The Ninth Circuit Rules that 523(a)(19) of the Bankruptcy Code does not apply to innocent wrongdoers who are the recipients of ill-gotten gains through securities fraud. On September 19, 2011, the Ninth Circuit Court of Appeal issued an important closely watched opinion, styled Sherman v. SEC, _____ F.3d ______, (9th Cir. 2011), which held that that a certain relatively new provision of the bankruptcy code does not establish a basis to except a debt from a debtor’s bankruptcy discharge unless the debtor themselves were culpable for a violation of either the federal or state securities laws.
Therefore, according to the Ninth Circuit, which is the highest court to rule on this issue, and the highest federal appellate court for all the district and bankruptcy courts of the western United States, if an investor received funds from a Ponzi scheme and either a court appointed receiver or a bankruptcy trustee seeks to recover these funds through a clawback action for the benefit of the estate, the innocent investor can file for bankruptcy themselves and discharge this debt.
The issue in the Sherman case arose when an attorney and his wife filed for bankruptcy and the attorney sought to have a disgorgement order, relating to a securities violation by a non-debtor, be discharged. The debtor was alleged to be a wrong-doer as it related to the securities violations. The SEC sought to have the debt owed by the attorney be deemed non-dischargable. The bankruptcy court found that, unless the debtor was a wrong-doer themselves, the debt should be dischargeable. The SEC appealed to the district court that disagreed with the bankruptcy court, and the Ninth Circuit disagreed with the district court and reinstated the bankruptcy court’s position.
Although it may seem intuitive by its nature, prior to this ruling by the Ninth Circuit, most courts that interpreted 11 U.S.C. §523(a)(19), which is part of the Sarbanes-Oxley Act based amendments of 2005, have held that the bankruptcy statute does not specifically state that it should be limited to only the wrongdoers involved in the securities violations, and therefore it did establish a basis to seek to recover these funds from an innocent investor that needs to file for bankruptcy to rid himself of this problem. In fact, the district court’s opinion adopted a broad interpretation of § 523(a)(19) and held reading any limitation into the statute would “frustrate the ability of the SEC to enforce the federal securities laws.”
Moreover, the Ninth Circuit was not unanimous in its opinion, found that the “question was a close one,” and it need not be followed by other federal courts outside of the Ninth Circuit. However, the opinion has an extensive analysis that was done by the Ninth Circuit looking to both the debtor’s arguments and the SEC’s arguments, as well as an analysis of the Congressional intent in passing the Sarbanes-Oxley amendments, and the basic bankruptcy principals set forth by the United States Supreme Court as it relates to the fresh start objective to the honest debtor.
This opinion is of significant importance because with all the Ponzi schemes that have surfaced over the last several years, investors all across the country are hard pressed to find viable defenses to the claims raised by court appointed receivers and bankruptcy trustees trying to recover false profits paid to innocent investors. These investors, often called “net winners”, some of which no longer have these alleged false profits, have had their backs to the wall without having the ability to have a fresh start through a bankruptcy filing.
Now, investors in the Ninth Circuit have the option of filing bankruptcy and discharging a claim brought by a court appointed receiver or a bankruptcy trustee, that was based upon false profits paid from investing in a Ponzi scheme. As for the cases that are pending outside of the Ninth Circuit, it is not clear if these courts will follow the Ninth Circuit’s rationale. Regardless, with this area of law in a state of flux, the innocent investor that is nearly wiped out as a result of the clawback claims can at least consider filing bankruptcy as an option and may use this threat as a tool to try to negotiate a settlement to avoid having to file bankruptcy.
Eric N. Assouline, Esq. is a senior litigation partner at the Assouline & Berlowe business law firm and he practices primarily in the areas of Business and Bankruptcy Litigation. The firm has offices in Miami, Ft.Lauderdale, and Boca Raton, Florida.
ERIC N. ASSOULINE, ESQ.
Commercial Litigation, Intellectual Property, Creditors’ Rights and Bankruptcy, Real Estate, and Corporate Law