A Collision of Fairness Sarbanes-Oxley and 510(b) of the Bankruptcy Code

A Collision of Fairness Sarbanes-Oxley and 510(b) of the Bankruptcy Code

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In response to a slew of instances of unprecedented and highly publicized corporate fraud, President Bush signed the Sarbanes-Oxley Act on July 31, 2002.1 Sarbanes-Oxley effected significant changes to corporate governance, including new rules to ensure auditor independence, to enhance corporate responsibility and the requirements for financial disclosures, and to provide the Securities and Exchange Commission (SEC) with new regulatory powers to protect investors.2 Section 308 of Sarbanes-Oxley, the "Fair Funds for Investors" provision, grants the SEC the discretion to seek to direct monies collected as civil penalties for violations of securities laws to a "disgorgement fund for the benefit of victims."3 The "victims" of securities laws violations are commonly stockholders.

The stockholder of an entity subject to both the Bankruptcy Code and Sarbanes-Oxley is thus potentially at the intersection of conflicting statutory schemes. An investor whose claims must be subordinated pursuant to §510(b) of the Code may also be qualified for a distribution pursuant to the Fair Funds for Investors provision of Sarbanes-Oxley. When a "disgorgement fund" under Sarbanes-Oxley is to be created from the limited resources of a bankruptcy estate, a stockholder claimant may receive a distribution, albeit indirectly from the SEC, to the direct detriment of unsecured creditors and in potential contravention of provisions of the Code, including §510(b) and the "absolute priority rule."4

Section 510(b) of the Code

Tension between the expectations and rights of wronged shareholders and those of unsecured creditors is not new. Under the former Bankruptcy Act, after Oppenheimer v. Harriman Nat'l. Bank & Trust Co., 301 U.S. 206, 215, 57 S.Ct. 719, 81 L.Ed. 1042 (1937), courts tended to favor equal treatment for the claims of defrauded shareholders and general unsecured creditors.5 Critics of the trend argued that parity of treatment for claims of creditors and interest-holders was inequitable, primarily because only shareholders may participate in the "upside" of a successful endeavor.6 Moreover, creditors may extend credit to an entity in reliance, at least in part, upon the perception of an equity "cushion" provided by an entity's investors. When a business fails and creditor claims are treated equally with those of investors, the cushion is unfairly diluted.

The era of defrauded shareholder/unsecured creditor distributive equality ended with the enactment of the Code and its §510(b), which provides that claims "arising" from the sale or purchase of a security of the debtor must be subordinated—the provision is mandatory.7 The prevailing view is that the statute should be applied both strictly and broadly, in light of the apparent "strong congressional disapproval of investor fraud claims in bankruptcy."8 Thus, claims based on failure to register stock, breach of an employment agreement with payment in stock and simple breach of contract have all been found sufficiently connected to transactions involving a debtor's securities to trigger mandatory subordination under §510(b).9

The "Fair Funds for Investors" Provision of Sarbanes-Oxley

In addition to the SEC's comprehensive regulatory and enforcement powers, federal courts have recognized the SEC's authority to fashion equitable remedies, including disgorgement orders that require the surrender of funds obtained through actions taken in violation of securities laws.10 Disgorgement is limited to a violator's profits, plus interest.11 Case law and SEC policy has developed such that district courts have discretion to order that disgorged funds be funneled into a restitution plan for defrauded investors.12 Otherwise, the funds may simply be paid into the U.S. Treasury.13 The primary goal of disgorgement is deterrence, and although disgorged funds may go to the victims of securities laws violations, "such compensation is a distinctly secondary goal."14

The SEC also has statutory authority to impose civil penalties upon violators.15 Penalties may be assessed to correspond to a defendant's culpability, and in more egregious cases are limited only by "the gross amount of pecuniary gain to such defendant as a result of the violation."16 Unlike disgorgement, prior to Sarbanes-Oxley, funds recovered pursuant to civil penalties imposed in an SEC action (or settlement) could not be distributed to investors, but were paid into the U.S. Treasury.17 The SEC may seek disgorgement and the imposition of civil penalties in the same action.18

Under the Fair Funds for Investors provision of Sarbanes-Oxley, in SEC actions where a disgorgement fund for investors is established, the SEC may now seek court authority to add monies to the fund recovered pursuant to civil penalties.19 The SEC has aggressively implemented the Fair Funds for Investors provision.20 In the majority of cases thus far, it appears that bankruptcy has not been an issue. When a Fair Funds for Investors program is established or administered concurrently with a case subject to the Code, however, the discord between the statutory mechanisms is apparent.

