Sarbanes-Oxley Expands Scope of Debts That Are Nondischargeable in Chapter 7, But Not Chapter 13
 
October 13, 2004
 

Two weeks after receiving the Official Report on Enron, the United States House of Representatives introduced the Sarbanes-Oxley Act (SOA).[1]  A month later, the United States Senate introduced the Corporate and Criminal Accountability Act (CCCA),[2] which was eventually enacted as part of the SOA.[3] Included in the SOA was an amendment to section 523 of the Bankruptcy Code that expands the scope of nondischargeable debts. This addition, codified at section 523(a)(19), renders any debt resulting from a judgment pursuant to a securities law violation nondischargeable.

At first glance, this is good news to creditors in a chapter 7 bankruptcy because the amendment greatly expands the scope of debts that cannot be discharged. At second glance, however, the amendment may have a lesser effect because debtors may attempt to make use of the so-called “chapter 20” by converting to chapter 13 and taking advantage of that chapter’s expanded discharge provisions.

The Basics of Section 523(a)(19)

Section 523 (a)(19) excepts from discharge any debt: (19) that –

 

(A) 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 11 U.S.C. § 523(a)(19).

Two conditions must be met to declare a debt nondischargeable pursuant to section 523(a)(19). First, the debt must result from the violation of a securities law or regulation. Second, the debt must have resulted from a valid judgment.

Few courts have examined section 523(a)(19).[4] Those courts that have done so all agree that Congress intended a broad application of section 523(a)(19).

Seeking a declaration that a NASD arbitral award was nondischargeble, the plaintiff in Smith v. Gibbons, 289 B.R. 588 (Bankr. S.D.N.Y. 2003), relied on section 523(a)(19) and moved for summary judgment that the judgment debt was nondischargeable. At issue was whether section 523(a)(19) had retroactive application on the bankruptcy, originally filed prior to the SOA’s enactment. After an extensive analysis of legislative history, the Gibbons court held for the plaintiff and retroactively applied section 523(a)(19). The Gibbons court stressed Congress’ intent that section 523(a)(19) be construed broadly to hold securities laws violators accountable.

Portions of the SOA’s legislative history are worth repeating:

Section 523(a)(19) was added to “[a]mend the Bankruptcy Code to make judgments and settlements based upon securities law violations nondischargeable, protecting victims’ ability to recover their losses.” 148 CONG. REC. S 1787 (daily ed. March 12, 2002)(statement of Senator Leahy); see also S. REP. No. 107-146 (2002). The Committee Report states:

Current bankruptcy law may permit such wrongdoers to discharge their obligations under court judgments or settlements based on securities fraud and other securities violations. This loophole in the law should be closed to help defrauded investors recoup their losses and to hold accountable those who violate securities laws after a government unit or private suit results in a judgment or settlement against the wrongdoer. . . .

The legislative history also demonstrates an intention to apply § 523(a)(19) as broadly as possible in pending bankruptcy cases. Senator Leahy stated, as part of his section-by-section analysis of the bill:

This provision [§523 (a)(19)] is meant to prevent wrongdoers from using the bankruptcy laws as a shield and to allow defrauded investors to recover as much as possible. To the maximum extent possible, this provision should be applied to existing bankruptcies. The provision applies to all judgments and settlements arising from state and federal securities laws violations entered in the future regardless of when the case was filed.

148 CONG. REC. S7418 (daily ed. July 26, 2002) (statement of Senator Leahy) (emphasis added). [footnote omitted] The section-by-section analysis was adopted as legislative history for the Accountability Act “in order to provide guidance in the legal interpretation of these provisions of Title VIII of H.R. 2673.” Id. Nothing in the legislative history indicates that § 523 (a)(19) should not apply in all existing bankruptcies.

Gibbons, 289 B.R. at 592-93.

No doubt Congress intended to close loopholes and “hold accountable those who violate securities laws “ and “allow defrauded investors to recover as much as possible.” Unfortunately for some creditors, “chapter 20” may remain a loophole that Congress missed.

Chapter 20

There is no “chapter 20” in the Bankruptcy Code. The term “chapter 20” refers to the filing of a chapter 7 bankruptcy followed by a conversion of the case to chapter 13, or alternately, the filing of a separate chapter 13 case. The raison d’etre for chapter 20 is to first discharge personal liability on dischargeable debts under chapter 7, with the goal of reducing unsecured debt to zero followed immediately by a chapter 13 case to address remaining non-discharged unsecured debts along with any remaining secured debt.

When a debtor completes a chapter 13 plan, he obtains a more comprehensive discharge than that accorded under chapter 7. Section 523 of the Bankruptcy Code identifies 19 types of debt that are excepted from chapter 7 discharge, or when, under circumstances of hardship, the court grants a discharge in a chapter 13 case despite the failure to complete plan payments. In contrast, completing a chapter 13 plan will entitle the debtor to the benefits of an enhanced order of discharge that extends to all but five categories of debt. As set forth in 11 U.S.C. § 1328(a), the only debts excepted from the enhanced discharge are claims arising from the cure of certain secured claims, debts “for restitution” or a criminal fine and debts specified in paragraphs (5), (8) and (9) of section 523(a). Thus, completing a chapter 13 plan operates generally to discharge 16 of the 19 categories of debt that would not be dischargeable in chapter 7. Among these dischargeable debts under a completed chapter 13 plan are obligations of the type described in paragraph 19 of section 523(a).

