A Collision of Fairness Sarbanes-Oxley and 510(b) of the Bankruptcy Code

Journal Issue

Oct 2005

Column Name

Affairs of State

Citation

ABI Journal, Vol. XXIV, No. 8, p. 8, October 2005

Bankruptcy Code

510

726

Topic Tags

Fraud

Legislation

SEC Issues

Journal HTML Content

In response to a slew of instances of
unprecedented and highly publicized corporate fraud, President Bush
signed the Sarbanes-Oxley Act on July 31, 2002.<a href="#1" name="1a">1</a> Sarbanes-Oxley effected significant
changes to corporate governance, including new rules to ensure auditor
independence, to enhance corporate responsibility and the requirements
for financial disclosures, and to provide the Securities and Exchange
Commission (SEC) with new regulatory powers to protect
investors.<a href="#2" name="2a">2</a> Section
308 of Sarbanes-Oxley, the "Fair Funds for Investors" provision, grants
the SEC the discretion to seek to direct monies collected as civil
penalties for violations of securities laws to a "disgorgement fund for
the benefit of victims."<a href="#3" name="3a">3</a> The "victims" of securities laws
violations are commonly stockholders.

The stockholder of an entity subject to both the Bankruptcy Code and
Sarbanes-Oxley is thus potentially at the intersection of conflicting
statutory schemes. An investor whose claims must be subordinated
pursuant to §510(b) of the Code may also be qualified for a
distribution pursuant to the Fair Funds for Investors provision of
Sarbanes-Oxley. When a "disgorgement fund" under Sarbanes-Oxley is to be
created from the limited resources of a bankruptcy estate, a stockholder
claimant may receive a distribution, albeit indirectly from the SEC, to
the direct detriment of unsecured creditors and in potential
contravention of provisions of the Code, including §510(b) and the
"absolute priority rule."<a href="#4" name="4a">4</a>

<h4>Section 510(b) of the Code</h4>

Tension between the expectations and rights of wronged shareholders
and those of unsecured creditors is not new. Under the former Bankruptcy
Act, after Oppenheimer v. Harriman Nat'l. Bank & Trust Co.,
301 U.S. 206, 215, 57 S.Ct. 719, 81 L.Ed. 1042 (1937), courts tended to
favor equal treatment for the claims of defrauded shareholders and
general unsecured creditors.<a href="#5" name="5a">5</a> Critics of the trend argued that parity of
treatment for claims of creditors and interest-holders was inequitable,
primarily because only shareholders may participate in the "upside" of a
successful endeavor.<a href="#6" name="6a">6</a> Moreover, creditors may extend credit to
an entity in reliance, at least in part, upon the perception of an
equity "cushion" provided by an entity's investors. When a business
fails and creditor claims are treated equally with those of investors,
the cushion is unfairly diluted.

The era of defrauded shareholder/unsecured creditor distributive
equality ended with the enactment of the Code and its §510(b),
which provides that claims "arising" from the sale or purchase of a
security of the debtor must be subordinated—the provision is
mandatory.<a href="#7" name="7a">7</a> The
prevailing view is that the statute should be applied both strictly and
broadly, in light of the apparent "strong congressional disapproval of
investor fraud claims in bankruptcy."<a href="#8" name="8a">8</a> Thus, claims based on failure to register
stock, breach of an employment agreement with payment in stock and
simple breach of contract have all been found sufficiently connected to
transactions involving a debtor's securities to trigger mandatory
subordination under §510(b).<a href="#9" name="9a">9</a>

<h4>The "Fair Funds for Investors" Provision of Sarbanes-Oxley</h4>

In addition to the SEC's comprehensive regulatory and enforcement
powers, federal courts have recognized the SEC's authority to fashion
equitable remedies, including disgorgement orders that require the
surrender of funds obtained through actions taken in violation of
securities laws.<a href="#10" name="10a">10</a> Disgorgement is limited to a violator's
profits, plus interest.<a href="#11" name="11a">11</a> Case law and SEC policy has developed
such that district courts have discretion to order that disgorged funds
be funneled into a restitution plan for defrauded
investors.<a href="#12" name="12a">12</a>

Otherwise, the funds may simply be paid into the U.S.
Treasury.<a href="#13" name="13a">13</a> The
primary goal of disgorgement is deterrence, and although disgorged funds
may go to the victims of securities laws violations, "such compensation
is a distinctly secondary goal."<a href="#14" name="14a">14</a>