WorldCom and Adelphia

As noted above, in most cases the claims of interest-holders are at the lower, or lowest, end of the distributive priority spectrum established by the Code, either pursuant to the absolute priority rule or by operation of §510(b). Moreover, in a chapter 7 case, §726(a)(4) of the Code provides that distributions of estate property for allowed claims based on fines or penalties that are "not compensation for actual pecuniary loss" hold a lower distributive priority vis-à-vis allowed general unsecured claims.21 Thus, if the SEC is able to fund a Fair Fund for Investors program with civil penalties imposed upon a bankruptcy estate for the benefit of interest-holders, such action could also run afoul of §726(a)(4), depending on whether an SEC penalty is characterized as "compensation for actual pecuniary loss."22 Section 726(a)(4) is operative in the chapter 11 context, as a plan may not be approved over the objection of an impaired class of claims or interests if the proposed plan's distribution for that class would be less than the class would receive under chapter 7.23

These issues were at play in the WorldCom Inc. case and, more recently, in the Adelphia Communications Corp. case.24 Both WorldCom and Adelphia filed chapter 11 cases in the Southern District of New York. In both cases, the SEC asserted claims against the estates implicating the Fair Funds for Investors provision of Sarbanes-Oxley—claims large enough, if allowed, to potentially force a liquidation. Also in both cases, the bankruptcy courts approved settlements with the SEC that will likely result in distributions to defrauded shareholders from estate assets. Rather than attempt to resolve the apparent conflicts between Sarbanes-Oxley and the Code, the bankruptcy courts in WorldCom and Adelphia invoked their settlement authority under Federal Rule of Bankruptcy 9019, and identified the uncertainties associated with the conflicting statutory schemes as reasons to support the proposed settlements.

On June 26, 2002, the SEC commenced a civil action in the U.S. District Court for the Southern District of New York against WorldCom alleging massive accounting fraud.25 On July 21, 2002, WorldCom filed for chapter 11 protection. The SEC action progressed concurrently with the bankruptcy case. The SEC gained an injunction against WorldCom and proposed a settlement agreement whereby the SEC would impose a $2.25 billion civil penalty, which could be satisfied by a $750 million payment from the bankruptcy estate—a $500 million cash payment and $250 million in the reorganized company's common stock.26 The settlement provided that the settlement assets would be directed to defrauded shareholders pursuant to the Fair Funds for Investors provision of Sarbanes-Oxley.

The district court hearing the SEC action approved the settlement on July 7, 2003. In a written opinion and order approving the settlement, Judge Rakoff took care to note that the SEC had authority to seek a civil penalty for the full value derived from WorldCom's fraud—estimated at between $10 billion and $17 billion—and that a penalty of that magnitude would necessarily "kill the company" to the detriment of some 50,000 innocent employees.27 Judge Rakoff recognized the potential conflict between the Fair Funds for Investors provision of Sarbanes-Oxley and the Code, and stated that any civil penalty imposed by the SEC "premised primarily" on compensating defrauded shareholders "might arguably run afoul of the provisions of the Code that subordinate shareholder claims below all others."28 Judge Rakoff wrote that the SEC could "give" the civil penalty to shareholders pursuant to Sarbanes-Oxley, and that the SEC could consider shareholder compensation in determining a proper penalty, but also that these factors could not dominate the SEC's motivations without contravening provisions of the Code and the SEC's own mandates regarding compensation of victims as a secondary goal.29

In the bankruptcy case, upon World-Com's motion to approve the settlement with the SEC pursuant to Federal Rule of Bankruptcy Procedure 9019, Bankruptcy Judge Arthur J. Gonzalez noted the apparent conflict between Sarbanes-Oxley and the Code, but stated that "[i]n considering approval of a settlement, the court is not required to resolve the underlying legal issues related to the settlement."30 Citing the support for the settlement announced by the committee in the case, the possibility of an even greater penalty if the matter proceeded to a litigated judgment, and the uncertainty of the law with respect to the priority issues, the bankruptcy court found that the settlement did not "fall below the lowest point in the range of reasonableness." On Aug. 6, 2003, the bankruptcy court approved the SEC's settlement with WorldCom.

