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adopting the In re Sherman approach and stating that "[ Section] 523 ’s scope is properly limited to debts for violations arising from the debtor's own misconduct rather than that of a third party."
Summary of this case from Blake v. Fusco (In re Fusco)Opinion
Case No. 18-13108 Adv. No. 18-1071
10-18-2019
In re: STEVEN EDWARD SCHUHOLZ Debtor JAMES UREN, ET AL. Plaintiffs v. STEVEN EDWARD SCHUHOLZ Defendant
Chapter 7
MEMORANDUM DECISION DENYING DEBTOR'S MOTION FOR JUDGMENT ON THE PLEADINGS [Docket Number 10] [This opinion is not intended for publication or citation.]
This matter is before this Court on the Debtor's Motion for Judgment on the Pleadings [Docket Number 10] ("Motion"); the Plaintiffs' Response in Opposition to Debtor's Motion for Judgment on the Pleadings [Docket Number 13]; and the Reply in Support of Motion for Judgment on the Pleadings [Docket Number 14].
In his Motion, Defendant-Debtor Steven Edward Schuholz ("Mr. Schuholz") argues that he is entitled to judgment and denial of the Plaintiffs', James T. Uren and Josephine Khoo-Smith ("Plaintiffs"), claims that an $864,534.16 class-action state court judgment debt is excepted from discharge pursuant to 11 U.S.C. § 523(a)(19), § 523(a)(2)(A) and/or § 523(a)(6). Mr. Schuholz asserts that the judgment does not qualify for exception from discharge under these provisions because it is based on unjust enrichment rather than securities laws violations or any fraud or intentional wrongdoing on the part of Mr. Schuholz. Instead, Mr. Schuholz asserts that Glen Galemmo, a convicted Ponzi scheme operator, is the person who violated Ohio securities laws and committed fraudulent or intentional acts injuring the plaintiff-investors in the scheme. Arguing that a debt cannot be held nondischargeable based on securities violations and/or the wrongdoing of another person, Mr. Schuholz requests a determination that the judgment debt is not excepted from discharge under § 523(a)(19), § 523(a)(2)(A), and § 523(a)(6).
Use of the terms "Bankruptcy Code," "Section" or "§" are references to provisions of Title 11 of the United States Code.
Although a split of authority exists on the issue, this Court agrees with Mr. Schuholz that a debt cannot be held nondischargeable under § 523(a)(19) based on the securities violations of another person. Nonetheless, in this case, the state court judgment includes an explicit determination that Mr. Schuholz, himself, violated Ohio securities laws by receiving money, without having a license, for recruiting investors into Galemmo's Ponzi scheme. Because the pleadings do not establish what portion, if any, of the state court judgment award is attributable to Mr. Schuholz's Ohio securities laws violation, the portion of the debt that may be held nondischargeable pursuant to § 523(a)(19) must be determined through subsequent dispositive motions or trial. With respect to the Plaintiffs' other nondischargeability claims, while the State court did not make specific findings that would establish certain elements required to hold the debt nondischargeable under § 523(a)(2)(A) and § 523(a)(6), the lack of such findings does not preclude this Court from making its own determination of those issues at trial. Accordingly, Mr. Schuholz's Motion is denied.
I. JURISDICTION
This Court has jurisdiction over this matter pursuant to 28 U.S.C. §§ 157(a) and 1334, and the standing General Order of Reference in this District. This is a core proceeding pursuant to 28 U.S.C. § 157(b)(2)(I). The parties have consented to final judgment being rendered by this Court in this adversary proceeding [Docket Number 12].
II. BACKGROUND
Plaintiffs filed an Amended Complaint to determine the dischargeability of a state court class-action judgment debt against Mr. Schuholz [Docket Number 4] ("Amended Complaint"). In the Amended Complaint, the Plaintiffs allege that they were appointed as class representatives and lead plaintiffs by the Court of Common Pleas of Hamilton County, Ohio, ("State Court"), in Case No. A1406892, captioned Uren v. Scoville, et al. ("Class Action") [Id., ¶ 4]. They were appointed on behalf of the following class of plaintiffs: "All persons or entities, individually and collectively, who invested money in or through Glen Galemmo or his affiliated entities from January 1, 2002 to July 26, 2013 and suffered a net loss (i.e., the funds invested exceeded the total of all funds received in the form of purported income or return of principal)" (the "Plaintiff Class") [Id.].
Mr. Schuholz was a defendant in the Class Action and the matter proceeded to trial against him [Id., ¶ 5]. On July 11, 2017, following a bench trial, the State Court entered final judgment in favor of the Plaintiff Class and against Mr. Schuholz in the amount of $864,534.16 plus interest and costs [Id.].
In the Amended Complaint, the Plaintiffs summarize findings and conclusions from the State Court, but do not provide a copy of the State Court's judgment [Id., ¶¶ 9-22]. However, Mr. Schuholz incorporates and attaches copies of the State Court's Final Judgment Entry and Findings of Fact and Conclusions of Law to his Answer [Docket Number 7, Exs. A and B]. The State Court Judgment Entry and Findings of Fact and Conclusions of Law include almost identical findings and conclusions. Accordingly, this Court lists the findings and conclusions from the State Court Judgment Entry except where stated:
Glen Galemmo operated a Ponzi scheme that began as early as 2008 and continued through approximately July 2013 [Id., Ex. A, p. 3].
