To bar discharge of a debt for violation of securities laws, Bankruptcy Judge Peter D. Russin of Fort Lauderdale, Fla., held that the debtor must have been a party in the lawsuit finding a violation of securities law.
As a result of the holding in Judge Russin’s April 29 opinion, a so-called net winner in a Ponzi scheme is not saddled automatically with a nondischargeable debt under Section 523(a)(19), although an elaboration of the facts might eventually render the debt nondischargeable under Section 523(a)(2)(A) for “actual fraud.”
Some of the questions left unanswered in Judge Russin’s case may be resolved when the Supreme Court rules on Bartenwerfer v. Buckley, 21-908 (Sup. Ct.), in the term to begin in October 2022. In Bartenwerfer, the Court will resolve a split of circuits and decide whether a debtor is saddled with a nondischargeable debt for a false representation or actual fraud under Section 523(a)(2)(A) based entirely on the fraud of someone else, such as a partner or an agent. More particularly, the question presented is:
May an individual be subject to liability for the fraud of another that is barred from discharge in bankruptcy under 11 U.S.C. § 523(a)(2)(A), by imputation, without any act, omission, intent or knowledge of her own?
To read ABI’s report on Bartenwerfer, click here.
The ‘Net Winner’
Several individuals ran a company from 2011 to 2012 that conducted a Ponzi scheme resulting in the losses of more than $700 million by defrauded investors. The fraud ended when the Securities and Exchange Commission filed suit and the perpetrators consented to an injunction. The district court appointed a receiver to recover fraudulent transfers.
The receiver brought fraudulent transfer actions alleging “actual fraud” against so-called net winners, meaning those who took out more cash than their principal investments. The receiver obtained a judgment in district court for some $75,000 against a net winner.
The net winner in the fraudulent transfer suit was not a party in the SEC’s injunction action, and the district judge did not attribute any fraudulent intent or conduct to the net winner who was saddled with the $75,000 judgment.
The net winner filed a chapter 7 petition, and the holder of the receiver’s judgment filed a complaint in bankruptcy court to declare that the judgment was nondischargeable. The complaint had two theories.
Under Section 523(a)(19), the creditor contended that the debt was nondischargeable as a judgment for violation of securities laws. Under Section 523(a)(2)(A), the creditor claimed that the judgment was a nondischargeable debt for money obtained by actual fraud. Judge Russin dealt with the claims separately.
Securities Law Nondischargeability
Section 523(a)(19) says that a debt is nondischargeable if it was for “the violation of any of the Federal securities laws . . . , any of the State securities laws, or any regulation or order issued under such Federal or State securities laws.”
The judgment creditor had a seemingly good case under Section 523(a)(19) in view of language from the Eleventh Circuit that might have been dicta. See Lunsford v. Process Tech. Servs., LLC (In re Lunsford), 848 F.3d 963 (11th Cir. 2017).
In Lunsford, the Eleventh Circuit said that the “text and structure of section 523(a)(19)(A) unambiguously prevent discharge of debts ‘for the violation’ of securities laws irrespective of debtor conduct.” Id. at 967–68. Consequently, the judgment creditor argued that all debts are nondischargeable that arise from a third party’s securities law violations.
Before leaping to a conclusion, Judge Russin read the complaint carefully. The judgment creditor did not allege that the debtor committed any securities law violations. Similarly, the district court did not find that the debtor-net winner had committed any securities law violations. Significantly also, the debtor was not a party in the SEC’s securities lawsuit against the Ponzi schemers.
Judge Russin found Lunsford to be “inapplicable.” In it, he said, the Eleventh Circuit “requires that the debtor be a party to the decision in which the court enters the judgment against the third party for the securities law violation.”
Rather than follow Lunsford, Judge Russin was persuaded by the Tenth Circuit’s decision in Okla. Dep’t of Sec. v. Wilcox, 691 F.3d 1171 (10th Cir. 2012). In Wilcox, he said that the debt was dischargeable because the debtor was not a party in the lawsuit where a third party was held liable for securities law violations.
Without leave to replead, Judge Russin dismissed the claim because Section 523(a)(19) “is not the mechanism by which to make that determination under the facts alleged in the” complaint.
The ‘Actual Fraud’ Claim
Section 523(a)(2)(A) excepts a debt from discharge if it was for money or property “obtained by false pretenses, a false representation, or actual fraud.”
Again, the judgment creditor had a worthy argument on first blush, based on Husky Intern. Elecs., Inc. v. Ritz, 578 U.S. 356 (2016). The judgment creditor latched onto the Supreme Court’s statement that “actual fraud” can encompass “forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation.” Id. at 359. To read ABI’s report on Husky, click here.
Judge Russin said it was not enough to plead that the debtor had received transfers in a fraudulent transfer that was made with “actual intent” by the transferor. He said that the debtor-transferee “must also have committed fraud with the requisite fraudulent intent.”
Consequently, Judge Russin held that the judgment creditor “cannot rely on the [decision by the district court] alone to establish the Husky elements. Plaintiff must also allege that [the debtor] committed fraud and acted with fraudulent intent in her participation in the Ponzi scheme.”
According to Judge Russin, the judgment creditor made “additional allegations supporting fraud beyond the findings of the” decision by the district court that met “the heightened pleading requirements under Rule 9.” He therefore held that the second count in the complaint stated a claim under Section 523(a)(2)(A).
Commentary
Courts have held under Sections 523(a)(2)(A) and (a)(19) that a debt for fraud or a securities law violation can be nondischargeable even if the debtor was without fault. Keep in mind that a finding of nondischargeability is punishment, in a sense.
In Bartenwerfer, the Supreme Court will decide whether scienter on the part of the debtor is necessary before a debt is nondischargeable under Section 523(a)(2)(A). If the Court rules that scienter is required, the lower courts are likely to engraft the same requirement onto Section 523(a)(19).
In other words, the result in Bartenwerfer may give Judge Russin another ground for dismissing the claim under Section 523(a)(19).
To bar discharge of a debt for violation of securities laws, Bankruptcy Judge Peter D. Russin of Fort Lauderdale, Fla., held that the debtor must have been a party in the lawsuit finding a violation of securities law.
As a result of the holding in Judge Russin’s April 29 opinion, a so-called net winner in a Ponzi scheme is not saddled automatically with a nondischargeable debt under Section 523(a)(19), although an elaboration of the facts might eventually render the debt nondischargeable under Section 523(a)(2)(A) for “actual fraud.”