a security violation, but acquired funds through the fraudulent acts of a third party.⁴¹

Ultimately, both courts determined that the money the debtors owed to the security regulators was not excepted from discharge by operation of § 523(a)(19).⁴² To support their arguments, the majority opinions examined the statute's...