The Ponzi scheme continued because of willful and criminal acts [by Galemmo] including fraudulent misrepresentations, fraud while acting in a fiduciary capacity, and theft [Id., Ex. A, p. 3; Ex. B, p. 1].
As a result of Glen Galemmo's Ponzi scheme, the Plaintiff Class suffered a net loss of $34,599,085.46 [Id., Ex. A, p. 4].
Plaintiffs' expert, Elliott Lieb, C.F.E., submitted a spreadsheet that identified all of the transactions between Defendant Schuholz and the Galemmo Ponzi scheme [in certain exhibits]. All of the transfers from the Galemmo Ponzi scheme to Defendant Schuholz . . . were both actually and constructively fraudulent [Id., Ex. A, p. 4].
Defendant Schuholz was associated with Total Care & Repair, LLC ("TC&R") as an owner. For each bank account identified during trial on which TC&R was identified as an account holder, Defendant Schuholz was also identified as an account holder on the same account [Id., Ex. A, p. 4].
Plaintiffs' expert correctly counted transactions from the Galemmo Ponzi scheme to a TC&R bank account as a fraudulent transfer attributable to Defendant Schuholz because Defendant Schuholz was named on the TC&R bank accounts and had unfettered access to, and exercised control and dominion over, those bank accounts [Id., Ex. A, p. 4].
Plaintiffs' expert testified that he believed that some (but not all) of the transfers from the Galemmo Ponzi scheme to a TC&R bank account were made in consideration for materials or labor performed by TC&R. He thus correctly excluded those transactions from his calculations of the amount of the fraudulent transfers received by Defendant Schuholz. In other words, Plaintiffs' expert did not count non-investment receipts when calculating Schuholz's net profit [Id., Ex. A, pp. 4-5].
Defendant Steven Schuholz received a net profit from the Galemmo Ponzi scheme of $864.534.16. In other words, the Galemmo Ponzi scheme transferred $864,534.16 more to Schuholz than Schuholz transferred to Galemmo. This all constitutes money obtained as a result of the fraudulent Ponzi scheme. Plaintiffs have proven the existence of a Ponzi scheme and all of the elements of these fraudulent transfers to Defendant Schuholz by clear and convincing evidence [Id., Ex. A, p. 5; Ex. B, p. 3].
Defendant Schuholz failed to plead the affirmative defense of good faith or reasonably equivalent value and those defenses are therefore waived. Even if he had pled such affirmative defenses, Schuholz failed to carry his burden at trial as to any such affirmative defense [Id., Ex. A, p. 5].
Defendant Schuholz was included on a list of four individuals used as references by Glen Galemmo while operating his Ponzi scheme. Galemmo encouraged potential investors to contact Schuholz as they evaluated whether to invest their money with Galemmo. Potential investors did, in fact, reach out to Schuholz before they transferred money to the Ponzi scheme [Id., Ex. A, p. 5].
Schuholz was not licensed to sell securities or to broker the sale of securities. Yet, Schuholz received money on account of people being recruited into the Galemmo Ponzi scheme [Id., Ex. A, p. 5].
Because their money was transferred to Defendant Schuholz, the members of the Plaintiff Class conferred a benefit upon Defendant Schuholz. Defendant Schuholz received the Plaintiffs' money and knew he had received the money [Id., Ex. A, p. 7].
In a Ponzi scheme, fraudulent "intent is presumed because the Debtor undeniably knows that 'future investors will not be paid', thus evidencing an intent to defraud creditors". In re Independent Clearing House Co., 77 B.R. 84 (D. Utah 1987); Bash v. Textron Financial Corp., 483 B.R. 630, 656 (N.D. Ohio 2012) [Id., Ex. A, p. 7].[Docket Number 7, Ex. A].
Courts hold that the existence of a Ponzi scheme establishes as a matter of law that any transfers pursuant to the scheme are constructively fraudulent because (1) the investors do not provide reasonably equivalent value for their "fictitious profits" and (2) the Ponzi scheme is inherently insolvent because each new investor has a tort claim that cannot be repaid. See Scholes v. Lehmann, 57 F.3d 750, 755 (7th Cir. 1995) [Id., Ex. A, p. 8].
Defendant Schuholz's receipt of money for people being recruited into the Galemmo Ponzi scheme is a violation of Ohio's state securities laws. See R.C. 1707.14(A); R.C. 1707.44(A) [Id., Ex. A, p. 8].
Plaintiffs have clearly and convincingly proven that Defendant Schuholz was unjustly enriched by his receipt of the money belonging to the members of the Plaintiff Class, to the detriment of the members of the Plaintiff Class, and it would be unjust for Defendant Schuholz to retain such money without providing compensation to the Plaintiff Class [Id., Ex. A, p. 8].
It would be inequitable for Defendant Schuholz to retain the funds transferred to him from the Galemmo Ponzi scheme that belong to the members of the Plaintiff Class. Defendant Schuholz gained possession of these funds only because of the fraudulent and criminal Ponzi scheme. As such, the law imposes a constructive trust upon these funds and Defendant Schuholz has a duty to convey the property to the Plaintiff Class to be distributed pursuant to the orders of this Court. See Bilovocki v. Marimberga, 62 Ohio App.2d 169, 171 (1979) [Id., Ex. A, p. 8].
