Tuesday, September 20, 2011
Court Upholds Discharge of Lawyer’s Debt to Receiver
Panel Says Attorney Not Culpable for Client’s Violation of Securities Laws
By SHERRI M. OKAMOTO, Staff Writer
A now-deceased Los Angeles attorney who declared bankruptcy was entitled to discharge of a half-million dollar debt representing the amount he held in trust for a contingency case involving a corporate client in receivership for alleged securities law violations, the Ninth U.S. Circuit Court of Appeals ruled yesterday.
The appellate panel concluded the exception to discharge set forth in 11 U.S.C. § 523(a)(19)(A)(i) did not apply to Richard G. Sherman since he was not culpable for the securities violation that caused the debt.
Sherman, who died in April at the age of 79, had represented various defendants in an enforcement action instituted by the Securities and Exchange Commission in 1997 in the Los Angeles Superior Court.
A receiver appointed in the enforcement action ordered Sherman to disgorge $54,980 that he withdrew from his clients’ litigation trust account in violation of a freeze order and to return money he had received and retained, but had not earned, in a separate contingency case, for a total of $581,313.43 plus interest.
Four days before a court hearing on the disgorgement motion, Sherman and his wife filed a petition for Chapter 7 bankruptcy.
The SEC and the receiver filed a motion to dismiss the petition, which the bankruptcy court denied. The SEC then appealed to the district court, which reversed. While the appeal was pending, the bankruptcy court granted Sherman a discharge
A Ninth Circuit panel reviewed the case in 2007 to address a number of standing-related questions and agreed with the bankruptcy court’s determination that Sherman’s conduct did not constitute “cause” sufficient to warrant dismissal for bad faith in filing his petition. The appellate panel also suggested “the SEC could have filed—and still could file—a complaint under § 523(a)(7) or (19),” but did not decide whether the SEC would prevail under either provision.
In a subsequent adversary proceeding, Sherman and his wife sought declaratory relief to establish that their debt to the SEC had been discharged under these statutory provisions as well.
Sec. 523(a)(7) exempts from discharge any debt that 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, other than a tax penalty,” while Sec. 523(a)(19) exempts any debt that is “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; or…common law fraud, deceit, or manipulation in connection with the purchase or sale of any security.”
The bankruptcy court granted summary judgment for the Shermans, finding as a matter of law that the SEC’s disgorgement order did not arise from a violation of securities laws and that “[s]ection 523(a)(19) was intended to apply to ‘wrongdoers’ and not to persons who are simply found to owe a debt which the SEC is authorized to enforce.”
U.S. District Judge Christina A. Snyder of the Central District of California disagreed, adopting a broader interpretation of the statute and treating as paramount the Sarbanes-Oxley Act’s goal of “protect[ing] investors by improving accuracy and reliability of corporate disclosures made pursuant to the securities laws.”
She found the statute is not limited “persons who have been accused or found guilty of violations of the securities laws” since “[r]eading a limitation into the SEC’s ability to enforce its powers to obtain disgorgement of ill-gotten funds in an appropriate case …would frustrate the ability of the SEC to enforce the federal securities laws.”
Judge Jay S. Bybee, writing for the appellate court, said the question of the dischargeability of Sherman’s debt “is a close one,” since “in some sense, Sherman’s debt was ‘the penalty on account of’ the securities violations committed by his clients,” but “we cannot say that Sherman owes the debt ‘in requital of” fraudulent conduct” as “Sherman’s debt results from the fact that he never ‘earned’ the money he owes, and not because he committed any wrongdoing.”
Bybee, however, said he agreed with the bankruptcy judge’s reasoning that Sec. 523(a)(19) only prevents the discharge of a debt for a securities violation when the debtor is responsible for that violation based on the “twin goals” of the Bankruptcy Code in “ensuring an equitable distribution of the debtor’s assets to his creditors and giving
the debtor a ‘fresh start.’ ”
As for the concerns raised by the district court, Bybee posited that the “Bankruptcy Code already includes protections against attempting to conceal assets or defraud creditors, or otherwise failing to disgorge available assets” so “[t]here is no additional need for us to expand the scope of § 523(a)(19) to cover innocent debtors in order to accomplish this goal.”
Bybee was joined in his opinion by Senior District Judge Lyle E. Strom of the District of Nebraska, Omaha, who sat on the appellate panel by designation, but Judge Raymond C. Fisher dissented.
Fisher contended that “Sherman does not owe the SEC simply because he never earned the advance fees from his client; rather, he owes the SEC because he held the proceeds of fraud in trust.”
He argued that the majority opinion “focuses on Sherman’s lack of personal culpability for a securities law violation, and loses sight of the fact that SEC is trying
to prevent discharge of a debt to repay money that never belonged to Sherman.”
Sherman’s debt, Fischer emphasized, was the amount of money he was ordered to disgorge from the advance payments from his client that “he did not earn and thus did not own” and so “he must disgorge it to the SEC because the owner would have been required to disgorge it had the money not been held in trust.”
He concluded “Sherman’s debt is caused by a securities law violation because he is legally obligated to disgorge the ill-gotten gains of such a violation that he held in trust for the violator.”
Northridge attorney M. Jonathan Hayes represented the Shermans and SEC Senior Litigation Counsel Hope Hall Augustini represented the government on appeal.
The case is In the Matter of Andrea P. Sherman; Richard G. Sherman, 09-55880.
Copyright 2011, Metropolitan News Company