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High Court Broadens the Definition of “Actual Fraud” under Section 523(a)(2)(A)

May 17, 2016

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The Supreme Court’s Decision:

On May 16, 2016, in Husky International Electronics, Inc. v. Daniel Lee Ritz, Jr., Case No. 15-145, the Supreme Court held that the term “actual fraud” in § 523(a)(2)(A) of the Bankruptcy Code encompasses fraudulent conveyance schemes, even if the scheme does not involve a false representation to the creditor.  In reversing the judgment of the Fifth Circuit, the Supreme Court’s ruling settled a split among the circuits regarding whether “actual fraud” under § 523(a)(2)(A) requires a misrepresentation or misleading omission to the creditor. Compare In re Ritz, 787 F.3d 312 (5th Cir. 2015) with McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000), and Sauer V. Lawson, 791 F.3d 214 (1st Cir. 2015).

The Appeal:

On March 1, 2016, the Supreme Court heard arguments as to whether the “actual fraud” exception to discharge under § 523(a)(2)(A) applied narrowly (i.e. only when the debtor has made a false representation) or broadly (i.e. in situations where the debtor did not make a misrepresentation but entered into a scheme that was intended to defraud a creditor).

Between 2003 and 2007, Husky International Electronics, Inc. (Husky) sold and delivered electronic equipment worth approximately $164,000 to Chrysalis Manufacturing Corp. (Chrysalis).  Chrysalis failed to pay for the goods it purchased on credit.  While this debt was outstanding, between 2006 and 2007, Daniel Ritz (Ritz), a director and partial owner of Chrysalis, transferred funds from Chrysalis to various other ventures in which he owned stock.  In 2009, Husky sued Ritz seeking to hold him personally responsible for payment on the outstanding debt based on the allegation that Ritz’ transfers of Chrysalis’ funds were “actual fraud” and Ritz was therefore liable under a Texas statute.  Ritz then filed his own Chapter 7 bankruptcy petition, and Husky filed an adversary proceeding to have the debt declared nondischargeable under § 523 of the Bankruptcy Code on the basis that the same transfers constituted “actual fraud” under the exception to discharge in § 523(a)(2)(A).  Ritz argued that because he didn’t make a false misrepresentation to Husky, the debt should not be excepted from discharge.  The bankruptcy court ruled that Husky had failed to prove “actual fraud,” by false representation.  Husky appealed to the district court, which affirmed the bankruptcy court’s determination.  Likewise, the U.S. Court of Appeals for the Fifth Circuit also affirmed the lower court judgments and held that the debt was dischargeable, because, in its view, “actual fraud” requires a misrepresentation from the debtor to the creditor.

Analysis and Conclusion:

Justice Sotomayor, writing for the eight justice majority, concluded that the common-law term “actual fraud” is broad enough to incorporate forms of fraud that may not include a misrepresentation, such as a fraudulent conveyance.  At common law, fraudulent conveyances do not require a misrepresentation from a debtor to a creditor.  The Supreme Court also rejected Ritz’ argument that this interpretation of “actual fraud” renders § 523(a)(2)(A) redundant of other subsections of § 523 and of § 727(a)(2).  The Supreme Court noted that although there is overlap between each of these sections and § 523(a)(2)(A), there is also meaningful distinction and that it could “see no reason to craft an artificial definition of ‘actual fraud’ merely to avoid narrow redundancies that appear unavoidable.”  The Supreme Court also rejected Ritz’ argument, which was adopted by Justice Thomas’ dissent, that § 523(a)(2)(A) requires that the debt be “obtained by . . . actual fraud” and therefore the fraud must occur at the inception of the credit transaction.  The Supreme Court distinguished the dissent’s conclusion, and the prior precedent upon which it relies, on the basis that a reliance requirement is imposed only when the fraud is perpetrated through a misrepresentation to the creditor, which was not the case here.

