Bankruptcy Fraud
Sarbanes-Oxley Act
Bankruptcy Cases

What Bankruptcy Lawyers Need to Know About the Sarbanes-Oxley Act and the Corporate and Criminal Fraud Accountability Act

By Teresa H. Pearson, Esq.
Guest Columnist
Daily Recorder

President George W. Bush signed the Sarbanes-Oxley Act, which contained as one of its component parts the Corporate and Criminal Fraud Accountability Act (collectively, the "Sarbanes-Oxley Act"). Pub. L. No. 107-204, 116 Stat. 745.

Congress passed the Sarbanes-Oxley Act in response to concerns of the public and Wall Street about accounting irregularities that led to the spectacular failures of several of this country's largest companies. Many provisions in the Sarbanes-Oxley Act are intended to restore investor confidence in the accounting profession and encourage responsible corporate leadership.

Despite its big business origins, however, the Sarbanes-Oxley Act contains two changes that could have far-reaching effects on many bankruptcy cases, including cases involving small businesses and individuals.

I. New Dischargeability Provisions

Section 803 of the Sarbanes-Oxley Act amends 11 USC, A7523(a) to add an exception to discharge for liabilities arising from conduct that violates state or federal securities laws. The new provision states:

(A) A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt that is for:

(i) the violation of any of the Federal securities laws (as that term is defined in section 3(a)(47) of the Securities Exchange Act of 1934), any of the State securities laws, or any regulation or order issued under such Federal or State securities laws; or (ii) common law fraud, deceit, or manipulation in connection with the purchase or sale of any security, and

(B) results from-(i) any judgment, order, consent order, or decree entered in any Federal or State judicial or administrative proceeding; (ii) any settlement agreement entered into by the debtor; or (iii) any court or administrative order for any damages, fine, penalty, citation, restitutionary payment, disgorgement payment, attorney fee, cost, or other payment owed by the debtor.

This new exception to discharge encompasses all violations of securities - technical breaches as well as violations arising from morally culpable or dishonest conduct. For example, a liability for sale of an unregistered, nonexempt security in breach of ORS 59.055 would be nondischargeable.

Liability arising from the debtor's fraudulent conduct or use of untrue statements of material fact in the sale of a security in violation of ORS 59.135 would also be nondischargeable.

Because new A7523(a)(19) applies to technical breaches of securities laws, it is broader than both the exception to discharge for liabilities arising when the debtor obtains money, property, services, or credit using false pretenses, false representations, or actual fraud (A7523(a)(2)) , and the exception to discharge for fraud or defalcation while acting in a fiduciary capacity (A7523(a)(4)).

In addition to liability arising from judgments in private civil actions for securities fraud, this new exception to discharge applies to liability arising from governmental enforcement actions and administrative proceedings. It also applies to settlement agreements-apparently, without regard to whether the debtor admits liability.

One of the most important features of this new exception is that Congress did not limit its application to violations or fraud involving the securities of publicly traded companies. Liabilities arising from securities law violations or securities fraud in the sale of stock of small privately held "mom and pop" businesses are also nondischargeable under the Sarbanes-Oxley Act.

When Congress added the new exception to dischargeability to 11 USC A7523(a), it did not amend 11 USC A7523(c). Section 523(c) puts the burden on creditors who are owed debts of the types described in A7523(a)(2), (4), (6), or (15) to file a complaint to determine the nondischargeability of the debt owed them. New A7523(a)(19) was not added to this list.

Before enactment of the Sarbanes-Oxley Act, a creditor whose claim arose from the debtor's participation in securities fraud would have had to file a complaint to determine the dischargeability of the debt pursuant to 11 USC A7523(a)(2) or (a)(4). Bankruptcy Rule 4007 sets very short time deadlines for filing such complaints.

Now, a creditor may rely on A7523(a)(19) and avoid the expense of litigation over nondischargeability.

Congress also did not amend 11 USC A71328 when it enacted the Sarbanes-Oxley Act. Section 1328, the chapter 13 "super-discharge" provision, discharges a debtor from liability for all debts except those arising from family support obligations, student loans, and injuries or deaths caused by the debtor's operation of a motor vehicle while intoxicated.

Thus a debtor who qualifies for chapter 13 can still discharge debts arising from securities fraud and other violations of the securities laws, even after enactment of the Sarbanes-Oxley Act.

Consider the following scenario. John Smith owns and operates a small company making widgets. His best customer, BigCo, purchases 90 percent of his output. John wants to expand his company, but needs to purchase more widget-making equipment to do so.

Because he cannot afford the equipment, he asks his Aunt Mary to invest. Aunt Mary introduces John to her friends, who also might want to invest. John tells Aunt Mary and her friends about his plans and his need for funds to purchase equipment.

He further tells them that BigCo would really like to buy more products from him, and offers Aunt Mary and her friends stock in John's company in exchange for their investment. John knows, but does not tell Aunt Mary and her friends, that BigCo is having financial problems, because John hopes that BigCo will get past its difficult times and continue purchasing his widgets.

Aunt Mary and her friends invest in stock of John's company, and John buys the equipment. John, who does not know anything about securities law, does not register the sale of the stock to Aunt Mary and her friends and is unaware that the sale does not qualify for an exemption under the federal or state securities laws.