This fact is stated somewhat differently in the State Court's Judgment Entry and its Findings of Fact and Conclusions of Law [Compare Docket Number 7, Ex. A, p. 3, ¶ 1 to Ex. B, p. 1, ¶ 2]. The Findings of Fact and Conclusions of Law specifically states that the Ponzi scheme continued because of willful and criminal acts "by Galemmo" whereas the Judgment Entry does not specify who conducted the willful and criminal acts.
Again, these factual conclusions are stated somewhat differently in the Judgment Entry and in the Findings of Fact and Conclusions of Law.
In their Amended Complaint, the Plaintiffs assert that the State Court judgment debt owed by Mr. Schuholz is for violations of securities laws and is nondischargeable under 11 U.S.C. § 523(a)(19). They further assert that Mr. Schuholz obtained money through material misrepresentations about the Galemmo Ponzi scheme when he spoke with investors, which makes the debt nondischargeable pursuant to 11 U.S.C. § 523(a)(2)(A). Finally, they assert that Mr. Schuholz acted willfully or with substantial certainty to cause injury and maliciously when he participated in the Galemmo Ponzi scheme as a referral source making the debt nondischargeable pursuant to 11 U.S.C. § 523(a)(6).
III. LEGAL ANALSYIS
A. Standard for Judgment on the Pleadings
Mr. Schuholz requests judgment on the pleadings pursuant to Federal Rule of Civil Procedure ("Rule") 12(c), incorporated in bankruptcy adversary proceedings by Federal Rule of Bankruptcy Procedure 7012. The motion is reviewed under the standard applicable to a Rule 12(b)(6) motion to dismiss for failure to state a claim. Ziegler v. IBP Hog Market, Inc., 249 F.3d 509, 511-12 (6th Cir. 2001); Michael v. Javitch, Block & Rathbone, LLP, 825 F. Supp. 2d 913, 918 (N.D. Ohio 2011). As such, a court is to construe a complaint in a light most favorable to the plaintiff accepting all of the complaint's well pleaded factual allegations as true to determine whether the plaintiff has stated a claim for relief that is plausible on its face. Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009); Ziegler, 249 F.3d at 512. However, a pleading that offers "labels and conclusion," a "formulaic recitation of the elements of a cause of action," or "'naked assertion devoid of further factual enhancement" is insufficient to survive dismissal. Iqbal, 556 U.S. at 678 (cleaned up).
When deciding a motion for judgment on the pleadings, a court is limited to considering the contents of the pleadings. Raymond Prof'l Group, Inc. v. William A. Pope Co. (In re Raymond Prof'l Group, Inc.), 386 B.R. 678, 681 (Bankr. N.D. Ill. 2008). However, "a court may consider: (1) any documents attached to, incorporated by, or referred to in the pleadings; (2) documents attached to the motion . . . that are referred to in the complaint and are central to the plaintiffs' allegations, even if not explicitly incorporated by reference; (3) public records; and (4) matters of which the court may take judicial notice." Embassy Realty Investments, LLC v. City of Cleveland, 877 F. Supp. 2d 564, 570 (N.D. Ohio 2012) (further citation omitted). See also Seaton v. TripAdvisor LLC, 728 F.3d 592, 596 (6th Cir. 2013) (stating that although matters outside the pleadings are not to be considered when ruling on a Rule 12(b)(6) motion to dismiss, documents attached to the motion to dismiss are considered part of the pleadings if they are referred to in the complaint and are central to the plaintiff's claims). In other words, "'[a] defendant may introduce certain pertinent documents if the plaintiff chooses not to do so.'" Embassy Realty, 877 F. Supp. 2d at 570 (further citation omitted). "'Otherwise, a plaintiff with a legally deficient claim could survive a motion to dismiss simply by failing to attach a dispositive document upon which it relied.'" Id.
In the Amended Complaint, the Plaintiffs reference, but do not attach, the State Court's Findings of Fact and Conclusions of Law as well as its Final Judgment Entry. Mr. Schuholz, however, attaches both of these documents to his Answer [Docket Number 7, Exs. A and B]. These critical documents are incorporated into the pleadings and may be considered by this Court in determining Mr. Schuholz's Motion.
B. 11 U.S.C. § 523(a)(19)
Mr. Schuholz calls upon this Court to address the adequacy of the Plaintiffs' claims that the $864,534.16 class-action State Court judgment debt is excepted from discharge under various provisions of 11 U.S.C. § 523(a). This Court begins with his assertion that the Plaintiffs fail to state a claim under 11 U.S.C. § 523(a)(19) because the judgment debt does not constitute a debt for a violation of securities laws as a matter of law.
Section 523(a) sets forth the types of debts that are excepted from a debtor's discharge. At trial, the Plaintiffs will bear the burden of proving that a debt falls within a provision of § 523(a) by a preponderance of the evidence. Grogan v. Garner, 498 U.S. 279, 286-87 (1991).
