Lenders are having another lend of us

I have previously posted about the hullabaloo the banks and other lenders have tried to make about having to share the unsecured assets of bankrupt companies with its defrauded shareholders (see, also).

Well, the lenders are hard at it now, hoping to marshall the support of Parliament to head off what they see as the writing on the wall. These poor, defenseless, helpless, innocent lenders are saying that any extension of the laws of bankruptcy in protection of defrauded shareholders will be the ruination of the lending industry in Australia.

They're saying that those tender lender souls in the USofA will be scared away from having any dealings with Australia if Australian law allows defrauded shareholders any benefits in the bankruptcy proceedings ahead of unsecured lenders. They're implying and expressing the view that the US lenders just have never heard of such a thing and it is so unweildy for them that they will just take their greenbacks and head back home or elsewhere. At least that is the sense you get from Elizabeth Sexton, who reports in the Herald: Riff-raff slip into the creditors' queue:

"[Connecticut lawyer Evan] Flaschen says the response among US lenders is to put Australia in the too-hard basket. He says his clients are not interested in the finer points of the Federal Court decision or the lesson from the HIH decision that there is a real hurdle for shareholders to prove they relied on statements from the company when deciding to buy.

"They can put their money anywhere they want. Why should they put it in Australia if this is how this issue is treated? What else can happen? The nuance about reliance or whatever, they don't care, it's not worth it to them."

A pullback in the US would limit the ability of the big Australian banks to sell their debt if they prefer not to stick around to manage a floundering loan.

Flaschen also predicts higher prices for Australian debt and, for some low-rated companies, difficulties issuing bonds at all.

He says his clients have been stung because there was a widespread assumption in Australia that there were no circumstances in which shareholders could get access to creditors' funds. "No one even raised this issue as a possibility," he says."

Well, in the first case, if they didn't see this coming, they were blind as the government in the AWB case, as I pointed out in my "Priorities" post.

But more fascinating is the suggestion that the coddled American lending industry just can't handle competing with defrauded shareholders and this is all a new and fantastic voyage for them. Nothing can be further from the truth.

The 1934 Securities Act essentially codified common law Federal fraud as a securities violation in its Section 16b formulation. Decades ago that was the basis for extending claims against accountants, auditors, lawyers, bankers, brokers and other professionals indirectly involved in fraud or making deceitful representations to shareholders of listed companies.

Moreover, and while this is dangerous to say because bankruptcy rules can be quite particulare and arcane, as a general rule all unsecured creditors share and share alike; lenders quo creditors are no more sancrosanct than any other kind of creditor. (There are certain priority unsecured claims, but mainly they refer to the types of creditors which administer the bankrupt estate and those that help keep it "alive" to the end, which usually eliminates those unsecured creditors who obtained a "vanilla" claim prior to bankruptcy.)

More recently, following the scandals surrounding off-balance sheet shenanigans and other fraud issues in WorldCom and Enron and the like, the Sarbanes-Oxley Act extended the scope of the fraud claim to include unregistered securities and, pertinent to the bankruptcy issues here, made such claims undischargeable in bankruptcy. In bankruptcy you might be able to dishcarge lenders' debts, but not the claims of securities fraud violation. In that sense, the defrauded shareholders have, under US law, greater protective rights than run-of-the-mill lenders.

Title VIII of the Act, which was effective immediately, outlines several new criminal penalties and civil liabilities for securities laws violations. The U.S. Sentencing Commission is directed to “adopt Federal Sentencing Guidelines that will reflect the serious nature of the offenses and the penalties set forth in the Act, the growing incidences of serious fraud offenses and the need to deter, prevent and punish offenses. If the SEC is investigating a company for an alleged securities law violation, a federal court can freeze any anticipatory extraordinary payments to a company’s executive officers or directors for a period of 45 days. [7] The SEC has further authority to ban individuals from serving as directors or officers of public companies if they have been convicted of violating the antifraud provisions of the SEC Act. The Act places an additional requirement on attorneys requiring them to report material violations of securities laws, or a breach of a fiduciary duty.