The SEC also has statutory authority to impose civil penalties upon
violators.<a href="#15" name="15a">15</a>
Penalties may be assessed to correspond to a defendant's culpability,
and in more egregious cases are limited only by "the gross amount of
pecuniary gain to such defendant as a result of the
violation."<a href="#16" name="16a">16</a>
Unlike disgorgement, prior to Sarbanes-Oxley, funds recovered pursuant
to civil penalties imposed in an SEC action (or settlement) could not be
distributed to investors, but were paid into the U.S.
Treasury.<a href="#17" name="17a">17</a> The
SEC may seek disgorgement and the imposition of civil penalties in the
same action.<a href="#18" name="18a">18</a>

Under the Fair Funds for Investors provision of Sarbanes-Oxley, in
SEC actions where a disgorgement fund for investors is established, the
SEC may now seek court authority to add monies to the fund recovered
pursuant to civil penalties.<a href="#19" name="19a">19</a> The SEC has aggressively implemented the
Fair Funds for Investors provision.<a href="#20" name="20a">20</a> In the majority of cases thus far, it
appears that bankruptcy has not been an issue. When a Fair Funds for
Investors program is established or administered concurrently with a
case subject to the Code, however, the discord between the statutory
mechanisms is apparent.

<h4>WorldCom and Adelphia</h4>

As noted above, in most cases the claims of interest-holders are at
the lower, or lowest, end of the distributive priority spectrum
established by the Code, either pursuant to the absolute priority rule
or by operation of §510(b). Moreover, in a chapter 7 case,
§726(a)(4) of the Code provides that distributions of estate
property for allowed claims based on fines or penalties that are "not
compensation for actual pecuniary loss" hold a lower distributive
priority vis-à-vis allowed general unsecured
claims.<a href="#21" name="21a">21</a> Thus,
if the SEC is able to fund a Fair Fund for Investors program with civil
penalties imposed upon a bankruptcy estate for the benefit of
interest-holders, such action could also run afoul of §726(a)(4),
depending on whether an SEC penalty is characterized as "compensation
for actual pecuniary loss."<a href="#22" name="22a">22</a> Section 726(a)(4) is operative in the
chapter 11 context, as a plan may not be approved over the objection of
an impaired class of claims or interests if the proposed plan's
distribution for that class would be less than the class would receive
under chapter 7.<a href="#23" name="23a">23</a>

These issues were at play in the WorldCom Inc. case and, more
recently, in the Adelphia Communications Corp.
case.<a href="#24" name="24a">24</a> Both
WorldCom and Adelphia filed chapter 11 cases in the
Southern District of New York. In both cases, the SEC asserted claims
against the estates implicating the Fair Funds for Investors provision
of Sarbanes-Oxley—claims large enough, if allowed, to potentially
force a liquidation. Also in both cases, the bankruptcy courts approved
settlements with the SEC that will likely result in distributions to
defrauded shareholders from estate assets. Rather than attempt to
resolve the apparent conflicts between Sarbanes-Oxley and the Code, the
bankruptcy courts in WorldCom and Adelphia invoked their
settlement authority under Federal Rule of Bankruptcy 9019, and
identified the uncertainties associated with the conflicting statutory
schemes as reasons to support the proposed settlements.

On June 26, 2002, the SEC commenced a civil action in the U.S.
District Court for the Southern District of New York against WorldCom
alleging massive accounting fraud.<a href="#25" name="25a">25</a> On July 21, 2002, WorldCom filed for
chapter 11 protection. The SEC action progressed concurrently with the
bankruptcy case. The SEC gained an injunction against WorldCom and
proposed a settlement agreement whereby the SEC would impose a $2.25
billion civil penalty, which could be satisfied by a $750 million
payment from the bankruptcy estate—a $500 million cash payment and
$250 million in the reorganized company's common stock.<a href="#26" name="26a">26</a> The settlement provided that
the settlement assets would be directed to defrauded shareholders
pursuant to the Fair Funds for Investors provision of Sarbanes-Oxley.

