Directors, Officers and Other Responsible Persons Be Aware - Your Vicarious Liability for Your Company’s Violations of Securities Laws May Not Be Dischargeable

by Dechert LLP

Dechert LLP

A debtor ordinarily may discharge debts in bankruptcy, unless one of several exceptions apply. One of the preclusions to dischargeability of certain debts, found in Section 523(a)(19) of the U.S. Bankruptcy Code, generally provides that the bankruptcy discharge does not apply to an individual debtor’s debt if the debt “(A) is for—the violation of any…Federal or State securities laws...; and (B) results…from—(i) any [Federal or State court] judgment….” This exception from discharge was added to the Bankruptcy Code by the Sarbanes-Oxley Act of 2002 in the wake of Enron’s collapse, and although the legislative history is scant, one purpose is to “prevent wrongdoers from using the bankruptcy laws as a shield...” to avoid payment for securities law violations. See 148 Cong. Rec. S7418-01, *S7418 (daily ed. July 26, 2002).

While considering the overall purpose of the statute (and fairness) might suggest that this preclusion to discharge should only apply if the debtor violated the securities laws, a textualist reading of the statute potentially begs the question: should Section 523(a)(19)’s exception also apply where the debt arose from the securities violation of another? In Lunsford v. Process Technologies Services, LLC, No. 16-11578 (11th Cir. Feb. 15, 2017), the Eleventh Circuit in an opinion by the panel majority answered that question in the affirmative, holding that Section 523(a)(19) “precludes discharge regardless of whether the debtor violated securities laws as long as the securities violation caused the debt.” In doing so, the panel majority focused on the literal reading of the statutory text, without reference to legislative purpose, and declined to follow two Circuit opinions to the contrary, thereby creating a Circuit split. 


Process Technologies Services, LLC invested in MIPCO, LLC after meeting with MIPCO and its president, John Lunsford. The offering documents assured Process Technologies that MIPCO maintained certain assets, but the representations were not entirely true. After discovering the discrepancies, Process Technologies sued MIPCO and Lunsford in Mississippi state court, accusing them of state securities law violations and seeking to rescind the sale. 

The Mississippi state court ordered the parties to arbitrate. Lunsford then filed for bankruptcy, but the bankruptcy court permitted the arbitration to proceed and damages were awarded to Process Technologies. The Mississippi state court confirmed the arbitration award and entered judgment against Lunsford, MIPCO, and another individual, on a joint and several basis.

Process Technologies then filed an adversary proceeding for a declaration that Lunsford may not discharge his debts to Process based on Section 523(a)(19). Lunsford responded that Section 523(a)(19) was inapplicable, since “his liability arose from a third party’s violation of securities laws and that the bar…from discharge only applies when the debtor violates securities laws.” 

The bankruptcy court ruled in favor of Process Technologies, finding that despite Lunsford’s assertions otherwise, the arbitrator determined that Lunsford violated the securities laws, which constituted a judgment against Lunsford once the award was confirmed by the Mississippi state court. Lunsford appealed. The district court affirmed, but on alternative grounds, holding that Section 523(a)(19) “applies irrespective of debtor conduct….” Lunsford further appealed. 


The Eleventh Circuit affirmed the bankruptcy court order that excluded the debt from discharge, issuing a majority opinion and concurrence. 

Majority Opinion

The opinion of the panel majority affirmed the order of the bankruptcy court on two, alternative grounds. The panel majority’s less controversial ground was that the bankruptcy court made a factual finding that Lunsford violated the securities laws, and had a sufficient basis in the record for doing so. This determination was made under the deferential clear error standard of review. 

The panel majority’s other ground is more dynamic. The majority alternatively found that the result would be the same regardless of whether the bankruptcy court had found Lunsford violated the securities laws, holding that “[t]he text and structure of Section 523(a)(19) unambiguously prevent discharge of debts ‘for the violation’ of securities laws irrespective of debtor conduct.” To reach this conclusion, the panel majority examined the words of the statute at length, employing textualist principles to ascertain its literal meaning, without considering other interpretative means such as legislative purpose.

The majority opinion is also notable for rejecting two Circuit-level precedents on this issue. In Oklahoma. Dep’t of Sec., ex. Rel. Faught v. Wilcox, 691 F.3d 1171 (10th Cir. 2012), the Tenth Circuit found that Section 523(a)(19) did not bar Ponzi scheme investors, many of whom were innocent, from discharging debts resulting from judgments against them for unjust enrichment. The Eleventh Circuit’s panel majority, however, found that, “even if we found [Wilcox’s] reasoning persuasive, [the] decision involved circumstances inapplicable here,” since the judgments at issue there were for “unjust enrichment resulting from someone else’s violation of [the securities laws],” whereas Lunsford was party to the judgment against MIPCO. The other precedent, In re Sherman, 658 F.3d 1009 (9th Cir. 2011), was not followed because, according to the panel majority, the Ninth Circuit in Sherman wrongly “followed prescriptions of general statutory purpose over text” by considering bankruptcy’s “fresh start” policy and the need to protect “the honest but unfortunate debtor[.]” 


The concurring opinion cautioned the majority that it should have rested on the first ground, and gone no further. In the concurrence view, the alternative holding only served to “needlessly create[] confusion about how that holding should be applied in cases where an innocent party has a judgment against it that results from someone else’s securities fraud.” The concurrence points out that, while the majority suggests it would not apply Section 523(a)(19)’s discharge preclusion to the facts presented in Wilcox, there is an “internal inconsistency” between this suggestion and the majority’s literal interpretation of the text. Further, to the extent the panel majority intended judgments against “entirely innocent investors” to be subject to discharge preclusion, this “appears to be at odds with ‘a central purpose’ of the Bankruptcy Code to provide ‘a completely unencumbered new beginning to the honest but unfortunate debtor.’” (citing Grogan v. Garner, 498 U.S. 279 (1991)). 


The Lunsford decision has potentially significant implications for directors, officers, and other responsible persons, who may find themselves on the hook vicariously for securities violations of the company, perhaps in turn due to the acts or omissions of a subordinate employee. To the extent Lunsford’s holding is stringently applied, whether in the Eleventh Circuit or adopted elsewhere, the debt might be precluded from discharge, saddling the responsible person with the consequences of the subordinate’s negligence or worse, intentional fraud. While there are already other reasons for doing so, responsible persons should take note in diligently exercising their supervisory duties. 

As noted in the tension between the majority and concurrence, Lunsford also has potentially harsh implications for innocent investors caught in the web of a securities fraud. Those who unwittingly invest in a Ponzi scheme, for example, could later be subject to court judgments for disgorgement of any distributions. The innocent investor could similarly be left on the hook for the consequences of the Ponzi fraudster’s conduct, to the extent Lunsford is strictly applied. 

Finally, the Lunsford decision is notable for its strict textualist approach, which avoids reconciling the statutory text with bankruptcy’s fundamental goals, while creating a Circuit split with two sister Circuits that did find a way to reconcile the two. 

Read the opinion » 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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