Section 523(a)(19) provides that:
(a) A [bankruptcy] discharge ... 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, before, on, or after the date on which the petition was filed, from—
11 U.S.C. § 523(a)(19). This provision is a relatively recent addition to the Bankruptcy Code enacted as part of the Sarbanes-Oxley Act in 2002 "to address perceived loopholes in securities laws after the Enron debacle." Oklahoma Dep't of Sec. v. Wilcox, 691 F.3d 1171, 1175 (10th Cir. 2012). The legislative history reveals Congressional concerns that current bankruptcy laws had permitted "wrongdoers to discharge their obligations under court judgments or settlements based on securities fraud and other securities violations." S. Rep. No. 107-146, 107th Cong., 2nd Sess. 2002, 2002 WL 863249, at *10, 16 (May 6, 2002). Accordingly, § 523(a)(19) was drafted to close this perceived loophole and "help defrauded investors recoup their losses and to hold accountable those who incur debts by violating our securities laws." Id.(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.
Mr. Schuholz asserts that for a debt to be excepted from discharge under § 523(a)(19), the debt must be for a securities violation by the debtor. According to Mr. Schuholz, the State Court determined all of the wrongdoing and securities violations to be on the part of the Ponzi scheme operator, Glen Galemmo, rather than Mr. Schuholz himself. As such, Mr. Schuholz's debt, which he construes as one for unjust enrichment in the form of profits from the Ponzi scheme, cannot be considered a debt for a securities violation because the securities laws were violated by someone other than himself.
Contrary to Mr. Schuholz's argument, a circuit split exists regarding whether a judgment may be excepted from discharge under § 523(a)(19) based on a debt arising from a violation of securities laws by another person. Compare Oklahoma Dep't of Sec. v. Wilcox, 691 F.3d 1171, 1176-77 (10th Cir. 2012) (determining that § 523(a)(19) does not apply to except from discharge a judgment debt for unjust enrichment resulting from a Ponzi scheme when the debtor was not charged with violating securities laws), and Sherman v. Sec. and Exch. Comm'n, 658 F.3d 1009, 1012 (9th Cir. 2011) (similar holding to Wilcox but decision was abrogated on other grounds relating to § 523(a)(4) by Bullock v. BankChampaign, N.A., 569 U.S. 267, 271 (2016)), with Lunsford v. Process Tech. Servs., LLC (In re Lunsford), 848 F.3d 963, 968 (11th Cir. 2017) (holding that the text of § 523(a)(19)(A) "precludes discharge regardless of whether the debtor violated securities laws as long as the securities violation caused the debt").
In Wilcox, the Tenth Circuit considered whether state court judgments based on unjust enrichment requiring debtors to disgorge profits received from their investments in a Ponzi scheme qualified as judgments "for a violation" of securities laws under § 523(a)(19)(A). 691 F.3d at 1174. The plaintiff in Wilcox, the Oklahoma Department of Securities, argued that, while the debtors themselves were not charged with violating securities laws, the debtors' required disgorgement of profits was a direct result of the Ponzi scheme operator's violations and the debtors materially aided in those violations. Id. at 1174-75.
In Wilcox, non-debtor Marsha Schubert pled guilty to operating a Ponzi scheme that she used to defraud investors of over $9,000,000. 691 F.3d at 1173. Her activities violated Oklahoma security laws. Id. After her conviction, the Oklahoma Department of Securities sued investors, including Robert Mathews and Marvin and Pamela Wilcox, to recover funds distributed to them in the Ponzi scheme on grounds of unjust enrichment. Id. The Department was granted summary judgment and judgment was entered against Mathews and the Wilcoxes requiring them to repay profits they received in the scheme. Id. Mathews and the Wilcoxes filed for bankruptcy protection and the Department filed adversary proceedings to except the judgment debts from discharge pursuant to § 523(a)(19). Id. The bankruptcy court concluded that the debts were excepted from discharge and that determination was affirmed at the district court level and the decision was appealed to the Tenth Circuit, which reversed and remanded the matter to the bankruptcy court. Id.
Turning to the plain language of § 523(a)(19)(A), the Tenth Circuit determined that a judgment debt against a debtor must be "for a violation" of securities laws in order to be excepted from discharge. Id. The Tenth Circuit concluded that the judgments at issue did not meet this requirement because they were based on a claim of unjust enrichment that resulted from someone else's violation of securities laws. Id. at 1176-77.
To support its determination, the Tenth Circuit reviewed legislative history and, particularly, the Senate Report, to determine the purpose behind the enactment of § 523(a)(19)(A). Id. at 1175-76. The Tenth Circuit cited statements in the Senate Report that the statute was designed to "'help defrauded investors recoup their losses,'" hold "'accountable those who incur debts by violating our securities laws'" and protect victims from "'those who have cheated them.'" Id. (citing S. Rep. No. 107-146 at 8, 11). From the statute's text and the legislative history behind it, the Tenth Circuit concluded that § 523(a)(19) was intended to:
. . . penalize the perpetrators of such schemes by denying them relief from their debts. Adopting the Department's interpretation would impose the heavy penalty of nondischargeability on violators and nonviolators alike. That Congress intended
such an extreme result is evident neither in the text of the statute nor in the historical record.Id. Accordingly, the Tenth Circuit concluded that a judgment debt for unjust enrichment against an innocent investor in someone else's Ponzi scheme, when that investor had not been found to violate securities laws but only profited from someone else's violation, was not a debt excepted from discharge under § 523(a)(19). Id. at 1176-77.