The district court hearing the SEC action approved the settlement on
July 7, 2003. In a written opinion and order approving the settlement,
Judge Rakoff took care to note that the SEC had authority to seek a
civil penalty for the full value derived from WorldCom's
fraud—estimated at between $10 billion and $17 billion—and
that a penalty of that magnitude would necessarily "kill the company" to
the detriment of some 50,000 innocent employees.<a href="#27" name="27a">27</a> Judge Rakoff recognized the
potential conflict between the Fair Funds for Investors provision of
Sarbanes-Oxley and the Code, and stated that any civil penalty imposed
by the SEC "premised primarily" on compensating defrauded shareholders
"might arguably run afoul of the provisions of the Code that subordinate
shareholder claims below all others."<a href="#28" name="28a">28</a> Judge Rakoff wrote that the SEC could
"give" the civil penalty to shareholders pursuant to Sarbanes-Oxley, and
that the SEC could consider shareholder compensation in determining a
proper penalty, but also that these factors could not dominate the SEC's
motivations without contravening provisions of the Code and the SEC's
own mandates regarding compensation of victims as a secondary
goal.<a href="#29" name="29a">29</a>

In the bankruptcy case, upon World-Com's motion to approve the
settlement with the SEC pursuant to Federal Rule of Bankruptcy Procedure
9019, Bankruptcy Judge Arthur J. Gonzalez noted the apparent
conflict between Sarbanes-Oxley and the Code, but stated that "[i]n
considering approval of a settlement, the court is not required to
resolve the underlying legal issues related to the
settlement."<a href="#30" name="30a">30</a>
Citing the support for the settlement announced by the committee in the
case, the possibility of an even greater penalty if the matter proceeded
to a litigated judgment, and the uncertainty of the law with respect to
the priority issues, the bankruptcy court found that the settlement did
not "fall below the lowest point in the range of reasonableness." On
Aug. 6, 2003, the bankruptcy court approved the SEC's settlement with
WorldCom.

In the Adelphia case, the Department of Justice (DOJ)
indicated a willingness to bring criminal charges against Adelphia, and
the SEC asserted claims against the debtors based on fraud and
accounting irregularities.<a href="#31" name="31a">31</a> The SEC claims were for disgorgement of
profits and for civil penalties for the "gross pecuniary gain" during
the period of asserted fraudulent activity—potentially in excess of
$10 billion combined. The committee commenced an adversary proceeding in
the bankruptcy case against the SEC seeking the subordination of any SEC
claims pursuant to §510(b).

In May 2005, the bankruptcy court considered a comprehensive
settlement proposal intended to resolve the claims, as well as potential
criminal actions, involving the debtors, DOJ, SEC and members of the
family of John Rigas, Adelphia's founder and former CEO.<a href="#32" name="32a">32</a> The proposal, among other
things, provided that Adelphia must contribute $715 million in value to
a "restitution fund" to be administered by the government. In exchange,
upon the establishment of the restitution fund, the DOJ agreed that it
would not institute a criminal action against Adelphia, and the SEC
would drop its claims for disgorgement and for the imposition of civil
penalties.

Several parties, including the committee, objected to the settlement
proposal based on the "likelihood" that proceeds from the restitution
fund would go to Adelphia's equity security-holders, in violation of the
absolute priority rule and §§510(b) and 726(a)(4) of the Code.
Bankruptcy Judge Robert E. Gerber, in a written opinion, stated:
"I assume that the government will indeed distribute the value as the
unsecured creditors fear."<a href="#33" name="33a">33</a> Judge Gerber noted, however, that the
settlement proposal was presented pursuant to Federal Rule of Bankruptcy
Procedure 9019 and not pursuant to a proposed plan or claim objection;
"while defrauded equity-holders will plainly have to confront the
Absolute Priority Rule and §510(b) when trying to share in assets
of the estate in this court, what I am asked to approve here is
twice removed from that scenario."<a href="#34" name="34a">34</a>

Judge Gerber cited the example of Judge Gonzalez's opinion in
WorldCom. Recognizing the issue of the status and potential
subordination of SEC claims as a "close and difficult one," Judge Gerber
declined to opine on how the matter would be resolved in litigation.
Considering all the points implicated in the proposed settlement,
including the preclusion of a potentially company-killing criminal
action against Adelphia by the DOJ, Judge Gerber approved the proposed
settlement.

While the Adelphia settlement did not ultimately channel
estate funds into a Fair Funds for Investors fund pursuant to
Sarbanes-Oxley, the probability that the SEC would attempt to do so in
the absence of a settlement was among the primary considerations cited
by Judge Gerber in his approval of the settlement and its restitution
fund.