Criminal Penalties

Several new crimes for securities laws violations have been identified and established. New rules provide penalties for the destruction of documents, the failure to maintain working papers, and schemes to defraud investors. It is now a felony to “knowingly” destroy or create documents to impede, obstruct, or influence any existing or contemplated federal investigation or bankruptcy proceeding; violations can result in up to 20 years imprisonment and/or a fine. The knowing and willful failure by an accountant to maintain all audit or review working papers for a period of five years after the end of the fiscal period in which the engagement was conducted is also prohibited, and violations can result in a sentence of up to ten years and/or a fine (Section 802). The current securities fraud laws have also been broadened. Knowingly devising and executing a scheme to defraud investors in connection with a security is now punishable by up to 25 years in prison and/or a fine (Section 807).

Civil Liabilities

Three main civil liabilities have been outlined in the Act, an amendment to the bankruptcy code, an extension of the statute of limitations for a shareholder to file suit, and a statutory cause of action for a retaliatory discharge. The first of the three civil liabilities is an amendment to the bankruptcy code, which helps avoid liability incurred due to federal or state securities laws violations. Therefore, an individual who has an outstanding judgment against him or her for a securities law violation, common law fraud, or deceit or manipulation in connection with the purchase or sale of a security will not be able to discharge the obligation in a bankruptcy proceeding (Section 803).

The second of the three civil liabilities is an extension of the statute of limitations for investors to file a civil action for fraud, deceit, manipulation or contrivance in contravention of a regulatory requirement concerning the securities laws (Section 804).” Under the new statute of limitations, the time period for an investor to file a civil action for securities fraud has been extended from one year to two years after discovery of the facts, and from three years to five years after there is an actual violation (exceptions are not made for statutes with their own limitations). It is not apparent which statute of limitations is applicable to claims for manipulation under §9(e) of the SEC Act and various insider-trading claims under §20A. Furthermore, it is unclear if claims arising under §§11 and 12(a) (2) of the SEC Act which are sounding in fraud and do not require an actual showing of fraud are subject to the extended statute of limitations.

More commonly known as the whistleblower protection provision, the last of three civil liabilities provides a statutory cause of action for retaliatory discharge (Section 806). Employees, agents, or contractors who lawfully provide information or otherwise assist investigations being conducted by a federal regulatory or law enforcement agency, a congressional member or committee, or any supervisor of the employee are protected. Employees, agents, or contractors who testify in, participate in, or file securities or antifraud proceedings are also protected. A whistleblower whose rights are violated may seek the remedy of special damages, attorney fees, back pay, and reinstatement; relief is sought by filing a complaint with the Secretary of Labor or filing a complaint in federal court. Research analysts who criticize investment-banking clients of firms are also afforded protection from retaliation by Wall Street investment firms. http://www.westga.edu/~bquest/2003/auditlaw.htm

Another review of the legislation advises as follows:

I. NEW DISCHARGEABILITY PROVISIONS

Section 803 of the Sarbanes-Oxley Act amends 11 USC §523(a) to add an exception to discharge for liabilities arising from conduct that violates state or federal securities laws. The new provision states:

(a) A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt- . . .

(19) 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; or (ii) common law fraud, deceit, or manipulation in connection with the purchase or sale of any security, and (B) results from-(i) any judgment, order, consent order, or decree entered in any Federal or State judicial or administrative proceeding; (ii) any settlement agreement entered into by the debtor; or (iii) any court or administrative order for any damages, fine, penalty, citation, restitutionary payment, disgorgement payment, attorney fee, cost, or other payment owed by the debtor.