This case potentially opens an avenue for creditors to defensively use a fraudulent transfer scheme that is outside of the one year limitation in § 727(a)(2) to prevent discharge of their claim.  As the Supreme Court noted, “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.”

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10th Circuit Holds That First Time Transactions Fall Within 11 U.S.C. 547(c)(2), Ordinary Course of Business Defense

October 16, 2015

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In a decision that surprised many, the United Stated Circuit Court of Appeals for the Tenth Circuit (the “10th Circuit Court of Appeals”) affirmed decisions finding that a payment made on account of a first time transaction between a debtor and creditor can qualify for the ordinary course of business defense under 11 U.S.C. § 547(c)(2).

C.W. Mining Company (the “Debtor”) entered into an equipment agreement with a new contractor, SMC Electric Products, Inc. (“SMC”), in an attempt to increase the Debtor’s coal production. This agreement was reached several months before the filing of an involuntary bankruptcy petition. Within 90 days of the involuntary bankruptcy filing, the Debtor made the first payment under the agreement in the amount of $200,000 to SMC via wire transfer. The Trustee filed an adversary proceeding seeking to avoid and recover the $2000,000 payment under 11 U.S.C. §§ 547(b) and 550, as an alleged preferential transfer. The bankruptcy court ruled that the payment could not be avoided because it was made in the ordinary course of business of the Debtor and SMC and was therefore protected by 11 U.S.C. §§ 547(c)(2). The United States Bankruptcy Appellate Panel affirmed the bankruptcy courts decision.

In affirming the decision, the 10th Circuit Court of Appeals held that the fact that the Debtor and SMC had entered into the agreement for the first time and that the alleged preferential payment was the first payment under the agreement did not alter the applicability of 11 U.S.C. § 547(c)(2). Under § 547(c)(2), a trustee may not avoid a transfer “to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee” when “such transfer was….(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or (B) made according to ordinary business terms.” The incurrence of the debt and the payment must be in the ordinary course of business for both the debtor and the transferee. See 11 U.S.C. § 547(c)(2) (emphasis added). The 10th Circuit Court of Appeals held that the statute refers to the “ordinary course of business or financial affairs of the debtor and the transferee,” not between the debtor and transferee. C.W. Mining, U.S. App. LEXIS 13981, at 10 (emphasis added). Further, the 10th Circuit Court of Appeals agreed with the Sixth, Ninth and Seventh Circuits that have held that a first time transaction can be protected by 11 U.S.C. § 547(c)(2). Wood v. Stratos Prod. Dev., LLC (In re Ahaza Sys. Inc.), 482 F.3d 1118, 1126 (9th Cir. 2007). (“[A] first-time debt must be ordinary in relation to this debtor’s and this creditor’s past practices when dealing with other, similarly situated parties.”); Kleven v. Household Bank F.S.B., 334 F.3d 638, 643 (7th Cir. 2003)( “[T]he court can imagine little (short of the certain knowledge that its debt will not be paid) that would discourage a potential creditor from extending credit to a new customer in questionable financial circumstances more than the knowledge that it would not even be able to raise the ordinary course of business defense, if it is subsequently sued to recover an alleged preference.”) (quoting Warsco v. Household Bank F.S.B., 272 B.R. 246, 252 (Bankr. N.D. Ind. 2002); Gosch v. Burns (In re Finn), 909 F.2d 903, 908 (6th Cir. 1990)(“Obviously every borrower who does something in the ordinary course of her affairs must, at some point, have done it for the first time.”).

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Second Circuit Decision Reminds Us to Double-Check Documents

March 13, 2015

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Official Committee of Unsecured Creditors v. JPMorgan Chase Bank, N.A. (In re Motors Liquidation Co.), Appeal No. 13-2187 (2nd Cir. Jan. 21, 2015)

Second Circuit Decision Reminds Us to Double-Check Documents

In a decision that sent a shiver down the spine of attorneys and lenders alike, on January 21, 2015, the U.S. Court of Appeals for the Second Circuit (the “Second Circuit”) ruled that JPMorgan Chase Bank, N.A. (“JPMorgan”) had released its security interest on a $1.5 billion loan to General Motors (“GM”) by inadvertently filing a UCC-3 termination statement. The Second Circuit held that although JP Morgan and GM did not intend to terminate the security interest at issue, the termination was effective because JP Morgan authorized the filing of the UCC-3 termination statement.