<h4>Conclusion</h4>

More than $5.5 billion in penalties have been designated by the SEC
for the Fair Funds for Investors program.<a href="#35" name="35a">35</a> Although Sarbanes-Oxley has entered its
third year of existence, significant distributions have only just begun.
Tangible distributions from "disgorgement funds" under Sarbanes-Oxley
are likely to increase pressure on the SEC to continue and broaden such
programs, especially in instances where an intervening bankruptcy would
otherwise leave interest-holders with no avenue for recovery. Thus far,
the courts have recognized, but not resolved, the dissonances between
Sarbanes-Oxley and the Code.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Sarbanes-Oxley Act of
2002, Pub. L. No. 107-204, 116 Stat. 745 (codified as amended in
sections of Titles 11, 15, 18, 28 and 29 U.S.C. (2002)). <a href="#1a">Return to article</a>

<a name="2">2</a> For a comprehensive
overview of Sarbanes-Oxley, see Egan, Byron, "The Sarbanes-Oxley
Act and Its Expanding Reach," 40 Tex. J. Bus. L. 305 (2005). <a href="#2a">Return to article</a>

<a name="3">3</a> Sarbanes-Oxley
§308(a), "Civil Penalties Added to Disgorgement Funds for the
Relief of Victims" provides:

<blockquote>
If in any judicial or administrative action brought by the Commission
under the securities laws (as such term is defined in §3(a)(47) of
the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(47)) the
Commission obtains an order requiring disgorgement against any person
for a violation of such laws or the rules or regulations thereunder, or
such person agrees in settlement of any such action to such
disgorgement, and the Commission also obtains pursuant to such laws a
civil penalty against such person, the amount of such civil penalty
shall, on the motion or at the direction of the Commission, be added to
and become part of the disgorgement fund for the benefit of the victims
of such violation. <a href="#3a">Return to article</a>

</blockquote>

<a name="4">4</a> The "absolute priority
rule" requires that under a chapter 11 plan, no junior class of
creditors or interest-holders may retain or receive any value until all
senior dissenting classes of unsecured creditors or interest-holders are
paid in full. See, e.g., In re Tucson Self-Storage Inc., 166 B.R.
892, 899 (9th Cir. BAP 1994) (applying Code §1129(b)(2)(B)(ii)). <a href="#4a">Return to article</a>

<a name="5">5</a> See In re Geneva Steel
Co., 281 F.3d 1173, 1176 (10th Cir. 2002) (discussing
Oppenheimer and its consequences). <a href="#5a">Return to
article</a>

<a name="6">6</a> Id. at 1176-77
(discussing the positions stated in Slain, John and Kripke, Homer, "The
Interface Between Securities Regulation and Bankruptcy-allocating the
Risk of Illegal Securities Issuance Between Security-holders and the
Issuer's Creditors," 48 N.Y.U. L. Rev. 261 (1973)). <a href="#6a">Return
to article</a>

7 Section 510(b) provides:

<blockquote>
For the purpose of distribution under this title, a claim arising from
rescission of a purchase or sale of a security of the debtor or of an
affiliate of the debtor, for damages arising from the purchase or sale
of such a security or for reimbursement or contribution allowed under
§502 on account of such a claim, shall be subordinated to all
claims or interests that are senior to or equal the claim or interest
represented by such security, except that if such security is common
stock, such claim has the same priority as common stock.
<a href="#7a">Return to article</a> </blockquote>

<a name="8">8</a> Geneva Steel Co.,
281 F.3d at 1179. <a href="#8a">Return to article</a>

<a name="9">9</a> See In re Telegroup
Inc., 281 F.3d 133, 144 (3d Cir. 2001) (breach of agreement to
register stock); In re Worldwide Direct Inc., 268 B.R. 69, 73
(Bankr. D. Del. 2001) (breach of employment agreement with payment in
stock); In re Betacom of Phoenix Inc., 240 F.3d 823, 832 (9th
Cir. 2001) (breach of contract). <a href="#9a">Return to article</a>

<a name="10">10</a> See, e.g., S.E.C. v.
Patel, 61 F.3d 137, 139 (2d Cir. 1995) ("In the exercise of its
equity powers, a district court may order the disgorgement of profits
acquired through securities fraud"). <a href="#10a">Return to
article</a>

<a name="11">11</a> See, e.g., S.E.C. v.
Blatt, 583 F.2d 1325, 1335 (5th Cir. 1978) (disgorgement limited to
amount "by which the defendant profited from his wrongdoing. Any further
sum would constitute a penalty assessment"). <a href="#11a">Return to
article</a>