However Congress intended to hold securities law violators accountable for their debts, debtors can still discharge their debts under the expanded discharge provisions of chapter13 by successfully converting the case to chapter 13 or starting a new case under chapter 13.

Converting a Chapter 7 Case to a Chapter 13 Case Post-Discharge

To prevent a debtor’s attempt to discharge a nondischargeable debt under chapter 7 by converting the case to chapter 13, a creditor is challenged to prevent the debtor from converting the case to chapter 13 in the first place. Once the case is converted, there is no minimum amount that debtor must pay under the chapter 13 plan.[5] In principal, a debtor can pay pennies on the dollar and have his debt, nondischargeable under section 523(a)(19) discharged in chapter 13. Preventing conversion of the case to chapter 13, however, may be a difficult task to accomplish.

Bankruptcy Code section 706(a) allows for conversion from chapter 7 to chapter 13, and as several courts have held,[6] provides an absolute one-time right to convert a case filed under chapter 7:

The debtor may convert a case under this chapter to a case under chapter 11, 12, or 13 of this title at any time, if the case has not been converted under section 1112, 1208, or 1307 of this title. Any waiver of the right to convert a case under this subsection is unenforceable.[7]

Some courts, however, have not found an absolute right to convert in section 706(a), especially following entry of the order of discharge.[8] Other courts deny all post-discharge conversions.[9] Generally, to prevent a debtor from converting the case to chapter 13, the creditor must allege bad faith or some abuse of process.[10] This requirement can be a difficult burden to satisfy because a previous discharge is only one of many factors courts examine to determine whether the conversion was made in good faith.[11]

Generally, good faith is a legal determination based on the totality of circumstances.[12] In deciding whether a chapter 13 plan has been proposed in good faith, courts consider the factual circumstances such as the motion’s timing, the debtor’s motive in filing the motion and whether the debtor has been forthcoming with the bankruptcy court and creditors.[13]

In addition to good faith, courts also review whether the debtor’s chapter 13 plan is confirmable, the effect of denying conversion weighed against any prejudice to creditors caused by allowing conversion and the effect of conversion on the efficient administration of the bankruptcy estate and whether the conversion is an abuse of the bankruptcy process. [14]

Attorneys commencing a nondischargeble adversary proceeding in chapter 7 should consider whether the debtor is well-suited to convert his/her bankruptcy to chapter 13 in order to take advantage of chapter 13’s expanded discharge provisions.

Commencing a New Chapter 13 Case

As an alternative to converting to chapter 13 from chapter 7, a debtor may opt to remain in chapter 7 and file a new chapter 13 case.[15] This option offers less of a tactical advantage to debtors because starting a new case under chapter 13 leaves the chapter 7 estate in existence. This route does not allow the debtor to avoid a chapter 7 liquidation, which is often a motivation for conversion in addition to chapter 13’s expanded discharge provisions. However, if all debts that remain from a chapter 7 case are nondischargeable debts, a debtor may file a chapter 13 case to pare down the debts in a payment plan, assuming the debtor is eligible for chapter 13 relief and filed the chapter 13 case in good faith.[16] Efforts to prevent such a discharge in chapter 13 would likely be unsuccessful except, perhaps, in those courts that deny post-discharge conversions as a “bright-line rule” since the debtor is merely adjusting his/her timing to ultimately avoid a debt declared unavoidable in chapter 7.[17]

Conclusion

While the SOA expands the categories of debts that may not be discharged, these provisions do not necessarily afford creditors more protection because the debtor can still discharge his debt pursuant to chapter 13. In appropriate circumstances, creditors should consider opposing the conversion of the case to chapter 13 in order to prevent the debtor from taking advantage of chapter 13’s expanded discharge provisions or seeking the dismissal of a subsequent chapter 13 case filed to pare down debts held nondischargeable in chapter 7. While many courts grant conversions liberally, a successful claim of bad faith can prevent ultimate discharge in chapter 13.

For more information, e-mail M. Owen Gabrielson at owen.gabrielson@hklaw.com or call toll free, 1-888-688-8500.

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1. H.R. 3763, 107^th Cong. (2002).

2. S. 2010, 107^th Cong. (2002).

3. The Sarbanes-Oxley Act, Pub. L. No. 107-204, § 1, 801, 116 Stat. 1, 745, 801 (2002).

4. See Griggs v. Berke (In re Berke), No. 03-80845, AP No. 04-9003 (Bankr. N.D. Ga. April 27, 2004) (order denying motion for default on section 523(a)(19) complaint); State v. McClung (In re McClung), 304 B.R. 419 (Bankr. D. Idaho 2004); Peterman v. Whitcomb (In re Whitcomb), 303 B.R. 806 (Bankr. N.D. Ill. 2004); Smith v. Gibbons (In re Gibbons), 289 B.R. 588 (Bankr. S.D.N.Y. 2003).

