Discovery Sanctions Imposed in Disciplinary Matter Dischargeable in Bankruptcy

Section 523(a)(7) excepts from bankruptcy discharge a debt “to the extent such debt is for a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit, and is not compensation for actual pecuniary loss.”[1] The law is clear that restitution payments constitute debts excepted from discharge under Section 523(a)(7).[2] Indeed, the Supreme Court has held that a restitution obligation imposed in a criminal proceeding is not subject to discharge in a chapter 7 proceeding.[3] In Kelly v. Robinson, the Supreme Court found that, because the “criminal justice system is not operated primarily for the benefit of victims, but for the benefit of society as a whole,” restitution is not actually for the benefit of the victim but is in the nature of a fine, like any other fine that is excepted from discharge.[4] The Supreme Court explained:

Because criminal proceedings focus on the State’s interests in rehabilitation and punishment, rather than the victim’s desire for compensation . . . restitution orders imposed in such proceedings operate ‘for the benefit of’ the State. Similarly, they are not assessed ‘for . . . compensation’ of the victim. The sentence following a criminal conviction necessarily considers the penal and rehabilitative interests of the State. Those interests are sufficient to place restitution orders within the meaning of § 523(a)(7).[5]

The Supreme Court concluded, “Section 523(a)(7) preserves from discharge any condition a state criminal court imposes as part of a criminal sentence.”[6] Other courts have confirmed this is the case, regardless of the recipient of the restitution payments.[7] Thus, the law is clear that state restitution payments constitute debts excepted from discharge under section 523(a)(7).

What about costs and discovery sanctions that must be paid as a condition to reinstate a state license? The Ninth Circuit recently considered the issue in In re Albert-Sheridan.[8] The debtor, Albert-Sheridan, was an attorney in California. The State Bar of California filed charges against her for failing to cooperate with State Bar investigations, failing to comply with court orders and other failings. As a condition to reinstate her license, the State Bar ordered her to pay unpaid discovery sanctions and costs related to the disciplinary action to the State Bar. Rather than pay the amounts due, she filed for chapter 13 relief.

The debtor’s case was soon converted to chapter 7, and she filed an adversary proceeding seeking, in part, a determination that the sanctions and costs were dischargeable. The State Bar filed a motion to dismiss, which the bankruptcy court granted. The bankruptcy court found both the discovery sanctions and the costs to the State Bar were nondischargeable pursuant to Section 523(a)(7). The debtor appealed. The Bankruptcy Appellate Panel affirmed.[9]

The debtor again appealed. The Ninth Circuit disagreed with the BAP that the two fees were nondischargeable.[10] It held that, while the costs of the disciplinary proceedings were nondischargeable, the discovery sanctions could be discharged.

The Ninth Circuit explained that Section 523(a)(7) expressly requires three elements for a debt to be nondischargeable. The debt must: (1) be a fine, penalty, or forfeiture; (2) be payable to and for the benefit of a governmental unit; and (3) not constitute compensation for actual pecuniary costs.[11] The Ninth Circuit found the discovery sanctions plainly did not satisfy the last two of these elements and, thus, were not excepted from discharge.[12]

The Court noted the debtor was ordered to pay the discovery sanctions to “Plaintiff 10675 S. Orange Park Boulevard, LLC.” Orange Park Boulevard is not a governmental unit, and the sanction was not for the benefit of a governmental unit. Accordingly, the discovery sanctions were not payable to or for the benefit of a governmental unit.[13] The Court concluded that, under the plain text of Section 523(a)(7), the discovery sanctions were not the type of debt protected from discharge, and it reversed the BAP’s finding that the debtor’s discovery sanctions were nondischargeable under chapter 7.[14]

The Ninth Circuit noted, though, that the California Supreme Court had ordered that the debtor could have alternatively paid the discovery sanctions to a client security fund. Some courts have considered reimbursements to such funds to be payable to the government. The Court did not consider the issue, though, since no funds had been disbursed from the fund in Albert-Sheridan’s case.[15] Thus, whether a debt based on a payment to a client security fund is nondischargeable may be up for debate in other cases.

Following Albert-Sheridan, an attorney stuck with discovery sanctions may find some relief in bankruptcy court, but she will still be on the hook for costs. Hopefully this is not something our Committee members, as competent and capable counsel, will need to worry about!