Likewise, in Sherman, the Ninth Circuit considered whether a debt may be excepted from discharge under § 523(a)(19) when the debt resulted from a violation of state or federal securities laws but the debtor himself was not culpable for the violation that caused the debt. 658 F.3d at 1010. Unlike the Tenth Circuit's analysis in Wilcox, the Ninth Circuit concluded that the language of the statute, and particularly the use of the word "for" was ambiguous. Id. at 1013. (concluding that § 523(a)(19)'s language leaves unclear whether the debtor had to commit the securities laws violation or whether, instead, the debt was excepted from discharge if it was a result of a violation by the debtor or anyone else). Nonetheless, the Ninth Circuit came to the same conclusion as the Tenth Circuit that § 523(a)(19) was limited to excepting from discharge a debt resulting from the debtor's own securities laws violation. In reaching this conclusion, the Ninth Circuit focused on the Supreme Court's rule of construction interpreting the § 523(a) exceptions to discharge narrowly against the objecting creditor and liberally in favor of the debtor's discharge. Id. at 1015-16 (citing Kawaauhau v. Geiger, 523 U.S. 57, 62 (1998) and Grogan v. Garner, 498 U.S. 279, 286-87) (1991). That rule of construction, along with the principle that an "unencumbered new beginning" should be provided to the "honest but unfortunate debtor" supported the Ninth Circuit's conclusion that § 523(a)(19), "should be limited to dishonest debtors seeking to abuse the bankruptcy system in order to evade the consequences of their misconduct." Id. Because the debtor in Sherman was only an innocent recipient of funds obtained by another party's participation in a securities laws violation, the Ninth Circuit concluded that the debt was dischargeable. Id. at 1016, 1019.
In Sherman, the debtor was an attorney who represented defendants involved in securities litigation and, as part of the enforcement action, was ordered to disgorge an unearned retainer that had been advanced by the defendants. 658 F.3d at 1010. The debtor himself was not found to have committed any securities laws violations. Id. at 1010-11.
Wilcox and Sherman stand in sharp contrast with the Eleventh Circuit's conclusion in Lunsford that a debt may be excepted from discharge under § 523(a)(19) whether the debt stems from the debtor's own violation of securities laws or a third party's violation. 848 F.3d at 968. In reaching this conclusion, the Eleventh Circuit reviewed the text and structure of § 523(a)(19)(A) concluding that they "unambiguously prevent discharge of debts 'for the violation' of securities laws irrespective of debtor conduct." Id. The Eleventh Circuit noted that when Congress wants to limit a discharge exception to debts based on a debtor's own conduct, Congress expressly employs limiting language, such as § 523(a)(6)'s exception for debts that are "for willful and malicious injury by the debtor to another entity." Id. (citing the language of 11 U.S.C. § 523(a)(6)). "Because Congress rendered discharge in some subsections dependent on debtor conduct but never did so for section 523(a)(19)(A), [the Eleventh Circuit inferred] that the limit does not extend to section 523(a)(19)(A)." Id. Accordingly, the Eleventh Circuit reached the conclusion that § 523(a)(19)(A) "precludes discharge regardless of whether the debtor violated securities laws as long as the securities violation caused the debt." Id.
In Lunsford, the debtor questioned whether an arbitration award against him was specific enough for the bankruptcy court to have concluded that the award was for the debtor's own securities laws violations rather than those of a related company. 848 F.3d at 966-67. On appeal, the Eleventh Circuit concluded that the bankruptcy court did have a sufficient basis to determine that the arbitrator made a specific finding that the debtor had violated securities laws. Id. However, the Eleventh Circuit alternatively concluded that even if the bankruptcy court had not made a finding that the debtor violated securities laws, the debt would still be nondischargeable if the debtor's liability arose from a securities laws violation committed by a third party. Id. at 967-68.
After review of these various interpretations, this Court sides with the Ninth and Tenth Circuits in concluding that § 523(a)(19) excepts from discharge only those debts arising from the debtor's own securities laws violations. First, the Supreme Court and the Sixth Circuit have made clear that § 523(a) provisions should be construed narrowly in favor of discharging debts of an honest debtor. Kawaauhau v. Geiger, 523 U.S. 57, 62 (1998) (concluding that exceptions to discharge "should be confined to those plainly expressed"); Grogan v. Garner, 498 U.S. 279, 286-87 (1991); Meyers v. Internal Revenue Serv. (In re Meyers), 196 F.3d 622, 624 (6th Cir. 1999) (citing Grogan to support that "[a]s a general matter, exceptions to discharge are narrowly construed to promote the central purpose of the discharge: relief for the 'honest but unfortunate debtor'"). Based on this principle of narrow construction, § 523(a)(19)(A)'s scope is properly limited to debts for violations arising from the debtor's own misconduct rather than that of a third party. To interpret this statute otherwise, as noted by the Ninth Circuit, would contravene this rule of narrow construction in favor of the opposite presumption, "that exceptions [to discharge] should be applied broadly unless expressly confined to guilty debtors." Sherman, 658 F.3d at 1015.
