Discharge of Securities Law Violations: Nothing Is Ever Straightforward

Lunsford v. Process Technology Services, LLC (In re Lunsford), 848 F.3d 963 (11th Cir. 2017)

An investor obtained a state court judgment against the debtor relating to securities law violations. After the debtor filed bankruptcy, the investor sought a determination that the debt could not be discharged because it was “for the violation” of securities laws. The bankruptcy court ruled in favor of the investor, the district court affirmed, and the debtor appealed to the 11th Circuit.

The background was that the debtor was president of a limited liability company (LLC). The investor met with the president to discuss investing in the LLC. The LLC sent documents to the investor stating that it had $1.2 million in tangible assets and $500,000 in intangible assets. Unbeknownst to the investor at the time it invested $300,000, the tangible assets had title problems and the LLC had not acquired the intangible assets.

After the investor discovered these issues, it brought a state court action to rescind the sale of the LLC securities. The court ordered arbitration. The arbitrator ruled in favor of the investor and awarded ~$600,000. The court confirmed the award and entered a final judgment against the LLC, the debtor and another individual, finding them jointly and severally liable. The debtor did not object or appeal the judgment.

In the bankruptcy proceeding the investor sought a determination that the debt could not be discharged. After the bankruptcy court disposed of an attempt by the debtor to obtain relief from the arbitrator’s award, it ruled that the debt could not be discharged under section 523(a)(19)(A) because it was for securities law violations.

This section provides that a bankruptcy discharge does not discharge the debtor from any debt 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.

In that regard, the 11th Circuit noted:

The bankruptcy court determined that the arbitrator “found that [the debtor] violated the [Mississippi Securities] Act. More specifically, the Arbitrator found that [the debtor] violated the Act by offering and selling an unregistered security. The Arbitrator also found that [the debtor] violated the Act by making an offer that contained untrue statements.”

The debtor argued that (1) the bankruptcy court never made a finding that the debtor violated securities laws, and (2) the arbitrator found that the LLC violated securities laws, but did not make a specific finding that the debtor violated the laws. The court rejected these arguments. In its view the bankruptcy court avoided the need to relitigate the matter of culpability by using issue preclusion. It still reached conclusions about the facts required to support the determination of nondischargeability. As for the arbitrator, the award stated that use of references to the LLC generally included the debtor.

Thus, it was reasonable to conclude that the arbitrator made a specific finding that the debtor violated securities laws, and the bankruptcy court’s determination based on the arbitration findings was sufficient.

Although this was all that was necessary to affirm the bankruptcy court, the 11th Circuit went on to hold that even if the bankruptcy court had not made a finding that the debtor violated securities laws, the debt could still be nondischargeable based on circumstances where the debtor’s liability arose from securities violations committed by a third party.

The court concluded that the text and structure of the statute “unambiguously prevent discharge of debts ‘for the violation’ of securities laws irrespective of debtor conduct. The term ‘for’ in section 523(a)(19)(A) denotes causation. The Supreme Court has interpreted the term ‘debt for’ to mean ‘debt as a result of,’ ‘debt with respect to,’ ‘debt by reason of,’ and the like’.” Continuing in this vein, the court identified a number of other subsections that, unlike this section, referred specifically to the debtor (injury by the debtor, injury caused by the debtor’s operation, the debtor caused to be made, the debtor made a fraudulent return, etc.). Thus, it concluded that Congress did not restrict this section to violations based on the debtor’s conduct.

The court acknowledged contrary decisions by the 10th Circuit and 9th Circuit, but found them inapplicable or unpersuasive.

Accordingly, the court affirmed the judgment against the debtor.

A concurring opinion argues that it was sufficient to affirm based on the fact that the bankruptcy court correctly determined that the debtor violated securities laws, and the court should not have gone on to reach its alternative holding. The basic objection was that the decision creates confusion, and the issues were not briefed by the parties. If the court was going to address liability not based on the debtor’s conduct, it would have benefited from advocacy by parties with a real interest.

This case is another illustration that almost 40 years after enactment of the Bankruptcy Code, many issues remain open for discussion. It is also a reminder for transaction attorneys that equity interests in limited liability companies may constitute securities, and failure to comply with registration and disclosure requirements of Federal and state securities laws can have substantial adverse consequences.

Vicki R Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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