Supreme Court Broadly Interprets “Actual Fraud” Exception to Bankruptcy Discharge

On Monday, May 16, 2016, the Supreme Court issued its decision in the case of Husky Int’l Elecs., Inc. v. Ritz, — S. Ct. —, 2016 WL 2842452 (2016) resolving a split between the Fifth and Seventh Circuit Courts of Appeal regarding the scope of the “actual fraud” exception to an individual debtor’s bankruptcy discharge.  In relevant part, Section 523(a)(2)(A) of the Bankruptcy Code prohibits debtors from discharging “any debt . . . for money, property, [or] services . . . to the extent obtained, by . . . false pretenses, a false representation, or actual fraud.”  (Emphasis added).  The question was whether the “actual fraud” contemplated by Section 523(a)(2)(A) required a false representation by the debtor to the creditor, or whether it also encompassed other forms of fraud, like fraudulent conveyance schemes, that can be accomplished without a false representation.  The justices ruled 7-1 (with Justice Sotomayor writing for the majority, and Justice Thomas dissenting) in favor of the broader interpretation, and held that a false representation was not required to show “actual fraud” under 11 U.S.C. § 523(a)(2)(A).

The facts in Husky were straightforward.  Husky International Electronics, Inc. (“Husky”) supplied electronic device components to Chrysalis Manufacturing Corp. (“Chrysalis”).  Husky, 2016 WL 284252 at *2.  Daniel Lee Ritz was a director and partial owner of Chrysalis and exercised financial control over the company.  Id.  Chrysalis failed to pay for $163,999.39 worth of Husky’s goods.  Ritz later drained Chrysalis of assets it could have used to pay its debts to creditors like Husky by transferring large sums of money to other entities which Ritz controlled.  Id. at *3.  Husky then sued Ritz to hold him personally liable for the $163,999.39 debt.  Ritz filed for Chapter 7 bankruptcy, and Husky, in turn, commenced an adversary proceeding in Ritz’s bankruptcy case seeking, among other things, a declaration that the $163,999.39 debt could not be discharged.  Id.  Husky invoked more than one discharge exception, but the issue on appeal to the Supreme Court concerned the actual fraud provision of Section 523(a)(2)(A).  Each of the courts below—the bankruptcy, the district court, and the Fifth Circuit in In re Ritz, 787 F.3d 312 (5th Cir. 2016)—held that Section 523(a)(2)(A) did not apply because the $163,999.39 debt did not accrue as a result of a false representation from the debtor and, therefore, was not “obtained by . . . actual fraud.”  See id.  As noted, the Supreme Court disagreed.

The Supreme Court observed that the term “actual fraud” was added to the exception in 1978 with the enactment of the Bankruptcy Code; before then, the exception was limited to debts obtained by “false pretenses or false representations.”  The Court proclaimed that “[w]hen Congress acts to amend a statute, we presume it intends its amendment to have a real and substantive effect,” id. at *4 (internal quotation marks omitted), and it therefore “start[ed] with the presumption that Congress did not intend ‘actual fraud’ to mean the same thing as ‘a false representation.’”  Id.  The Court rested its interpretation of “actual fraud” on its historic, common law meaning.  It observed that “from the beginning of English bankruptcy practice, courts and legislatures have used the term ‘fraud’ to describe a debtor’s transfer of assets that, like Ritz’ scheme, impairs a creditor’s ability to collect a debt.”  Id.  Citing to the Statute of 13 Elizabeth and past Supreme Court precedent, the Court concluded that “the common-law term ‘actual fraud’ is broad enough to incorporate a fraudulent conveyance.”  Husky, 2016 WL 2842452 at *5.

The main debate, however, and the basis for the circuit split and Justice Thomas’ dissent, centered on satisfying the “obtained by” language in the statute.  In his dissent, Justice Thomas emphasized that “the statutory phrase ‘obtained by’ is an important limitation on the reach of the provision.”  Id. at *10.  The provision “covers only situations in which ‘money, property, [or] services’ are ‘obtained by . . . actual fraud,’ and results in a debt.”  Id. (citing Cohen v. de la Cruz, 523 U.S. 213, 218 (1998)).  In other words, Section 523(a)(2)(A) applies “only when the fraudulent conduct occurs at the inception of the debt, i.e., when the debtor commits a fraudulent act to induce the creditor to part with his money, property, services, or credit.”  Id. (emphasis in original).  Justice Thomas reasoned that “the general rule that a common-law term of art should be given its established common-law meaning gives way where that meaning does not fit.”  Id. at *9 (internal quotation marks omitted).  Fraudulent transfers, he explained, generally do not fit the mold of tricking a creditor to enter into a transaction with the debtor, and thus, the historic common-law meaning of “actual fraud” does not fit the rest of § 523(a)(2).  See id. at *9-10.  Referring to the facts at bar, Justice Thomas highlighted that Chrysalis, not Ritz, incurred a debt to Husky; Ritz made no oral or written representations to Husky; and, in fact, the only communication between Ritz and Husky occurred after Husky shipped the goods to Chrysalis.  See id. at 11.  Thus, according to Justice Thomas, “the majority’s attempt to broaden § 523(a)(2)(A) to cover fraudulent transfers impermissibly second-guesses Congress’ choices.”¹ Id.

