U.S. Supreme Court Rules ‘Actual Fraud’ Exception to Discharge Includes Fraudulent Transfer Schemes

June 1, 2016Alerts Financial Restructuring & Bankruptcy Alert

Last month, the U.S. Supreme Court held that the “actual fraud” bar to discharge debts under Bankruptcy Code section 523(a)(2)(A) includes claims based on intentional fraudulent transfers, regardless of whether the debtor made a false representation to the creditor.

In Husky Int’l Elecs., Inc. v. Ritz, 2016 WL 2842452 (May 16, 2016), the justices reversed a Fifth Circuit ruling and resolved a split among the circuits on the issue of whether “actual fraud” under section 523(a)(2)(A) requires a false representation. (Compare In re Ritz, 787 F.3d 312 (5th Cir. 2015)(“actual fraud” requires false representation) with McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000)(“actual fraud” encompasses actual fraudulent transfer schemes that do not necessarily include false representation).)

The facts in Husky were fairly straightforward. Husky International Electronics, Inc. sold electronic device components to Chrysalis Manufacturing Corp., which failed to pay for about $164,000 worth of the goods. Chrysalis’s principal, Daniel Lee Ritz, drained Chrysalis of assets by transferring them to other entities that he controlled while Chrysalis was insolvent, and for less than reasonably equivalent value. Husky sued Ritz, seeking to hold him personally liable for the $164,000 debt based on fraudulent transfer and alter ego claims. Ritz then filed a Chapter 7 petition. Husky responded by filing a complaint in the bankruptcy court, objecting to the discharge of Ritz’s alleged debt under Bankruptcy Code Section 523(a)(2)(A) (making debt obtained by “false pretenses, a false representation, or actual fraud” nondischargeable).

The bankruptcy court, district court and Fifth Circuit all held that the debt at issue was dischargeable where the debtor made no false representation to the creditor. Although Ritz may have hindered Husky’s ability to recover its debt by transferring away Chrysalis’ assets, the Fifth Circuit ruled that he did not commit “actual fraud” within the meaning of section 523(a)(2)(A) because he did not make any false representations to Husky regarding those assets or the transfers.

On appeal, Justice Sonia Sotomayor, writing for the majority in a 7-1 decision, concluded that the common law term “actual fraud” used in Section 523(a)(2)(A) broadly “encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation.” She observed that “from the beginning of English bankruptcy practice, courts and legislatures have used the term ‘fraud’ to describe a debtor’s transfer of assets that, like Ritz’ scheme, impairs a creditor’s ability to collect the debt.”

The majority emphasized as “equally important” that “the common law also indicates that fraudulent conveyances, although a ‘fraud,’ do not require a misrepresentation from a debtor to a creditor. As a basic point, fraudulent conveyances are not an inducement-based fraud. Fraudulent conveyances typically involve a transfer to a close relative, a secret transfer, a transfer of title without transfer of possession or grossly inadequate consideration. In such cases, the fraudulent conduct is not in dishonestly inducing a creditor to extend a debt, it is in the acts of concealment and hindrance. In the fraudulent-conveyance context, therefore, the opportunities for a false representation from the debtor to the creditor are limited.”

The Supreme Court rejected Ritz’s argument that this interpretation of Section 523(a)(2)(A) created redundancy with Bankruptcy Code Section 727(a)(2), which prevents a debtor from discharging all of his debts if, within the year preceding the bankruptcy petition, he transferred property “with intent to hinder, delay, or defraud a creditor.” The Court observed that “Section 727(a)(2) is broader than §523(a)(2)(A) in scope—preventing an offending debtor from discharging all debt in bankruptcy. But it is narrower than §523(a)(2)(A) in timing—applying only if the debtor fraudulently conveys assets in the year preceding the bankruptcy filing. In short, while §727(a)(2) is a blunt remedy for actions that hinder the entire bankruptcy process, §523(a)(2)(A) is a tailored remedy for behavior connected to specific debts.”

The Supreme Court also rejected Ritz’s argument (adopted by Justice Clarence Thomas in his dissent) that Section 523(a)(2)(A)’s requirement that the relevant debt be “obtained by” fraud excluded fraudulent transfers that are not used to obtain property, but function instead to hide valuables that a debtor already possesses. The Court noted that, although the transferor does not “obtain” debts in a fraudulent transfer, “the recipient of the transfer—who, with the requisite intent, also commits fraud—can ‘obtai[n]’ assets ‘by’ his or her participation in the fraud. If that recipient later files for bankruptcy, any debts ‘traceable to’ the fraudulent conveyance will be nondischargable under § 523(a)(2)(A).”

Since Husky contended that Ritz was both the transferor and transferee—having transferred Chrysalis assets to other companies he controlled—the majority left it to the Fifth Circuit to decide on remand whether Husky’s debt was “obtained by” Ritz’ asset-transfer scheme.

The Husky decision offers the fraudulent transfer victim a possible means to block the discharge of its debt where the transfer occurred more than one year before the bankruptcy. At the same time, in cases where the debtor is not the transferee, it remains to be seen whether courts will find that the victim’s debt was “obtained by” actual fraud under Husky’s rationale.

For more information about this alert or if you have any questions or concerns, please contact Audrey Noll at 310.693.4414 or [email protected] or any member of Fox Rothschild’s Financial Restructuring & Bankruptcy Practice Group.