Supreme Court Clarifies “Actual Fraud” for Purposes of Debt Discharge
Business Restructuring, Creditors’ Rights & Bankruptcy Update
Date: June 09, 2016
Recently, in Husky International Electronics, Inc. v. Ritz, the U.S. Supreme Court held that the phrase “actual fraud,” as used in 11 U.S.C. § 523(a)(2)(A), encompasses fraudulent conveyance schemes, even when those schemes do not involve a false representation, resolving a split among the circuits. Although the ruling provides creditors comfort that a debtor in bankruptcy will not be able to discharge a debt obtained through a fraudulent conveyance not involving a false representation, the need to demonstrate that the debt was “obtained” by fraudulent means may, as a practical matter, limit the impact of the Court’s ruling.
Husky International Electronics, Inc. (Husky) sold and distributed electronic devices to Chrysalis Manufacturing Corp. (Chrysalis). Daniel Ritz was a director and part owner of the company. Chrysalis owed Husky $163,999 for purchases between 2003 and 2007. In 2007, Ritz started transferring funds from Chrysalis to different ventures he owned or controlled. In 2009, Husky filed a lawsuit against Ritz seeking to hold him personally responsible for Chrysalis’s debt. Shortly thereafter, Ritz filed a Chapter 7 petition under the Bankruptcy Code. In 2011, Husky filed a complaint in Ritz’s bankruptcy case seeking a judgment that Ritz was personally liable to Husky for the Chrysalis debt. Husky also contended that the debt was not dischargeable in bankruptcy because Ritz fraudulently moved funds from Chrysalis to other accounts in a scheme that constituted actual fraud under 11 U.S.C. § 523(a)(2)(A)’s exception to discharge.
The district court held that Ritz’s debt to Husky had not been obtained by actual fraud under § 523(a)(2)(A), and thus could be discharged in bankruptcy. Husky appealed to the United States Court of Appeals for the Fifth Circuit, which affirmed the lower court’s decision to discharge Ritz’s debt, finding no actual fraud had occurred because Ritz had made no misrepresentation to Husky.
On appeal, the Supreme Court held that the use of the term “actual fraud” in §523(a)(2)(A) includes traditional forms of fraud and is not limited to fraudulent misrepresentation. The Court determined that actual fraud is fraud committed with a wrongful intent, and that fraud has traditionally been defined to encompass a transfer of assets that hinders or impairs a creditor’s ability to collect on a debt, irrespective of whether the fraudulent transfer was accompanied by a false representation made to a creditor. Therefore, since a misrepresentation has not historically been required to prove actual fraud, it should not be treated as a necessary element to establish actual fraud within the meaning of §523(a)(2)(A).
In holding that debts obtained through a fraudulent conveyance scheme not involving misrepresentations may be non-dischargeable under §523(a)(2)(A), the Court acknowledged that “such circumstances may be rare” and recognized that the transferor in a fraudulent transfer scheme does not “obtain” debts as a result of the transfer. While a transferee who knowingly participates in the scheme obtains assets as a result of the scheme and may be subject to having debts traceable to the fraudulent transfer determined to be non-dischargeable, such a person will not usually be a debtor on the brink of bankruptcy. The Court noted that the situation in the Ritz case “may be unusual” and remanded the case to the Fifth Circuit to decide whether the debt owed to Husky had been obtained by Ritz’s fraudulent transfer scheme.
It remains to be seen whether the Court’s holding in this case will provide creditors with a valuable weapon to deal with debtors who transfer assets with actual intent to hinder, delay and defraud, or is merely an interesting application of statutory interpretation without much practical impact.
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