The Husky Court’s response to the dissent is rather terse and may be difficult to follow, but is better understood after reviewing the Seventh Circuit’s decision in McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000), which it cites.  The Husky majority conceded that “[i]t is of course true that the transferor does not ‘obtain’ debts in a fraudulent conveyance.”  Husky, 2016 WL 2842452 at *8.  The Court countered, however, that “the recipient of the transfer—who, with the requisite intent, also commits fraud—can ‘obtain’ assets ‘by’ his or her participation in the fraud.”  Id. (citing McClellan, 217 F.3d at 897).  The McClellan decision illustrates the Court’s meaning.  There, a creditor sold machinery to the debtor’s brother for $200,000 payable in installments.  McClellan, 217 F.3d at 892.  The brother defaulted, owing the creditor more than $100,000.  Id.  The creditor sued the brother and, with the suit pending, the brother sold the machinery to his sister, the debtor, for $10.  Id.  She turned around and sold the machinery for $160,000 and then filed for bankruptcy.  Id.  The creditor than commenced an adversary proceeding to declare his $100,000 claim against her non-dischargeable.  The Seventh Circuit reasoned that the debtor “obtained” the assets (i.e., the machinery) “by” her participation in the fraud.  After further and more comprehensive analysis, the Seventh Circuit excepted the debt from discharge pursuant to Section 523(a)(2)(A).  See id. at 893-96.  The Supreme Court, citing to McClellan by example, concluded that, “at least sometimes a debt ‘obtained by’ a fraudulent conveyance scheme could be nondischargeable under § 523(a)(2)(A).”  Husky, 2016 WL 2842452 at *8.  The Court stated that although “[s]uch circumstances may be rare,” “they make clear that fraudulent conveyances are not wholly incompatible with the ‘obtained by’ requirement.”² Id.

Notably, however, in footnote 3 of the Husky opinion, the Supreme Court qualified that Ritz’s situation “may be unusual in this regard because Husky contends that Ritz was both the transferor and the transferee in his fraudulent conveyance scheme, having transferred Chrysalis assets to other companies he controlled.”  Id. at *8 n.3.  The Supreme Court expressly disclaimed:  “We take no position on that contention here and leave it to the Fifth Circuit to decide on remand whether the debt to Husky was ‘obtained by’ Ritz’ asset-transfer scheme.”  Id.  Thus, the full extent of the Supreme Court’s holding in Husky is unclear.  Although it is fair to say the Supreme Court held that a fraudulent transfer could be an example of “actual fraud,” it remains to be seen what type fact patterns will be found to satisfy the “obtained by” requirement, the parameters of which Husky left uncertain.

¹ The dissent (and the Fifth Circuit) also pointed out that another provision of the Bankruptcy Code, to wit, 11 U.S.C. § 727(a)(2), already excepts from discharge actual (as opposed to constructive) fraudulent transfers that occur within one year of the bankruptcy filing.  See id. at *14; accord Ritz, 787 F.3d at 320.  Accordingly, the dissent concluded that “[w]hen Congress wants to stop a debtor from discharging a debt that he has concealed through a fraudulent transfer scheme, it ordinarily says so.”  Id. at 14 (citing 11 U.S.C. § 727(a)(2)).

² In regard to Section 727(a)(2) of the Bankruptcy Code (noted in footnote 1 above), the Supreme Court reconciled that “[a]lthough the two provisions cover some of the same conduct, they are meaningfully different” because (i) § 727(a)(2) effects a complete denial of a chapter 7 discharge to a debtor, as opposed to § 523(a)(2)(A) which only excepts from discharge particular debts; and (ii) § 727(a)(2) is narrower than § 523(a)(2)(A) in timing, in that it only applies to transfer in the year preceding the bankruptcy filing.  Id. at *7.