Second, the Senate Report, cited by both the Ninth and Tenth Circuits, supports this narrow interpretation of § 523(a)(19). The Senate report reveals that Congress intended § 523(a)(19) to "hold accountable those who incur debts by violating our securities laws" and prevent "wrongdoers" from discharging their obligations. S. Rep. No. 107-146 at *11, 16. There is no indication in the Senate Report that Congress intended to render nondischargeable debts of innocent investors who happen to profit from a third-party's scheme. Id. While courts may order investors to disgorge profits remaining in their possession that were received in a Ponzi scheme, this Court agrees with the Ninth Circuit that Congress did not intend to immunize these debts from discharge in bankruptcy when the debtor has not been found guilty of any wrongdoing. Sherman, 658 F.3d at 106.
While this Court agrees with Mr. Schuholz's interpretation of the limited scope of § 523(a)(19), that conclusion does not end the inquiry. This Court must still determine whether the State Court judgment debt, or some part of it, falls within the scope of that provision. Mr. Schuholz argues that the judgment debt falls outside the scope of § 523(a)(19) because only Mr. Galemmo, the Ponzi scheme operator, was found to have violated securities laws by the State Court. Accordingly, Mr. Schuholz likens himself to the "innocent investors" in the Wilcox case who were not found to have violated securities laws themselves and whose debts were based solely on common law unjust enrichment arising from someone else's securities laws violations. See Wilcox, 691 F.3d at 1176-77.
Contrary to Mr. Schuholz's argument, this case is distinguishable from Wilcox. Unlike the "innocent investors" in that case, the State Court found Mr. Schuholz, himself, to have violated Ohio securities laws:
Defendant Schuholz was included on a list of four individuals used as references by Glen Galemmo while operating his Ponzi scheme. Galemmo encouraged potential investors to contact Schuholz as they evaluated whether to invest their money with Galemmo. Potential investors did, in fact, reach out to Schuholz before they transferred money to the Ponzi scheme.[Docket Number 7, Ex. A (Final Judge Entry), pp. 5, 8]. With these findings, the State Court makes clear that Mr. Schuholz's own conduct of receiving funds or commissions, without an appropriate license, for recruiting investors into Mr. Galemmo's Ponzi scheme violated Ohio securities laws. Accordingly, his situation is distinguishable from the "innocent investors" in Wilcox.
Schuholz was not licensed to sell securities or to broker the sale of securities. Yet, Schuholz received money on account of people being recruited into the Galemmo Ponzi scheme.
* * *
Defendant Schuholz's receipt of money for people being recruited into the Galemmo Ponzi scheme is a violation of Ohio's state securities laws. See R.C. 1707.14(A); R.C. 1707.44(A).
While the State Court found Mr. Schuholz to have violated Ohio securities laws, it is less clear whether its award of damages to the Plaintiff Class, in whole or in part, is attributable to Mr. Schuholz's securities laws violation. Mr. Schuholz argues that, as a matter of law, the damages award could not be "for" a violation of Ohio securities laws because those laws create no civil liability for violations.
In making this argument, Mr. Schuholz refers to Ohio Rev. Code § 1707.40 which provides:
Except as provided in section 1707.261 of the Revised Code, sections 1707.01 to 1707.45 of the Revised Code create no new civil liabilities, and do not limit or restrict common law liabilities for deception or fraud other than as specified in sections 1707.042, 1707.043, 1707.41, 1707.42, and 1707.43 of the Revised Code, and there is no civil liability for noncompliance with orders, requirements, rules, or regulations made by the division of securities under sections 1707.19, 1707.20, 1707.201, and 1707.23 of the Revised Code.Ohio Rev. Code § 1707.40. Read in conjunction with the civil liability and remedy provisions that follow it, this provision has been interpreted to mean that Ohio securities laws, Ohio Rev. Code § 1707.01 - § 1707.99, do not replace or negate common law claims based on securities violations (except where provided), but do set the parameters for liability and remedies in various ways. For example, Ohio Rev. Code § 1707.41 sets forth civil liability, in addition to other liability imposed by law, that a seller may have to a purchaser for false written materials about securities offered for sale and creates a statute of limitations for such actions. See In re Nat'l Century Fin. Enter., Inc., 504 F. Supp. 2d 287, 305-06 (S.D. Ohio 2007) (concluding that Ohio Rev. Code § 1707.41 "imposes liability for misstatements in a 'written, or printed circular, prospectus or advertisement.'"). Ohio Rev. Code § 1707.42 sets forth liability and damages of an adviser to a purchaser of securities. See Ohio Bureau of Workers' Comp. v. MDL Active Duration Fund, Ltd., 476 F. Supp. 2d 809, 818 (S.D. Ohio 2007) (noting that Ohio Rev. Code § 1707.42(B) "provides that an investment adviser is liable for damages resulting from acts of an investment adviser which violate Ohio Rev. Code Chapter 1707."). Furthermore, Ohio Rev. Code § 1707.43 provides limited remedies that a purchaser may have against a person selling unlawful securities as well as persons participating in the sale or aiding the seller and sets forth a statute of limitations. See Federated Mgmt. Co. v. Coopers & Lybrand, 738 N.E.2d 842, 857 (Ohio Ct. App. 2000) (concluding that § 1707.43 extends liability beyond the actual seller/issuer of an unlawful security to any other person who participated in the sale or aided the seller in any way). Moreover, various courts have concluded that when common law claims are "predicated on or inextricably interwoven with the sale of securities. . .," the applicable statute of limitations is set by the Ohio securities laws. Lopardo v. Lehman Bros., Inc., 548 F. Supp. 2d 450, 467 (N.D. Ohio 2008) (citing cases). See also Wuliger v. Anstaett, 363 F. Supp. 2d 917, 935 (N.D. Ohio 2005) (applying the § 1707.43 statute of limitations to claims sounding in common law fraud, breach of contract and unjust enrichment when they arise from the sale of securities investments); Helman v. EPL Prolong, Inc., 743 N.E.2d 484, 493 (Ohio Ct. App. 2000) (concluding that the statute of limitation in Ohio Rev. Code § 1707.43 applied to a breach of contract claim involving an unlawful sale of securities).
