If you watch late night television, you no doubt are aware that “Ponzi schemes” do exist. They are out there, and are very real. One recent case from the 10th Circuit demonstrated the interesting intersection of criminal and bankruptcy law. In our blog, we have tried to make a point of demonstrating the nuances of bankruptcy law by showing how it can be interpreted when it intersects with tax law, criminal law, disability law, domestic law, intellectual property law, and other areas of the law.
The case in question is the Oklahoma Dept. of Securities v. Wilcox, 267 P.3d 106 (2011) from the Tenth Circuit Court of Appeals. In the Wilcox case, the background was that a defendant named Schubert pled guilty to several Oklahoma securities laws. Schubert had been running a Ponzi scheme that had defrauded numerous investors out of a total of about 9 million dollars. The reader will recall that a Ponzi scheme is defined as an scam where the perpetrator seeks out more and more new “investors” as a way of pretending that the operation really is a legitimate “investment.” Eventually, the entire house of cards collapses, leaving most “investors” with little or nothing.
After Schubert had pled guilty in the criminal case, the state of Oklahoma filed civil actions against many of the other “investors” in the Ponzi scheme who had received money from it, claiming that they had been unjustly enriched. There were many such investors, and the state of Oklahoma was trying to recoup the money that had been fraudulently paid out, so that it might be more evenly distributed among the victims of the Ponzi scheme. A few of the “investors” could not, or would not, turn over the money they had received from the scheme to the state of Oklahoma. When the state continued to try to collect the debt from the investors, the investors filed for bankruptcy, listing the alleged debt owed to Oklahoma on their schedules.
This triggered extended litigation on the issue of whether the debt to Oklahoma was dischargeable. A bankruptcy court and a district court said that the debt was not dischargeable, since it had been incurred through a violation of the state of Oklahoma’s securities laws. The fact that Schubert, and not the debtors, had been the one who violated the law did make any difference to the bankruptcy court. But the Tenth Circuit Court of Appeals, in a very nuanced decision, reversed. The debt was, in fact, dischargeable.
Why? The Tenth Circuit noted that Oklahoma knew the debtors had not been the ones to violate any laws. Even though they may have profited from Schubert’s Ponzi scheme, that was irrelevant. Oklahoma had declined to prosecute any of the debtors for any securities laws violations. Had it successfully prosecuted the debtors, the debt would likely have been nondischargeable under Section 523(a)(19). However, this did not happen. It was not enough, the Appeals Court noted, that someone had committed fraud. In order for the debt to be nondischargeable, the fraud had to have been committed by the debtors, not some third party like Schubert.
Even if the state of Oklahoma had a noble end in trying to recover fraudulent transfers for the benefit of the Ponzi scheme victims, this was not enough to sustain a nondischargeability action in a bankruptcy case. The debtors themselves had not committed any actionable fraud, only had profited from it.
This case demonstrates yet again the principle that nondischargeability actions in bankruptcy court are narrowly construed in favor of a debtor. A creditor trying to have a debt declared nondischargeable under Section 523(a)’s many subparts has a significant hurdle to overcome. From my own experience in litigating many nondischargeability adversary proceedings in bankruptcy court and before the Bankruptcy Appellate Panel, I can say that a creditor wishing to prevail under this section will need to have a strong set of facts in his favor. Benefits of the doubt will, more often than not, go in favor of the debtor.
Read More: What Is An Adversary Proceeding?