Supreme Court Expands Scope of “Actual Fraud” for Dischargeability Purposes

10/1/2016

First published in the Oregon State Bar Debtor-Creditor Newsletter Vol. XXXV, No. 3

Husky Int’l. Electronics, Inc. v. Ritz, 136 S.Ct. 1581 (2016)

A few months ago, the Supreme Court issued an opinion to resolve a circuit split over the interpretation and application of Bankruptcy Code § 523(a)(2)(A). That provision prohibits debtors from discharging debts “for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by […] false pretenses, a false representation, or actual fraud.” 11 U.S.C. § 523(a)(2)(A). Congress added “actual fraud” to that list when it passed the Bankruptcy Reform Act of 1978. Husky addresses the question of whether “actual fraud” is broad enough to encompass fraudulent transfers.

That case involved a fairly typical fraudulent transfer scheme. Chrysalis Manufacturing Corp. (“Chrysalis”) was a Texas-based manufacturer of circuit boards. It purchased certain parts from Husky International, Inc. (“Husky”), a Colorado-based distributor. Chrysalis ran up a debt of $164,000. At the same time, Chrysalis’s director and partial owner, Daniel Lee Ritz, Jr., transferred large sums of money from Chrysalis to other entities that he controlled. When Chrysalis was unable to pay its debt, Husky sued Ritz personally. Ritz subsequently filed a Chapter 7 bankruptcy petition. Husky countered by filing an adversary proceeding seeking to have Ritz’s liability for fraudulently transferring Chrysalis’s assets held non-dischargeable under § 523 (a) (2) (A).

Specifically, Husky argued that Ritz’s fraudulent transfer of funds from Chrysalis to other entities amounted to “actual fraud.” Previously, the First and Seventh Circuits held that the “actual fraud” bar applies when an individual debtor obtains money through a fraudulent transfer scheme that is intended to cheat a creditor. The Fifth Circuit, however, held that as a matter of law no “actual fraud” exists unless a debtor makes a false representation to the creditor. In Husky, both the Texas Bankruptcy Court and Court of Appeals applied that ruling and dismissed the adversary complaint. The Supreme Court disagreed.

The Supreme Court clarified that “actual fraud” is “broad enough to incorporate fraudulent conveyances.” Husky, 136 S.Ct. at 1584. Departing from the ordinary elements of fraud, a “fraudulent transfer” does not require either a misrepresentation (from debtor to creditor) or a creditor’s reliance on a debtor’s bad acts. As the Supreme Court pointed out, fraudulent conveyance does not lie “in dishonestly inducing a creditor to extend a debt but in the acts of concealment and hindrance.” Id. (Stating also, “[f] raudulent conveyances typically involve ‘a transfer to a close relative, a secret transfer, a transfer of title without transfer of possession, or grossly inadequate consideration.’”)

Ritz and the dissenting Justices stressed that a fraudulent transfer functions to hide valuables that a debtor already possesses, so it cannot amount to a “debt … obtained by … actual fraud” under § 523(a)(2)(A). The dissent also stressed that a debt at the “end” of a fraudulent transfer does not “result from” nor is it “traceable to” the fraud itself. In other words, the debt exists before the fraudulent transfer is performed. Thus, a fraudulent transfer is inconsistent with § 523(a)(2)(A)’s “obtained by” requirement. The majority disagreed, explaining that

      It is of course true that the transferor does not “obtai[n]” debts in a fraudulent conveyance. But 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 nondischargeable under § 523(a)(2)(A). Thus, at least sometimes a debt “obtained by” a fraudulent conveyance scheme could be nondischargeable under § 523(a)(2)(A).

It is interesting to note that Ritz was not the direct recipient of the fraudulent transfers. Given that, it appears that the majority was much more interested in function over form and preventing complex schemes from being used to defraud creditors. Nonetheless, this decision does seem to be a departure from a strict textualist reading of § 523(a)(2)(A). That leads one to wonder if the Supreme Court would have used the same analysis had the late Hon. Antonin Scalia been involved.

Although the Ninth Circuit has not historically required a creditor to show a “false misrepresentation” to prove “actual fraud” (like the Fifth Circuit), the Supreme Court’s decision in Husky is a substantial departure from its prior holdings. The Ninth Circuit has “consistently held that a creditor must demonstrate five elements to prevail on any claim arising under § 523(a)(2)(A)” –
     
      (1) misrepresentation, fraudulent omission or deceptive conduct by the debtor; (2) knowledge of the falsity or deceptiveness of his statement or conduct; (3) an intent to deceive; (4) justifiable reliance by the creditor on    the debtor’s statement or conduct; and (5) damage to the creditor proximately caused by its reliance on the debtor’s statement or conduct.

See, In re Slyman, 234 F3d 1081, 1085 (9th Cir 2000) (quoting In re Britton, 950 F2d 602, 604 (9th Cir 1991) and In re Hashemi, 104 F3d 1122, 1125 (9th Cir 1996), among others) (internal quotations omitted). Although a fraudulent transfer involves “deceptive conduct,” it does not involve reliance on that conduct or damages resulting from such reliance. It will be interesting to see how far and how liberally our courts apply this new Supreme Court ruling.

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