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In the Matter of: andrea P. Sherman; Richard G. Sherman v. Securities and Exchange Commission

September 19, 2011

IN THE MATTER OF: ANDREA P. SHERMAN; RICHARD G. SHERMAN, DEBTORS, RICHARD G. SHERMAN, APPELLANT,
v.
SECURITIES AND EXCHANGE COMMISSION, APPELLEE.



Appeal from the United States District Court for the Central District of California Christina A. Snyder, District Judge, Presiding D.C. No. 2:08-cv-02517-CAS

The opinion of the court was delivered by: Bybee, Circuit Judge:

FOR PUBLICATION

OPINION

Argued and Submitted October 7, 2010-Pasadena, California

Before: Raymond C. Fisher and Jay S. Bybee, Circuit Judges, and Lyle E. Strom, Senior District Judge.*fn1

Opinion by Judge Bybee; Dissent by Judge Fisher

OPINION

Ordinarily, an individual's debts may be discharged in Chapter 7 bankruptcy under 11 U.S.C. § 727. However, a debt may not be discharged if it results from a violation of state or federal securities laws. 11 U.S.C. § 523(a)(19)(A)(i). The question in this case is whether the exception to discharge in § 523(a)(19)*fn2 applies when the debtor himself is not culpable for the securities violation that caused the debt. The bankruptcy court held that the debt was subject to discharge; the district court disagreed and held that the debt was excepted from discharge in bankruptcy. We agree with the bankruptcy court that the exception to discharge applies only to those who have themselves violated the securities laws. We thus reverse the judgment of the district court.

I

We have previously described the facts in this case, which we will relate briefly. See In re Sherman ("Sherman I"), 491 F.3d 948, 953-56 (9th Cir. 2007). In 1997, the SEC instituted an enforcement action against several companies, which, among other things, led to the court appointment of a receiver.*fn3

See id. at 953-54 & n.3 (citing SEC v. Whitworth Energy Res. Ltd., 243 F.3d 549 (9th Cir. 2000) (unpublished table decision)). Debtor-Appellant Richard Sherman is an attorney who represented some of the defendants in this enforcement action. Id. at 954.

As part of the enforcement action, the receiver ordered Sherman to disgorge two separate sums of money. Id. First, he was ordered to disgorge $54,980 that he withdrew from his clients' litigation trust account in violation of a freeze order issued by the district court. Id. This debt is not at issue in this case. Second, the receiver ordered Sherman to return money he had received and retained, but had not earned, in a separate contingency case. Id. at 954-55. The district court calculated that he was responsible for disgorging $581,313.43 plus interest. The court held that Sherman lacked any interest in the money because he was obligated by the California Rules of Professional Conduct to return the amount by which his advances exceeded his ultimate fee. Importantly for our purposes, the SEC conceded that Sherman had not been found to have committed any securities violations on his own. See id. at 974 n.33 ("[T]he present case involves a debtor who was not found to have himself violated the securities laws and has not been alleged to have committed other acts of fraud by the SEC.").

Four days before the hearing on the disgorgement motion, Sherman and his wife filed a petition for Chapter 7 bankruptcy. Id. at 954. The SEC and the receiver responded by filing a motion to dismiss the petition. Id. at 955. The receiver independently filed a motion seeking a determination by the court that Sherman's debts arising from the disgorgement order should be held non-dischargeable under § 523(a)(4) and (6)*fn4 of the Bankruptcy Code. Id. The bankruptcy court denied the motion, and the SEC appealed to the district court, which reversed. Id. at 955-56. While the appeal was pending, the bankruptcy court granted Sherman a discharge under 11 U.S.C. § 727. Id. at 955. In Sherman I, we addressed a number of standing-related questions*fn5 and held that Sherman's conduct did not constitute "cause" sufficient to warrant dis-missal under § 707(a) of the Code, which allows a bankruptcy court to dismiss petitions filed in bad faith. Id. at 975. We then mentioned that "the SEC could have filed-and still could file-a complaint under § 523(a)(7) or (19)," though we did not explicitly conclude whether the SEC would prevail under either provision.*fn6 Id. at 975 n.39.

In a subsequent adversary proceeding, the Shermans sought declaratory relief to establish that their debt to the SEC had been discharged under § 727 notwithstanding § 523(a)(19)'s discharge exception. The bankruptcy court granted summary judgment for the Shermans. It concluded, as a matter of law, that the SEC's disgorgement order did not arise from a violation of securities laws. It further ruled that "[s]section 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."

The SEC appealed to the district court, which reversed the bankruptcy court. The district court adopted a broad interpretation of § 523(a)(19), treating as paramount the SarbanesOxley Act's goal of "protect[ing] investors by improving accuracy and reliability of corporate disclosures made pursuant to the securities laws." It expressed particular concern that "[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." Sherman appeals.*fn7

II

We begin by making it clear that, in this case, the validity of the disgorgement order against Sherman is not at issue. We have previously held that a so-called "nominal defendant" may be ordered to disgorge funds that are traceable to fraud. See SEC v. Colello, 139 F.3d 674, 676 (9th Cir. 1998) ("[A]mple authority supports the proposition that the broad equitable powers of the federal courts can be employed to recover ill gotten gains for the benefit of the victims of wrongdoing, whether held by the original wrongdoer or by one who has received the proceeds after the wrong."). The courts can order the disgorgement of proceeds of fraud held by "nominal defendants" because they " 'hold[ ] the subject matter of the litigation in a subordinate or possessory capacity as to which there is no dispute.' " Id. at 676 (quoting SEC v. Cherif, 933 F.2d 403, 414 (7th Cir. 1991)). A nominal defendant is "not a real party in interest because 'he has no legitimate claim to the disputed property.' " SEC v. Ross, 504 F.3d 1130, 1141 (9th Cir. 2007) (quoting Colello, 139 F.3d at 676).*fn8

We found that Sherman "was effectively acting as a depository for those funds, as he legitimately obtained them in the first place but no longer had a valid claim to retain them," and thus could be ordered to disgorge "money . . . retained in excess of his fee for the ...


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