In the Adelphia case, the Department of Justice (DOJ) indicated a willingness to bring criminal charges against Adelphia, and the SEC asserted claims against the debtors based on fraud and accounting irregularities.31 The SEC claims were for disgorgement of profits and for civil penalties for the "gross pecuniary gain" during the period of asserted fraudulent activity—potentially in excess of $10 billion combined. The committee commenced an adversary proceeding in the bankruptcy case against the SEC seeking the subordination of any SEC claims pursuant to §510(b).

In May 2005, the bankruptcy court considered a comprehensive settlement proposal intended to resolve the claims, as well as potential criminal actions, involving the debtors, DOJ, SEC and members of the family of John Rigas, Adelphia's founder and former CEO.32 The proposal, among other things, provided that Adelphia must contribute $715 million in value to a "restitution fund" to be administered by the government. In exchange, upon the establishment of the restitution fund, the DOJ agreed that it would not institute a criminal action against Adelphia, and the SEC would drop its claims for disgorgement and for the imposition of civil penalties.

Several parties, including the committee, objected to the settlement proposal based on the "likelihood" that proceeds from the restitution fund would go to Adelphia's equity security-holders, in violation of the absolute priority rule and §§510(b) and 726(a)(4) of the Code. Bankruptcy Judge Robert E. Gerber, in a written opinion, stated: "I assume that the government will indeed distribute the value as the unsecured creditors fear."33 Judge Gerber noted, however, that the settlement proposal was presented pursuant to Federal Rule of Bankruptcy Procedure 9019 and not pursuant to a proposed plan or claim objection; "while defrauded equity-holders will plainly have to confront the Absolute Priority Rule and §510(b) when trying to share in assets of the estate in this court, what I am asked to approve here is twice removed from that scenario."34

Judge Gerber cited the example of Judge Gonzalez's opinion in WorldCom. Recognizing the issue of the status and potential subordination of SEC claims as a "close and difficult one," Judge Gerber declined to opine on how the matter would be resolved in litigation. Considering all the points implicated in the proposed settlement, including the preclusion of a potentially company-killing criminal action against Adelphia by the DOJ, Judge Gerber approved the proposed settlement.

While the Adelphia settlement did not ultimately channel estate funds into a Fair Funds for Investors fund pursuant to Sarbanes-Oxley, the probability that the SEC would attempt to do so in the absence of a settlement was among the primary considerations cited by Judge Gerber in his approval of the settlement and its restitution fund.


More than $5.5 billion in penalties have been designated by the SEC for the Fair Funds for Investors program.35 Although Sarbanes-Oxley has entered its third year of existence, significant distributions have only just begun. Tangible distributions from "disgorgement funds" under Sarbanes-Oxley are likely to increase pressure on the SEC to continue and broaden such programs, especially in instances where an intervening bankruptcy would otherwise leave interest-holders with no avenue for recovery. Thus far, the courts have recognized, but not resolved, the dissonances between Sarbanes-Oxley and the Code.


1 Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (codified as amended in sections of Titles 11, 15, 18, 28 and 29 U.S.C. (2002)). Return to article

2 For a comprehensive overview of Sarbanes-Oxley, see Egan, Byron, "The Sarbanes-Oxley Act and Its Expanding Reach," 40 Tex. J. Bus. L. 305 (2005). Return to article

3 Sarbanes-Oxley §308(a), "Civil Penalties Added to Disgorgement Funds for the Relief of Victims" provides:

If in any judicial or administrative action brought by the Commission under the securities laws (as such term is defined in §3(a)(47) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(47)) the Commission obtains an order requiring disgorgement against any person for a violation of such laws or the rules or regulations thereunder, or such person agrees in settlement of any such action to such disgorgement, and the Commission also obtains pursuant to such laws a civil penalty against such person, the amount of such civil penalty shall, on the motion or at the direction of the Commission, be added to and become part of the disgorgement fund for the benefit of the victims of such violation. Return to article

4 The "absolute priority rule" requires that under a chapter 11 plan, no junior class of creditors or interest-holders may retain or receive any value until all senior dissenting classes of unsecured creditors or interest-holders are paid in full. See, e.g., In re Tucson Self-Storage Inc., 166 B.R. 892, 899 (9th Cir. BAP 1994) (applying Code §1129(b)(2)(B)(ii)). Return to article

5 See In re Geneva Steel Co., 281 F.3d 1173, 1176 (10th Cir. 2002) (discussing Oppenheimer and its consequences). Return to article