What is clear from these Ohio statutory provisions and case law is that a person may be held civilly liable to a purchaser or investor for violating Ohio securities laws whether under a common law claim or the "intertwining" of common law and the statutory provisions of Ohio Rev. Code § 1707.01 - § 1707.99.
While rejecting Mr. Schuholz's legal argument, this Court remains unable to determine on the pleadings and the documents incorporated therein whether the judgment debt, or a portion thereof, is "for" Mr. Schuholz's securities laws violation and, thus, excepted from discharge under § 523(a)(19). The language of the State Court's Final Judgment Entry and Findings of Fact and Conclusions of Law fails to specify what portion, if any, of the $864,534.16 in damages awarded to the Plaintiff Class was "for" (or attributable to) Mr. Schuholz's receipt of funds for recruiting investors into the Ponzi scheme without a license, i.e. the conduct found to violate Ohio securities laws.
When the language of a judgment does not reasonably establish whether the damage award is based on a violation of securities laws, a court must look to the context and circumstances under which the award arose to make the determination. Schouten v. Jakubiak (In re Jakubiak), 591 B.R. 364, 375-79 (Bankr. E.D. Wis. 2018). See also Hines v. Aetna Cas. & Sur. Co., 1992 Ohio App. LEXIS 47, at *15, 1992 WL 2588, at *5 (Ohio Ct. App. Jan. 9, 1992) (citing Hofer v. Hofer, 42 N.E.2d 165, 167 (Ohio Ct. App. 1940) and other case law to support that when an Ohio judgment is ambiguous, the entire record may be examined and considered to determine its construction and interpretation). This issue cannot be determined at this stage of the litigation.
Accordingly, this Court concludes that Mr. Schuholz is not entitled to judgment on the pleadings with respect to the Plaintiffs' § 523(a)(19) claim.
C. 11 U.S.C. § 523(a)(2)(A) and § 523(a)(6)
Mr. Schuholz further requests judgment on the pleadings with respect to claims that the State Court judgment debt is excepted from discharge under 11 U.S.C. § 523(a)(2)(A) and § 523(a)(6). For a debt to be held nondischargeable under either provision, he asserts that the fraudulent acts or willful and malicious injury must be attributable to the debtor and not a third party. According to Mr. Schuholz, the State Court's Final Judgment Entry and Findings of Fact and Conclusions of Law include determinations of fraud and criminal acts on the part of the Ponzi scheme operator, Glen Galemmo, but no such determinations on the part of Mr. Schuholz. Raising preclusionary principles, Mr. Schuholz asserts that the State Court's judgment precludes this Court from making independent findings of fraud or willful and malicious conduct on his part in connection with this adversary proceeding.
Bankruptcy Code Section 523(a)(2)(A) excepts from discharge a debt, "for money, property, services . . . to the extent obtained by . . . false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor's or an insider's financial condition[.]" 11 U.S.C. § 523(a)(2)(A). Bankruptcy Code Section 523(a)(6) excepts from discharge a debt for a "willful and malicious injury by the debtor to another entity or property of another entity[.]" 11 U.S.C. § 523(a)(6).
Mr. Schuholz further argues that this Court is precluded from relitigating not only those issues actually determined by the State Court, but also issues that could have been decided and that arise out of the same transaction or occurrence. As such, Mr. Schuholz maintains that the Plaintiffs are precluded from asserting claims for securities violations, fraud, and other intentional torts in this adversary proceeding.
This Court recognizes that, pursuant to 28 U.S.C. § 1738, federal courts are directed to give the same "full faith and credit" to a state court judgment as another court of that state would give. Sill v. Sweeney (In re Sweeney), 276 B.R. 186, 189 (B.A.P. 6th Cir. 2002) (citing Markowitz v. Campbell (In re Markowitz), 190 F.3d 455, 461 (6th Cir. 1999)). Consequently, to determine whether the State Court's Final Judgment Entry and Findings of Fact and Conclusions of Law are entitled to preclusive effect in this dischargeability proceeding, this Court must determine whether they would be entitled to such effect under Ohio's preclusionary principles.
Mr. Schuholz raises both issue preclusion and claim preclusion. "Issue preclusion refers to the effect of a judgment in foreclosing relitigation of a matter that has been actually litigated and decided." Corzin v. Fordu (In re Fordu), 201 F.3d 693, 703 (6th Cir. 1999) (citing Migra v. Warren City Sch. Dist. Bd. of Educ., 465 U.S. 75, 77 n.1 (1984)). Under Ohio law, the doctrine of issue preclusion has four elements:
(1) A final judgment on the merits in the previous case after a full and fair opportunity to litigate the issue; (2) The issue must have been actually and directly litigated in the prior suit and must have been necessary to the final judgment; (3) The issue in the present suit must have been identical to the issue in the prior suit; (4) The party against whom estoppel is sought was a party or in privity with the party to the prior action.Sweeney, 276 B.R. at 189 (citations omitted).
