Debt To Client Security Fund Dischargeable as Compensatory

Posted by NCBRC - August 5, 2022

“Indebtedness arising from a disbarred attorneys’ obligation to reimburse the State Bar for payments made by the CSF to victims of that attorney’s misconduct are not excluded from discharge under § 523(a)(7).” Kassas v. State Bar of Calif., No. 21-55900 (9th Cir. Aug. 1, 2022).

After the chapter 7 debtor was disbarred from the practice of law, the State Supreme Court ordered him to pay restitution in the amount of $201,706 to be distributed to 56 of his clients, and $61,122.27 to the State Bar to reimburse its costs of investigation and discipline. The court also ordered the debtor to reimburse California’s Client Security Fund (CSF) for its payments to clients injured by his misconduct.

The CSF provides that “[to] qualify for reimbursement, an applicant must establish a loss of money or property that was received by an active attorney who was acting as an attorney or in a fiduciary capacity customary to the practice of law.” The rules implementing the CSF call for notice and hearings including investigation and discovery. Pursuant to its mandate, the CSF distributed a total of $1,367,978.12 to 51 of the 56 named complainants and to 305 additional unnamed complainants.

The debtor filed for chapter 7 bankruptcy in December, 2019, and received his discharge in March, 2020. Nine months later he filed an adversary complaint seeking a declaration that all the claims in his bankruptcy case were discharged. The State Bar opposed the complaint and moved for summary judgment.

The bankruptcy court found the court order of restitution in the amount of $201,706 to 56 of the debtor’s former clients was discharged because it was not a payment for the benefit of a governmental unit as required under section 523(a)(7). The debtor did not dispute this finding.

With respect to the costs associated with the disciplinary proceedings, the court relied on In re Findley, 593 F.3d 1048, 1054 (9th Cir. 2010), to find that the debt was not discharged.

Finally, the bankruptcy court held that the debt incurred by reason of the CSF’s payment to the unnamed complainants was nondischargeable as a “penalty imposed in furtherance of the State’s interest in punishing and rehabilitating errant attorneys, rather than compensation for actual pecuniary loss.”

The bankruptcy court certified to the Ninth Circuit the question: “Is indebtedness arising from a disbarred attorney’s obligation to reimburse the State Bar for payments made by the CSF to victims of that attorney’s misconduct while practicing law non-dischargeable under 11 U.S.C. § 523(a)(7)?”

On appeal, the debtor also argued that Findley was wrongly decided and that the debt for costs should have been discharged.

The Ninth Circuit began with the primary issue of whether the debt based on the CSF payments to the debtor’s victims was dischargeable. Section 523(a)(7) excepts from discharge debts that represent “a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit, and [are] not compensation for actual pecuniary loss.” Because the CSF was a governmental agency, the Ninth Circuit turned to the questions of whether the debt was a “fine or penalty” and whether it was in compensation for actual loss.

The court found the $2 million debt to the unnamed complainants was dischargeable as “compensation for actual pecuniary loss.” In support of that finding, the court noted that the stated purpose of the CSF was to “relieve or mitigate pecuniary losses caused by the dishonest conduct of active members of the State Bar.” The court found this purpose was comparable to a public insurance program overseen by a governmental agency. This conclusion was supported by the language in the statute referring to the government agency’s right of reimbursement as “subrogation.”

The court acknowledged that fines and penalties, such as those imposed in criminal cases, may be calculated with reference to actual loss. But in those cases, the actual loss is merely a guidepost and other considerations may add to or reduce the amount owed. In contrast, under the CSF, the attorney’s obligation is determined solely by the actual payment made by the government and the government’s outlay is in compensation for financial loss. The court found that payment comparable to an arbitration award which it has determined to be “purely compensatory.”

The court stated: “Accordingly, the CSF is limited—both by its organic statute and by long-standing principles of subrogation—to recovering the ‘actual pecuniary costs,’ 11 U.S.C. § 523(a)(7), of the ‘pecuniary losses caused by the dishonest conduct of licensees of the State Bar,’ Cal. Bus. & Prof. Code § 6140.5(a).”

Like the debtor’s court-ordered debt to the named complainants, the court found the debt based on the CSF payment to other complainants was dischargeable. “In other words, the dischargeability of Kassas’s debt does not turn on whether the CSF decides to step in to compensate his former clients and then seek subrogation against him. Were we to conclude otherwise, Kassas could obtain a discharge for debts he owed directly to 56 of his clients but not for debts owed to the 305 of his clients compensated by the CSF.”

The court turned next to the issue of whether the disciplinary costs were nondischargeable as determined by the bankruptcy court. The court agreed that Findley dictated that result. In Findley, the court held that the state legislature amended Cal. Bus. & Prof. Code § 6086.10(e) specifically to avoid the decision in In re Taggart, 249 F.3d 987 (9th Cir. 2001) which said that costs of attorney disciplinary hearings were not penal in nature and were therefore dischargeable. Thus, under Findley, such costs were determined to be penal as required for nondischargeability under section 523(a)(7).

The court here found that one circuit panel could not overturn the holding of another panel unless that holding was undermined by a subsequent Supreme Court case. Therefore, it was compelled to uphold the bankruptcy court’s decision that the costs were not discharged in the debtor’s chapter 7 case. In the absence of Supreme Court intervention, the debtor’s only recourse was through an en banc hearing on the issue.

The court reversed the bankruptcy court holding that the CSF debt was nondischargeable. It affirmed the bankruptcy court’s holding that the debt based on costs was nondischargeable.

Kasses 9th Cir Aug 2022


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