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Securities and Exchange Commission v. Sherman

May 14, 2009


The opinion of the court was delivered by: Christina A. Snyder United States District Judge



This appeal presents an issue of first impression concerning the application of 11 U.S.C. § 523(a)(19), which was added to the Bankruptcy Code as part of the Public Company Accounting Reform and Investor Protection Act of 2002, Pub. L. No. 107-204, § 803(3), 116 Stat. 745, commonly referred to as the Sarbanes-Oxley Act. The issue to be decided is whether that section renders non-dischargeable a debt that arises out of the violation of the federal securities laws where the debtor himself did not violate those laws. The experienced bankruptcy judge who decided this issue held that the debt was dischargeable. In so ruling, the Bankruptcy Court noted that this is a novel issue that will surely be reviewed on appeal. Def.'s Opening Br., Ex. 5 at 46-47 ("I'm absolutely convinced . . . no matter what I do today, there will be at least two appeals or more . . . . It's a fascinating discussion and my opinion is having been in the appellate myself for almost 14 years."). This is an appeal from the bankruptcy judge's decision.

Familiarity with the background and procedural history of this case, set forth in prior opinions of the Court and the opinion of the Court of Appeals for the Ninth Circuit, In re Sherman, 491 F.3d 948 (9th Cir. 2007), is presumed

In summary, the Securities Exchange Commission ("SEC") obtained a judgment against Richard G. Sherman (hereinafter "Sherman") based on a finding by the Court that Sherman had obtained funds derived from a violation of federal securities laws to which he had no legitimate claim of ownership. The judgment required Sherman to disgorge those funds. Sherman sought bankruptcy protection four days before the Court held a hearing on whether disgorgement was required. Those proceedings were allowed to proceed pursuant to an exception to the automatic stay granted by the Bankruptcy Code in favor of regulators like the SEC. 11 U.S.C. § 362(b)(4). There is no question presented in this case about the authority of the SEC to seek and obtain an order requiring disgorgement of funds derived from a violation of the federal securities laws where those funds are held by a third party who has no legitimate claim to these funds, even though the third party did not violate the federal securities laws. See SEC v. Colello, 139 F.3d 674, 677 (9th Cir. 1998). The Ninth Circuit in this case cited case law upholding the SEC's authority in that regard and affirmed the judgment on the merits against Sherman.Id. at 959 ("The SEC obtained the disgorgement judgment against Sherman pursuant to Colello . . . [which] authorizes courts to order the disgorgement of ill-gotten gains held by third parties who are acting as depositories and have no legitimate claim to the funds . . . [t]he parties do not argue that the district court's disgorgement judgment was in error under Colello.").

The Ninth Circuit held, however, that the SEC had sought the wrong remedy to enable it to enforce its judgment against Sherman, namely a motion to vacate the order of discharge of Sherman by the Bankruptcy Court. Because more avenues of relief are available under the Bankruptcy Code for the three abuses alleged by the SEC, "cause" within the meaning of Section 707 of the Bankruptcy Code did not exist to require that the order of discharge of Sherman be overturned. The Ninth Circuit specifically cited § 523(a)(19) as potentially providing an alternative avenue of relief in that regard. Sherman, 491 F.3d at 974-75 ("Our holding hardly leaves the SEC unprotected, as the SEC could have pursued -- and did pursue -- several vehicles for protecting itself. . . . the SEC may have been able -- and may still be able -- to avoid discharge of the contempt and disgorgement judgments under § 523."). The Ninth Circuit, however, did not decide whether § 523(a)(19) provides a remedy in the present case.


Federal Rule of Bankruptcy Procedure 8013 provides:

On appeal the district court or bankruptcy appellate panel may affirm, modify, or reverse a bankruptcy judge's judgment, order, or decree or remand with instructions for further proceedings. Findings of fact, whether based on oral or documentary evidence, shall not be set aside unless clearly erroneous, and due regard shall be given to the opportunity of the bankruptcy court to judge the credibility of the witnesses.

U.S.C. Bankr. R. 8013. A "finding is clearly erroneous when although there is evidence to support it, the reviewing court on the entire evidence is left with the definite and firm conviction that a mistake has been committed." United States. v. United States Gypsum Co., 333 U.S. 364, 395 (1948). Questions of law are reviewed de novo. In re Luna, 122 B.R. 575, 576 (9th Cir. BAP 1991).


The sole issue to be decided on this appeal is whether the Bankruptcy Court erred in concluding that the debt in question is not excepted from discharge under 11 U.S.C. § 523(a)(19), which provides

(a) A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title does not discharge an ...

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