In comparison, "'[c]laim preclusion generally refers to the effect of a judgment in foreclosing litigation of a matter that never has been litigated, because of a determination that it should have been advanced in an earlier suit.'" In re Fordu, 201 F.3d at 703 (quoting Migra, 465 U.S. at 77 n.1). Under Ohio law, claim preclusion has four elements:
(1) a prior final, valid decision on the merits by a court of competent jurisdiction; (2) a second action involving the same parties, or their privies, as the first; (3) a second action raising claims that were or could have been litigated in the first action; and (4) a second action arising out of the transaction or occurrence that was the subject matter of the previous action.Hapgood v. City of Warren, 127 F.3d 490, 493 (6th Cir. 1997) (citations omitted).
The party seeking to invoke preclusion has the burden to establish its applicability. Simmons Capital Advisors, Ltd. v. Bachinski (In re Bachinski), 393 B.R. 522, 535 (Bankr. S.D. Ohio 2008) (discussing issue preclusion); Winget v. JP Morgan Chase Bank, N.A., 537 F.3d 565, 572 (6th Cir. 2008) (discussing claim preclusion).
Mr. Schuholz correctly notes that the State Court Court's Final Judgment Entry and Findings of Fact and Conclusions of Law lack any determinations that he committed fraudulent acts or a willful and malicious injury to the Plaintiffs. However, for issue preclusion to apply, Mr. Schuholz would further have to establish that these issues were actually litigated by the parties and necessarily determined by the State Court in its judgment. Sweeney, 276 B.R. at 189; Miller v. Grimsley (In re Grimsley), 449 B.R. 602, 609 (Bankr. S.D. Ohio 2011). At this stage, neither the pleadings nor the Final Judgment Entry and Findings of Fact and Conclusions of Law establish that Mr. Schuholz's commission (or non-commission) of fraudulent acts or a willful and malicious injury were actually litigated and necessary to the State Court's judgment.
Mr. Schuholz similarly fails to meet his burden to establish claim preclusion. This Court would first note that it does not appear from the Amended Complaint that the Plaintiffs are asserting claims for new or additional debt owed to them. Rather, they seek a determination that a debt that has already been awarded to them is nondischargeable under § 523(a) of the Bankruptcy Code. To the extent that Mr. Schuholz is asserting that this Court is precluded from considering the Plaintiffs' nondischargeability claims under § 523(a)(2) and (6) of the Bankruptcy Code because those claims arise out of the same transaction or occurrence as the claims asserted in the State Court action, such an assertion is incorrect.
When a bankruptcy court is called upon to determine the preclusive effect of a prior judgment in a subsequent proceeding to except the debt from discharge, it is helpful to consider the nondischargeable debt action as being comprised of two separate, but related, determinations: one regarding the existence, validity, and amount of the debt and a second regarding whether the debt is dischargeable. In instances where a prior judgment has been entered, the bankruptcy court may not be required to make the first of these determinations because the existence and amount of the debt is established by the prepetition judgment. Assuming other prerequisites for application of [claim preclusion] are met, the prior determination regarding the existence and amount of the debt will be entitled to preclusive effect in the nondischargeability proceeding.
By contrast, the second determination as to whether a particular debt should be excepted from discharge under § 523(a)(2), (4) or (6) is a
legal conclusion which is within the exclusive jurisdiction of the bankruptcy courts. Accordingly, [claim preclusion] does not bar the bankruptcy court from deciding the issue of whether a debt is dischargeable, even when similar issues have already been decided by a state court of competent jurisdiction.Bruinsma v. Wigger (In re Wigger), 595 B.R. 236, 249 (Bankr. W.D. Mich. 2018) (quotation marks and citations omitted). See also, MD Acquisition, LLC v. Myers (In re Myers), 2012 Bankr. LEXIS 5953, at *16-17, 2012 WL 6761356, at *5 (Bankr. N.D. Ohio, Dec. 31, 2012); In re Hall, 98 B.R. 777, 779 (Bankr. S.D. Ohio 1989).
The State Court case was the Plaintiffs' cause of action on the debt itself and this adversary proceeding is the Plaintiffs' cause of action to determine whether that debt is nondischargeable. Whereas claim preclusion may apply to the existence and amount of the debt, it does not apply to this Court's determination as to whether such debt is nondischargeable. Accordingly, Mr. Schuholz is not entitled to judgment with respect to the Plaintiffs' claims under § 523(a)(2)(A) and (a)(6) of the Bankruptcy Code.
IV. CONCLUSION
For the reasons stated above, Debtor's Motion for Judgment on the Pleadings [Docket Number 10] is DENIED.
SO ORDERED.
This document has been electronically entered in the records of the United States Bankruptcy Court for the Southern District of Ohio.
IT IS SO ORDERED.
/s/_________
Beth A. Buchanan
United States Bankruptcy Judge
Dated: October 18, 2019
Distribution List:
Brian Patrick O'Connor, Esq.
Jeffrey M. Nye, Esq.
Paul T. Saba, Esq.