Supreme Court Clarifies the Standard for Actual Fraud

Supreme Court Clarifies the Standard for Actual Fraud

courtroom-justicescalesOn May 16, 2016, the United States Supreme Court decided Husky International Electronics Inc. v. Ritz[1], holding by a 7-1 vote that the "actual fraud" standard found at 11 U.S.C. Section 523(a)(2)(A) encompasses fraudulent transfer schemes, even when these schemes do not have a fraudulent representation or any misrepresentation made as part of the scheme.

Petitioner Husky International is a supplier of components used in electronic devices. During the years 2003 through 2007, Husky sold its components to Chrysalis Manufacturing, which in the course of this business, incurred a debt of over $163,000 owed to Husky. Respondent Daniel Lee Ritz served as the director of Chrysalis and owned 30 percent of its common stock. In the years 2006 and 2007, Ritz transferred assets, namely large amounts of cash, to different companies he owned or had an interest in, assets which could have been used to pay the debt owed to Husky.

"The Justices continued by opining that the term "fraud", going back to English bankruptcy practice, had always included transfer schemes such as the one Ritz had intentionally committed."

This transfer scheme prompted Husky to file a lawsuit in Texas State Court seeking to hold Ritz personably liable for the debt owed to Husky by Chrysalis. Husky argued in the state court that Ritz committed actual fraud by use of the transfers, relying on a state statute making shareholders responsible for corporate debts[2]. Ritz then promptly filed a chapter 7 petition in the United States Bankruptcy Court for the Southern District of Texas. Husky then filed an adversary proceeding seeking to except the debt from discharge pursuant to 11 U.S.C. Section 523(a)(2)(A), among other claims. The District Court ruled that the debt could be discharged because the transfer scheme did not amount to "actual fraud" as the debt was not obtained by use of actual fraud, or the use of a fraudulent representation which is relied upon by the creditor[3]. The Fifth Circuit Court of Appeals affirmed the decision of the District Court, disagreeing with Husky that transfer schemes are a form of actual fraud. The Fifth Circuit held that a necessary element of actual fraud is a misrepresentation made by the debtor to the creditor in which the creditor relies. Ritz had not made any representations to Husky, and therefore, couldn't have committed actual fraud as meant in the statute.

After granting certiorari, the Supreme Court reversed. The Justices began their opinion with a history of the use of the term actual fraud in the Bankruptcy Code. Beginning with the term "actual fraud" initially appearing in the Bankruptcy Reform Act of 1978, the Court then explained that the term has two parts: "actual" and "fraud". "Actual" having the common law meaning of fraud. One that involves moral turpitude or intentional wrongs, going so far as to say, that any "fraud" done with wrongful intent is "actual fraud".

The Justices continued by opining that the term "fraud", going back to English bankruptcy practice, had always included transfer schemes such as the one Ritz had intentionally committed. Interestingly, Ritz's counsel at oral argument before the Court agreed that fraudulent transfer schemes are a form of actual fraud. Ritz attempted to counter this admission by arguing that the term actual fraud in 523(a)(2)(A) meant something other than fraudulent schemes.

Ritz argued that incorporating fraudulent conveyances into actual fraud would render 11 U.S.C. Section 523(a)(4) and 11 U.S.C. Section 523(a)(6) duplicative. Allowing fraudulent conveyance schemes to be part of actual fraud, Ritz argued, 523(a)(2)(A) would overlap and encompass the same conduct that 523(a)(4) and (a)(6) prohibited. The Court intertwined through the "unavoidable" redundancies holding that actual fraud contains fraudulent transfers, finding very small distinctions in the statutes text the Justices held that actual fraud encompassed fraudulent conveyances, without disturbing the natural overlap between the three sections.

Ritz even went further than Section 523 and argued that the Court's holding would also create redundancies in other areas of the Code. Ritz argued that fraudulent conveyances already had a section created to deal with the fraudulent conveyances by debtors in 11 U.S.C. Section 727(a)(2). That section prevents a debtor from discharging all debts if the debtor transferred property "with intent to hinder, delay, or defraud a creditor or an officer of the estate charged with custody of property."[4] The Justices made quick work of this argument, lecturing that Section 727 was much larger in scope, allowing denial of discharge of all debts, rather than the singular debt that Section 523 would cover. Additionally, the Justices found that Section 727 only covered a specific period of time, namely one year prior to petition, while no such qualifier was found in Section 523.

Justice Thomas was the lone dissenter in the group. He argued that the term "obtained by" in the statutes text could never mean fraudulent conveyances as the debtor would never "obtain" anything in a fraudulent conveyance context. No debt could remain or be traced to the fraudulent conduct of the debtor when transfers are made. Going even further into the text, Justice Thomas contended that debts "obtained by" actual fraud had to originate from a credit transaction, such as a credit card application or a loan. He enthusiastically argued that the Court's holding may allow individuals to be prevented from obtaining a discharge of a debt without having made any false representation, without having the creditor rely on any statements by the debtor and no actual conveyance, fraudulent or otherwise, having happened at the inception of the credit transaction.

Finding no support for Justice Thomas's reading of the statute in the text itself, the majority quickly swept aside the dissent. The majority quickly noted that the reliance element the dissent was hanging its hat on was only discussed in prior opinions of the Court that discussed frauds that actually did require a misrepresentation. The Court has never held in any previous case, that a reliance requirement remained for frauds that did not require a misrepresentation to complete.

By allowing actual fraud to encompass fraudulent conveyance schemes without the use of a misrepresentation, the Court greatly broadened the scope by which a creditor could except their debts from a debtor's general discharge. The Court found that it should give the words "actual fraud" the meaning it has held since the early English Bankruptcy Acts (pre-dating the US Code) and that this broad definition does include fraudulent conveyance schemes. This decision will likely result in further litigation for debtors that attempt to transfer assets prior to bankruptcy, allowing creditors the ability to pursue debtors after the discharge in Bankruptcy has entered.

----------------------------------

[1] 578 U.S. _____(2016)

[2] See Tex. Bus. Orgs. Code Ann. Section21.223(b)

[3] See In Re Ritz, 787 F.3d 312 (2015)

[4] See 11 U.S.C. Section 727(a)

Brett A. Border is the supervising attorney of Fabrizio & Brook’s bankruptcy department. Border has more than 12 years’ experience in creditors’ rights and all aspects of Chapter 7, 11, and 13 bankruptcies. His prior experience includes working for the Office of the Chapter 13 Trustees in Detroit. Border received his Juris Doctor from the Thomas M. Cooley Law School and earned his Bachelor of Science degree from Eastern Michigan University. He is an adjunct professor at Madonna University and teaches Introduction to Bankruptcy for the university¹s paralegal program.