In October 2001, GM entered into a synthetic lease financing transaction (“Synthetic Lease”), by which it obtained approximately $300 million in financing from a syndicate of lenders (the “Lenders”) including JPMorgan who served as the administrative agent. The Synthetic Lease was secured by mortgages on several pieces of real estate, which were perfected by the filing of two UCC-1 financing statements by JPMorgan (the “Synthetic Lease UCC-1s”). Separately, GM entered into an unrelated term loan facility (the “Term Loan”). JPMorgan also served as the administrative agent on this loan. The Term Loan was secured by security interests in a variety of GM’s assets, including equipment and fixtures at forty-two facilities throughout the United States. JPMorgan properly filed UCC-1 financing statements to perfect its security interest in the various assets, including one such statement filed in Delaware covering all of GM’s equipment and fixtures at 42 of the facilities (the “Term Loan UCC-1”).

In September 2008, as the Synthetic Lease was nearing maturity, GM decided to pay-off the loan and contacted its counsel to prepare the necessary documentation, including documents to release the Lender’s security interests. In order to prepare the documents necessary to terminate the Lender’s security interests, GM’s counsel ordered a search for UCC-1 statements that had been recorded against GM in Delaware. This search yielded three UCC-1s: the Synthetic Lease UCC-1s and the Term Loan UCC-1. As part of the transaction, GM’s counsel prepared a closing checklist and UCC-3 termination statements to terminate all three security interests, mistakenly including the Term Loan UCC-1. Although all parties and their counsel reviewed the checklist and the draft documentation, no one caught the error. In October 2008, GM paid off the Synthetic Lease and the three UCC-3 termination statements were filed with the Delaware Secretary of State.

The mistake went unnoticed until 2009 when GM filed its Chapter 11 bankruptcy. JPMorgan became aware of the inadvertent filing of the UCC-3 statement relating to the Term Loan. JPMorgan advised the Official Committee of Unsecured Creditors (the “Committee”) appointed in GM’s bankruptcy of this filing mistake and asserted that the Term Loan was secured nonetheless because the filing was ineffective because it was unauthorized. The Committee commenced the underlying action against JPMorgan seeking a determination that, despite the error, the UCC-3 statement with respect to the Term Loan was effective and the Term Loan was unsecured. JPMorgan opposed this determination under UCC §9-509(d)(1) because it did not intend to terminate the security interest related to the Term Loan, therefore, the filing was not authorized and was not effective. The United States Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”) agreed with JPMorgan and held that the mistaken UCC-3 statement was unauthorized and therefore not effective to terminate a secured lender’s interest in a debtor’s property. The Committee filed a direct appeal of the Bankruptcy Court’s decision to the Second Circuit.

The Second Circuit certified the question related to interpretation of UCC §9-509(d)(1) to the Delaware Supreme Court because it presented a significant issue of Delaware state law. The Delaware Supreme Court held that under UCC §9-509(d)(1) if the secured party of record authorized the filing of the UCC-3 statement, that statement is effective regardless of whether the secured party subjectively intended or understood the effect of filing the statement. The Second Circuit then held that although JP Morgan never intended to terminate the Term Loan UCC-1, it clearly authorized the filing of the UCC-3 statement with respect thereto. Accordingly, the Second Circuit held that the UCC-3 with respect to the Term Loan was effective, reversing the Bankruptcy Court’s decision, and thereby rendering the Term Loan unsecured.

This decision provides a terrifyingly simple, and for parties involved costly, reminder to always double check your documents.

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