6 Id. at 1176-77 (discussing the positions stated in Slain, John and Kripke, Homer, "The Interface Between Securities Regulation and Bankruptcy-allocating the Risk of Illegal Securities Issuance Between Security-holders and the Issuer's Creditors," 48 N.Y.U. L. Rev. 261 (1973)). Return to article

7 Section 510(b) provides:

For the purpose of distribution under this title, a claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a security or for reimbursement or contribution allowed under §502 on account of such a claim, shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security, except that if such security is common stock, such claim has the same priority as common stock. Return to article

8 Geneva Steel Co., 281 F.3d at 1179. Return to article

9 See In re Telegroup Inc., 281 F.3d 133, 144 (3d Cir. 2001) (breach of agreement to register stock); In re Worldwide Direct Inc., 268 B.R. 69, 73 (Bankr. D. Del. 2001) (breach of employment agreement with payment in stock); In re Betacom of Phoenix Inc., 240 F.3d 823, 832 (9th Cir. 2001) (breach of contract). Return to article

10 See, e.g., S.E.C. v. Patel, 61 F.3d 137, 139 (2d Cir. 1995) ("In the exercise of its equity powers, a district court may order the disgorgement of profits acquired through securities fraud"). Return to article

11 See, e.g., S.E.C. v. Blatt, 583 F.2d 1325, 1335 (5th Cir. 1978) (disgorgement limited to amount "by which the defendant profited from his wrongdoing. Any further sum would constitute a penalty assessment"). Return to article

12 See, e.g., S.E.C. v. Fischbach Corp., 133 F.3d 170, 175 (2d Cir. 1997). Return to article

13 See, e.g., S.E.C. v. Lorin, 869 F. Supp. 1117, 1129 (S.D.N.Y. 1994) ("disgorged profits can very well end up in the U.S. Treasury...where numerous victims suffered relatively small amounts thereby making distribution of the disgorged profits to them impractical"). Return to article

14 Fischback Corp., 133 F.3d at 175. Return to article

15 See 15 U.S.C. §77t(d) (2002). Return to article

16 Id. Return to article

17 See "Report Pursuant to §308(c) of the Sarbanes Oxley Act of 2002," at 5: http://www.sec.gov/news/studies/sox308creport.pdf (last visited Aug. 29, 2005). Return to article

18 See, e.g., S.E.C. v. Phoenix Telecom LLC, 231 F.Supp.2d 1223, 1225-26 (N.D. Ga. 2001). Return to article

19 See supra note 3. Return to article

20 See Solomon, Deborah, "For Wronged Investors, It's Payback Time," Wall St. J. July 7, 2005, at D1. Return to article

21 See 11 U.S.C. §726(a)(4). Return to article

22 If an SEC claim based on a civil penalty is determined to be "compensation for actual pecuniary loss," it would presumably be entitled to a distribution on par with allowed general unsecured claims, and thus still in potential conflict with §510(b) of the Code. Return to article

23 See 11 U.S.C. §1129(a)(7)(A)(ii). Return to article

24 See In re WorldCom Inc., Ch. 11 Case No. 02-13533 (Bankr. S.D.N.Y. July 21, 2002 (petition date)); In re Adelphia Communications Corp., Chapter 11 Case No. 02-41729 (Bankr. S.D.N.Y. June 25, 2002 (petition date)). Return to article

25 See S.E.C. v. WorldCom Inc., Litigation Release No. 17588 (Civil Action 02 CV 4963 (S.D.N.Y.) (June 27, 2002)), available at http://www.sec.gov/litigation/litreleases/lr17588.htm (last visited Aug. 29, 2005). Return to article

26 See S.E.C. v. WorldCom Inc., 273 F.Supp.2d 431, 435 (S.D.N.Y. 2003). Return to article

27 Id. at 433-34. Return to article

28 Id. at 434. Return to article

29 Id. (citing Fischback, 133 F.3d at 175). Return to article

30 In re WorldCom Inc., Ch. 11 Case No. 02-13533, Docket #8125 (Bankr. S.D.N.Y. Aug. 6, 2003). Return to article

31 In re Adelphia Communications Corp., 327 B.R. 143, 149 (Bankr. S.D.N.Y. 2005). Return to article

32 Id. at 147 (The potential criminal actions were against the debtor corporation. John and Timothy Rigas were convicted of several criminal charges following a jury trial in the district court). Return to article

33 Id. at 168. Return to article

34 Id. at 169 (emphasis in original). Return to article

35 See supra note 20. Return to article

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Saturday, October 1, 2005