This new exception to discharge encompasses all violations of securities laws - technical breaches as well as violations arising from morally culpable or dishonest conduct. For example, a liability for sale of an unregistered, nonexempt security in breach of ORS 59.055 would be nondischargeable. Liability arising from the debtor's fraudulent conduct or use of untrue statements of material fact in the sale of a security in violation of ORS 59.135 would also be nondischargeable. Because new §523(a)(19) applies to technical breaches of securities laws, it is broader than both the exception to discharge for liabilities arising when the debtor obtains money, property, services, or credit using false pretenses, false representations, or actual fraud (§523(a)(2)) , and the exception to discharge for fraud or defalcation while acting in a fiduciary capacity (§523(a)(4)).

In addition to liability arising from judgments in private civil actions for securities fraud, this new exception to discharge applies to liability arising from governmental enforcement actions and administrative proceedings. It also applies to settlement agreements-apparently, without regard to whether the debtor admits liability.

One of the most important features of this new exception is that Congress did not limit its application to violations or fraud involving the securities of publicly traded companies. Liabilities arising from securities law violations or securities fraud in the sale of stock of small privately held "mom and pop" businesses are also nondischargeable under the Sarbanes-Oxley Act.

When Congress added the new exception to dischargeability to 11 USC §523(a), it did not amend 11 USC §523(c). Section 523(c) puts the burden on creditors who are owed debts of the types described in §523(a)(2), (4), (6), or (15) to file a complaint to determine the nondischargeability of the debt owed them. New §523(a)(19) was not added to this list. Before enactment of the Sarbanes-Oxley Act, a creditor whose claim arose from the debtor's participation in securities fraud would have had to file a complaint to determine the dischargeability of the debt pursuant to 11 USC §523(a)(2) or (a)(4). Bankruptcy Rule 4007 sets very short time deadlines for filing such complaints. Now, the creditor may rely upon §523(a)(19) and avoid the expense of litigation over nondischargeability.

Congress also did not amend 11 USC §1328 when it enacted the Sarbanes-Oxley Act. Section 1328, the chapter 13 "super-discharge" provision, discharges a debtor from liability for all debts except those arising from family support obligations, student loans, and injuries or deaths caused by the debtor's operation of a motor vehicle while intoxicated. Thus a debtor who qualifies for chapter 13 can still discharge debts arising from securities fraud and other violations of the securities laws, even after enactment of the Sarbanes-Oxley Act.

Consider the following scenario. John Smith owns and operates a small company making widgets. His best customer, BigCo, purchases ninety percent of his output. John wants to expand his company, but needs to purchase more widget-making equipment to do so. Because he cannot afford the equipment, he asks his Aunt Mary to invest. Aunt Mary introduces John to her friends, who also might want to invest. John tells Aunt Mary and her friends about his plans and his need for funds to purchase equipment. He further tells them that BigCo would really like to buy more products from him, and offers Aunt Mary and her friends stock in John's company in exchange for their investment. John knows, but does not tell Aunt Mary and her friends, that BigCo is having financial problems, because John hopes that BigCo will get past its difficult times and continue purchasing his widgets. Aunt Mary and her friends invest in stock of John's company, and John buys the equipment. John, who does not know anything about securities law, does not register the sale of the stock to Aunt Mary and her friends and is unaware that the sale does not qualify for an exemption under the federal or state securities laws.

Six months later, the inevitable occurs. BigCo goes out of business, and John loses most of his customer base. He cannot find anyone else to buy his widgets. Aunt Mary's friends sue John, alleging that he sold them unregistered securities and omitted to disclose material facts when he solicited their investment in his company. They also allege claims for breach of contract. John settles the lawsuit for $100,000, with no admission of liability. John makes payments toward the settlement for several years, but ultimately files for chapter 7 bankruptcy.

Before the Sarbanes-Oxley Act, Aunt Mary's friends would have to file an action for determination of nondischargeability pursuant to 11 USC §523(a)(2) or (4) within 60 days after the first date set for the meeting of creditors in John's bankruptcy case. They would have to prove that John obtained money from them by false pretenses, a false representation, or actual fraud, or that he engaged in fraud while acting in a fiduciary capacity. John might defend such an action and prove the debt is dischargeable by showing that he had no intent to deceive Aunt Mary's friends and that he owed them no fiduciary duties.

