Third-Party Debtors and the Securities Law Violation Exception to Discharge

Abstract

In general, an individual debtor can discharge his debts in bankruptcy. But Congress has created several debt-specific exceptions to discharge. With the passage of the Sarbanes-Oxley Act, Congress added another debt-specific discharge exception to the Bankruptcy Code: debts for the violation of federal or state securities laws cannot be discharged in bankruptcy. The provision is ambiguous: is the exception limited to debts incurred by securities violators directly, or does it also apply to the debts of third parties that indirectly benefit from a securities violation? Several courts have considered this issue, appealing to statutory text, legislative intent, and policy considerations.

This comment takes a different tack, starting from the premise that the right of discharge functions to allocate risk between debtors and creditors. The aim of third-party securities liability is deterrence — limiting the damage that results from securities violations by giving third parties an incentive to put a stop to them before losses mount. Thus, third-party securities violation debts should be nondischargeable in bankruptcy. The approach outlined in the comment is consistent with both the risk-allocation function of bankruptcy law and Sarbanes-Oxley’s strategy of enlisting third-party gatekeepers to prevent securities violations.