May 17, 2016
Authored by: Michelle McMahon and Mark Duedall
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).
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.”