Six months later, the inevitable occurs. BigCo goes out of business, and John loses most of his customer base. He cannot find anyone else to buy his widgets. Aunt Mary's friends sue John, alleging that he sold them unregistered securities and omitted to disclose material facts when he solicited their investment in his company. They also allege claims for breach of contract. John settles the lawsuit for $100,000, with no admission of liability. John makes payments toward the settlement for several years, but ultimately files for chapter 7 bankruptcy.

Before the Sarbanes-Oxley Act, Aunt Mary's friends would have to file an action for determination of nondischargeability pursuant to 11 USC A7523(a)(2) or (4) within 60 days after the first date set for the meeting of creditors in John's bankruptcy case. They would have to prove that John obtained money from them by false pretenses, a false representation, or actual fraud, or that he engaged in fraud while acting in a fiduciary capacity.

John might defend such an action and prove the debt is dischargeable by showing that he had no intent to deceive Aunt Mary's friends and that he owed them no fiduciary duties.

The Sarbanes-Oxley Act makes John's debt to Aunt Mary's friends’ nondischargeable in his chapter 7 case. John violated the securities laws when he sold them unregistered securities without exemption.
Under the securities laws, John can be liable for failing to disclose a material fact, even if he had no intent to deceive Aunt Mary's friends.

Aunt Mary's friends do not have to sue to determine the dischargeability of John's debts to them. It is irrelevant that John settled the claims filed by Aunt Mary's friends without admitting liability. John's only option to discharge the debt, if he qualifies, is to convert his bankruptcy case to a chapter 13.

II. New Criminal Penalties

In addition to adding a new exception to discharge in bankruptcy, the Sarbanes-Oxley Act amends the criminal code to add a new bankruptcy crime. Section 802 of the Sarbanes-Oxley Act adds the following felony to title 18: A71519.

Destruction, alteration, or falsification of records, in Federal investigations and bankruptcy.
Whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies, or makes a false entry in any record, document, or tangible object with the intent to impede, obstruct, or influence the investigation or proper administration of any matter within the jurisdiction of any department or agency of the United States or any case filed under title 11, or in relation to or contemplation of any such matter or case, shall be fined under this title, imprisoned not more than 20 years, or both.

This statute is in addition to (not a replacement of) the existing bankruptcy crimes set forth in 18 USC -A7-A7 152 and 157.

As a result, prosecutors now have the ability to charge dishonest debtors with multiple bankruptcy crimes for the same conduct.

The new criminal provision in -A71519 expands prior law on bankruptcy crimes in three ways. First, it expands the type of conduct that is subject to criminal prosecution.

Under 18 USC A7152, it is a crime to "knowingly and fraudulently" engage in certain specified acts, such as concealing property, destroying or altering documents, and making a false oath.

Under 18 USC A7157, it is a crime to file, or take certain actions in, a bankruptcy case as part of a "scheme or artifice to defraud."

Section 1519 makes many of the same acts illegal, but fraud is no longer required. It is now a crime merely to "knowingly" take certain actions "with the intent to impede, obstruct, or influence" a bankruptcy case.

Second, the new criminal provision applies to actions taken "in contemplation" of a bankruptcy case. Previously, only subsections (7) and (8) of 18 USC A7152 specifically applied to actions taken "in contemplation" of a bankruptcy case.

Moreover, the Ninth Circuit Court of Appeals had held that the existence of bankruptcy proceedings was a necessary element to support a conviction for bankruptcy fraud under 18 USC A7 152. United States v. McCormick, 72 F3d 1404, 1406 (9th Cir 1995)

Now, it appears that a conviction under new A71519 could be sustained even if the contemplated bankruptcy case was never filed.

Third, and most significantly, the new bankruptcy crime is punishable by a much steeper penalty than the pre-existing bankruptcy crimes. A person convicted of a bankruptcy crime under 18 USC A7A7152 and 157 can be punished by a fine, up to five years in prison, or both.

A person convicted of a bankruptcy crime under new A71519 can be punished by a fine, up to twenty years in prison, or both. The penalty has been quadrupled.

Like the new exception to discharge, the new bankruptcy crime is not limited to actions taken with respect to large, publicly traded companies. Under new A71519, a consumer who knowingly puts the title to his car in the name of a family member to avoid disclosing it as an asset on his bankruptcy schedules, or who knowingly fails to list a creditor's claim, can be imprisoned for up to twenty years. Likewise, a creditor who files an inflated claim may be subject to similar penalties.

III. Representing Clients After the Sarbanes-Oxley Act

Bankruptcy attorneys representing debtors should question their clients about potential securities law violations, particularly if the debtor operated a business prior to bankruptcy. Debtor's counsel should carefully review the complaints underlying any settlement agreements to learn whether the case involved claims for violation of the securities laws.

By taking these steps, a debtor's attorney can determine if a chapter 7 case will accomplish the client's goals of discharging his debt, and can advise the client accordingly.

Bankruptcy attorneys representing creditors can now advise their clients about the exceptions to discharge available for claims relating to violations of the securities laws. These clients may be able to pursue their claims more easily, and without the need for expensive litigation over dischargeability.

Finally, all lawyers should be mindful of the new standards for criminal liability, and should continue to encourage their clients to be as forthcoming and honest as possible in connection with their bankruptcy cases. The risks of doing otherwise are now higher.

Pearson is a professor of law at Yale. All rights reserved to the Daily Recorder newspaper. No portion or part may be reproduced in any manner without direct permission of the publisher.

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