<a name="12">12</a> See, e.g., S.E.C. v.
Fischbach Corp., 133 F.3d 170, 175 (2d Cir. 1997). <a href="#12a">Return to article</a>

<a name="13">13</a> See, e.g., S.E.C. v.
Lorin, 869 F. Supp. 1117, 1129 (S.D.N.Y. 1994) ("disgorged profits
can very well end up in the U.S. Treasury...where numerous victims
suffered relatively small amounts thereby making distribution of the
disgorged profits to them impractical"). <a href="#13a">Return to
article</a>

<a name="14">14</a> Fischback Corp.,

133 F.3d at 175. <a href="#14a">Return to article</a>

<a name="15">15</a> See 15 U.S.C.
§77t(d) (2002). <a href="#15a">Return to article</a>

<a name="16">16</a> Id. <a href="#16a">Return to article</a>

<a name="17">17</a> See "Report
Pursuant to §308(c) of the Sarbanes Oxley Act of 2002," at 5: <a href="http://www.sec.gov/news/studies/sox308creport.pdf">http://www.sec.gov/n…;
(last visited Aug. 29, 2005). <a href="#17a">Return to article</a>

<a name="18">18</a> See, e.g., S.E.C. v.
Phoenix Telecom LLC, 231 F.Supp.2d 1223, 1225-26 (N.D. Ga. 2001). <a href="#18a">Return to article</a>

<a name="19">19</a> See supra note
3. <a href="#19a">Return to article</a>

<a name="20">20</a> See Solomon,
Deborah, "For Wronged Investors, It's Payback Time," Wall St. J. July 7,
2005, at D1. <a href="#20a">Return to article</a>

<a name="21">21</a> See 11 U.S.C.
§726(a)(4). <a href="#21a">Return to article</a>

<a name="22">22</a> If an SEC claim based
on a civil penalty is determined to be "compensation for actual
pecuniary loss," it would presumably be entitled to a distribution on
par with allowed general unsecured claims, and thus still in potential
conflict with §510(b) of the Code. <a href="#22a">Return to
article</a>

<a name="23">23</a> See 11 U.S.C.
§1129(a)(7)(A)(ii). <a href="#23a">Return to article</a>

<a name="24">24</a> See In re WorldCom
Inc., Ch. 11 Case No. 02-13533 (Bankr. S.D.N.Y. July 21, 2002
(petition date)); In re Adelphia Communications Corp., Chapter 11
Case No. 02-41729 (Bankr. S.D.N.Y. June 25, 2002 (petition date)). <a href="#24a">Return to article</a>

<a name="25">25</a> See S.E.C. v.
WorldCom Inc., Litigation Release No. 17588 (Civil Action 02 CV 4963
(S.D.N.Y.) (June 27, 2002)), available at <a href="http://www.sec.gov/litigation/litreleases/lr17588.htm">http://www.sec.g…;

(last visited Aug. 29, 2005). <a href="#25a">Return to article</a>

<a name="26">26</a> See S.E.C. v.
WorldCom Inc., 273 F.Supp.2d 431, 435 (S.D.N.Y. 2003). <a href="#26a">Return to article</a>

<a name="27">27</a> Id. at 433-34.

<a href="#27a">Return to article</a>

<a name="28">28</a> Id. at 434. <a href="#28a">Return to article</a>

<a name="29">29</a> Id. (citing
Fischback, 133 F.3d at 175). <a href="#29a">Return to article</a>

<a name="30">30</a> In re WorldCom
Inc., Ch. 11 Case No. 02-13533, Docket #8125 (Bankr. S.D.N.Y. Aug.
6, 2003). <a href="#30a">Return to article</a>

<a name="31">31</a> In re Adelphia
Communications Corp., 327 B.R. 143, 149 (Bankr. S.D.N.Y. 2005). <a href="#31a">Return to article</a>

<a name="32">32</a> Id. at 147 (The
potential criminal actions were against the debtor corporation. John and
Timothy Rigas were convicted of several criminal charges following a
jury trial in the district court). <a href="#32a">Return to article</a>

<a name="33">33</a> Id. at 168. <a href="#33a">Return to article</a>

<a name="34">34</a> Id. at 169
(emphasis in original). <a href="#34a">Return to article</a>

<a name="35">35</a> See supra note
20. <a href="#35a">Return to article</a>

Journal Authors

Marvin E. Sprouse

Journal Date

Saturday, October 1, 2005 - 12:00