5. In re Smith, 286 F.3d 461, 468 (7th Cir. 2002) (citing In re Rimgale, 669 F.2d, 426, 431-32 (7th Cir. 1982)).

6. Matter of Martin, 880 F.2d 852, 858-59 (5^th Cir. 1989); In re Mead, 28 B.R. 1000, 1002 (E.D.Pa. 1983); In re Sobin, 99 B.R. 483, 484 (Bankr. M.D. Fla. 1989); Matter of Kleber, 81 B.R. 726, 727 (Bankr. N.D. Ga. 1987); In re Easley, 72 B.R. 948, 951 (Bankr. M.D. Tenn. 1987); In re Caldwell, 67 B.R. 296, 300-01 (Bankr. E.D. Tenn. 1986); Street v. Lawson (In re Street), 55 B.R. 763, 765 (9th Cir.BAP 1985); Matter of Jennings, 31 B.R. 378, 380 (Bankr. S.D. Ohio 1983).

7. 11 U.S.C. § 706(a).

8. See, e.g., In re Copper, 2004 WL 2113041 (6^th Cir. BAP 2004) (plain language of section 706(a) does not grant absolute right to convert and bankruptcy court’s denial of chapter 7 debtor’s motion to convert case to chapter 13 is denied due to bad faith); In re Starkey, 179 B.R. 687, 691 (Bankr. N.D. Okla. 1995) (neither the text, the legislative history, nor the case law regarding section 706(a) grants a debtor a “truly `absolute’ right to convert”); In re Schwartz, 178 B.R. 340 (Bankr. E.D.N.Y. 1995); In re Jeffrey, 176 B.R. 4, 5 (Bankr. D. Mass. 1994) (denial of conversion to protect against abuse of process); In re Spencer, 137 B.R., 506, 513-14 (Bankr. N.D. Okla. 1992) (appropriate to deny conversion in light of extreme circumstances amounting to bad faith, imposition on court’s jurisdiction, abuse of process or other gross inequity); In re Safley, 132 B.R. 397, 399-400 (Bankr. E.D. Ark. 1991) (denial of conversion if objectively futile to meet eligibility for chapter 13); In re Jones, 111 B.R. 674, 680 (Bankr. E.D. Tenn. 1990) (limit one time conversion right to circumstances where debtor did not receive discharge or the discharge has been revoked); In re Calder, 93 B.R. 739, 740 (Bankr. D. Utah 1988) (denied conversion where debtor, who was an attorney, abused the system).

9. In re Lesniak, 208 B.R. 902 (Bankr. N.D. Ill. 1997) (imposing a bright line rule prohibiting conversions from chapter 7 to chapter 13 if the request is made after the chapter 7 discharge is entered). In re Hauswirth, 242 B.R. 95, 96 (Bankr. N.D. Ga. 1999) (stating, “[C]ollaps[ing] the two proceedings into one ... is inimical to the structure of the Bankruptcy Code. Debtor’s conversion to Chapter 13 before the Chapter 7 trustee has completed [his] administration of the estate but after the discharge order is entered thwarts the proper operation of the Code.”); In re Jones, 111 B.R. 674, 680 (Bankr. E.D. Tenn. 1990

10. In re Young, 269 B.R. 791, 825 (10th Cir. B.A.P. 1999) (holding that one of the factors to be considered in allowing conversion is whether conversion was sought in good faith); In re Pakuris, 262 B.R. 330, 335 (Bankr. E.D. Pa. 2001) (requiring that conversion to chapter 13 be made in good faith because the court could reconvert pursuant to § 1307(c)); In re Thornton, 203 B.R. 648, 652 (Bankr. S.D. Ohio 1996) (denying conversion due to debtor’s bad faith).

11. In re Estus, 695 F.2d 311 (8th Cir. 1982) was the first court of appeals decision to expressly include a debt’s nondischargeability in chapter 7 as an indicator of bad faith.

12. Matter of Chaffin, 816 F.2d 1070 (5th Cir. 1987).

13. In re Miller, 303 B.R. 471, 474 (10th Cir. B.A.P. 2003) (citing In re Carter, 285 B.R. 61, 64 (Bankr. N.D. Ga. 2002); In re Marcackis, 254 B.R. 77, 82 (Bankr. E.D. N.Y. 2000).

14. Id.

15. See In re Jeffrey, 176 B.R. 4, 6 (Bankr. D. Mass. 1994); but see Associates Financial Services Corp. v. Cowen, 29 B.R. 888, 894 (Bankr. D. Ohio 1983) (holding debtor’s concurrent chapter 13 petition “is a nullity”).

16. "That a debt would be nondischargeable under chapter 7 ... is not alone sufficient as a matter of law to constitute bad faith ... .” In re Smith, 848 F.2d 813, 818 (7th Cir.1988); see also In re Ferrell 227 B.R. 706, 710 (Bankr. S.D. Ind. 1998).

17. See In re Lesniak, 208 B.R. at 906.

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