The Sarbanes-Oxley Act makes John's debt to Aunt Mary's friends nondischargeable in his chapter 7 case. John violated the securities laws when he sold them unregistered securities without exemption. Under the securities laws, John can be liable for failing to disclose a material fact, even if he had no intent to deceive Aunt Mary's friends. Aunt Mary's friends do not have to sue to determine the dischargeability of John's debts to them. It is irrelevant that John settled the claims filed by Aunt Mary's friends without admitting liability. John's only option to discharge the debt, if he qualifies, is to convert his bankruptcy case to a chapter 13.

II. NEW CRIMINAL PENALTIES

In addition to adding a new exception to discharge in bankruptcy, the Sarbanes-Oxley Act amends the criminal code to add a new bankruptcy crime. Section 802 of the Sarbanes-Oxley Act adds the following felony to title 18:

§1519. Destruction, alteration, or falsification of records in Federal investigations and bankruptcy. Whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies, or makes a false entry in any record, document, or tangible object with the intent to impede, obstruct, or influence the investigation or proper administration of any matter within the jurisdiction of any department or agency of the United States or any case filed under title 11, or in relation to or contemplation of any such matter or case, shall be fined under this title, imprisoned not more than 20 years, or both.

This statute is in addition to (not a replacement of) the existing bankruptcy crimes set forth in 18 USC §§ 152 and 157. As a result, prosecutors now have the ability to charge dishonest debtors with multiple bankruptcy crimes for the same conduct.

The new criminal provision in §1519 expands prior law on bankruptcy crimes in three ways. First, it expands the type of conduct that is subject to criminal prosecution. Under 18 USC §152, it is a crime to "knowingly and fraudulently" engage in certain specified acts, such as concealing property, destroying or altering documents, and making a false oath. Under 18 USC §157, it is a crime to file, or take certain actions in, a bankruptcy case as part of a "scheme or artifice to defraud." Section 1519 makes many of the same acts illegal, but fraud is no longer required. It is now a crime merely to "knowingly" take certain actions "with the intent to impede, obstruct, or influence" a bankruptcy case.

Second, the new criminal provision applies to actions taken "in contemplation" of a bankruptcy case. Previously, only subsections (7) and (8) of 18 USC §152 specifically applied to actions taken "in contemplation" of a bankruptcy case. Moreover, the Ninth Circuit Court of Appeals had held that the existence of bankruptcy proceedings was a necessary element to support a conviction for bankruptcy fraud under 18 USC § 152. United States v. McCormick, 72 F3d 1404, 1406 (9th Cir 1995). Now, it appears that a conviction under new §1519 could be sustained even if the contemplated bankruptcy case was never filed.

Third, and most significantly, the new bankruptcy crime is punishable by a much steeper penalty than the pre-existing bankruptcy crimes. A person convicted of a bankruptcy crime under 18 USC §§152 and 157 can be punished by a fine, up to five years in prison, or both. A person convicted of a bankruptcy crime under new §1519 can be punished by a fine, up to twenty years in prison, or both. The penalty has been quadrupled.

Like the new exception to discharge, the new bankruptcy crime is not limited to actions taken with respect to large, publicly traded companies. Under new §1519, a consumer who knowingly puts the title to his car in the name of a family member to avoid disclosing it as an asset on his bankruptcy schedules, or who knowingly fails to list a creditor's claim, can be imprisoned for up to twenty years. Likewise, a creditor who files an inflated claim may be subject to similar penalties. http://www.millernash.com/showarticle.aspx?Show=265

Compared to the small advance in shareholder protections the Sons of Gwalia line of cases may advance, it is a piece of cake, a walk in the park, for lenders compared to the situation the American finance industry faces in its own back yard. Methinks they're drowning in their own crocodile tears.

Further reading: http://www.sec.gov/investor/pubs/bankrupt.htm
http://en.wikipedia.org/wiki/Bankruptcy_in_the_United_States