High Court to Decide Scope of 'Actual Fraud' Exception to Discharge
Reprinted with permission from the March 18, 2016 issue of The Legal Intelligencer. © 2016 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.
Clearly, the most powerful tool available to an individual Chapter 7 debtor is the ability to obtain a discharge. As a check against abuse, the U.S. Bankruptcy Code allows creditors to challenge the discharge of certain debts incurred through unscrupulous behavior. Recently, the scope of discharge where "actual fraud" is alleged has found its way to the center of a circuit split soon to be decided by the U.S. Supreme Court in Husky International Electronics v. Ritz, No. 15-145.
Husky involved claims against an individual, Daniel Lee Ritz Jr., that originally arose from the sale of equipment to Chrysalis Manufacturing Corp., a company run and partially owned by him. Between 2003 and 2007, Chrysalis incurred unpaid debt to Husky International Electronics Inc. in the amount of $163,999.38. During that same period, Ritz transferred more than $1 million of Chrysalis' assets to other companies that he also controlled. In 2009, Husky sued Ritz in federal court, claiming Ritz was personally liable for Chrysalis' debts because Ritz used Chrysalis to perpetrate the fraudulent transfers for his own benefit.
Before the federal court case was decided, Ritz commenced a voluntary Chapter 7 bankruptcy proceeding. Soon thereafter, Husky filed an adversary proceeding, arguing that Ritz's debt to Husky was nondischargeable pursuant to Bankruptcy Code Section 523(a)(2)(A) on account of Ritz's fraudulent transactions involving Chrysalis and his other companies. That section provides, in relevant part, that an individual debtor cannot be discharged from any debt "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, other than a statement respecting the debtor's or an insider's financial condition." While the bankruptcy court found that Ritz "drained substantial funds out of Chrysalis's operating account and funneled these funds to other entities [he] controlled," it ruled that Ritz's debt to Husky remained dischargeable because he made no false representation to Husky during the course of his fraudulent-transfer scheme. The district court affirmed the bankruptcy court's ruling. Although the district court acknowledged that, under Texas law, "actual fraud" does not require a misrepresentation (which would make Ritz personally liable), Section 523(a)(2)(A) does. The U.S. Court of Appeals for the Fifth Circuit affirmed, holding that, because the parties agreed that Ritz's fraudulent-transfer scheme did not involve a misrepresentation, and because a false representation by the debtor "is a necessary prerequisite for a showing of 'actual fraud' under Section 523(a)(2)(A)," Ritz's debt was dischargeable.
Notwithstanding the Fifth Circuit's holding, at least two other circuits have established that "actual fraud" under Section 523(a)(2)(A) "is not limited to misrepresentations and misleading omissions" (McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000)) and that the "actual fraud" exception to discharge under Section 523(a)(2)(A) means all intentional fraud, including receiving property that the transferee knows is intentionally fraudulent (without misrepresentation) (In re Lawson, 791 F.3d 214, 225 (1st Cir. 2015)). Given the circuit split over the meaning of Section 523(a)(2)(A)'s "actual fraud," the U.S. Supreme Court agreed to hear the Husky case and is expected to issue its decision clarifying the scope of this Bankruptcy Code provision in the near future.
Before the Supreme Court Justices, Husky argued that the structure, history and purpose of Section 523(a)(2)(A) confirms that "actual fraud" does not categorically require a misrepresentation. Before 1978, Section 523(a)(2)(A) prohibited only the discharge of debts arising from intentional misrepresentations ("false pretenses" and "false representations"). In 1978, however, Congress amended the section by adding the phrase "actual fraud;" Husky asserted that such change was made in order to clarify that debts obtained from intentional fraud are also barred from discharge. According to Husky, under the common-law meaning reflected in case law dating back to the 16th century as well as the Supreme Court's own rulings, "actual fraud" means intentional fraud (which, of course, includes the acts committed by Ritz, who, "by receiving a fraudulent transfer, with intent to commit a fraud or to help the transferor in doing so, makes the transferee liable for actual fraud"). Further, as argued by Husky, if "actual fraud" also required a misrepresentation, the 1978 amendment would be superfluous and drafted for no purpose. Rather, Congress wished to expand the discharge bar to include an additional type of wrongdoing, i.e., debts obtained through intentional fraud but not necessarily through false pretenses.
Husky further contended that its reading of Section 523(a)(2)(A) comports with the Bankruptcy Code's underlying policy of affording relief only to honest, but unfortunate, debtors. Whereas the Fifth Circuit's construct, which would allow debts to be discharged as long as there is no misrepresentation, conflicts with this basic policy.
Not surprisingly, Ritz argued that Section 523(a)(2)(A) only applies to a fraudulently induced debt, and it is "obvious" that a debtor could not fraudulently induce a creditor to part with anything without uttering some sort of misrepresentation. Thus, Ritz urged the court to affirm the Fifth Circuit's interpretation that his debts remained dischargeable because he made no false representation.
Ritz also disagreed with Husky's expansive "catchall" use of the term "actual fraud" to include as Section 523(a)(2)(A) debts those arising from conduct broader than fraudulent misrepresentation — which conceivably might be described as conduct "intended to defraud." Rather, Ritz focused on the statutory language, which limits nondischargeable debts to those for money "obtained by" the conduct that it enumerates. Thus, in terms of "actual fraud," the misrepresentation must be intended to injure the creditor giving rise to the debt falling within the exception. According to Ritz, Congress added the "actual fraud" language in 1978 to confirm only that the exception applies to debts for things induced by intentional, not "constructive" or "implied," fraud. Under this analysis, Section 523(a)(2)(A) incorporates the common-law meaning of fraud: a knowingly false or misleading word or act used to induce the victim's detrimental reliance. In other words, far from expanding the scope of Section 523(a)(2)(A), Ritz contended that the "actual fraud" addition narrows its scope by requiring that the creditor prove the debtor made the misrepresentation with actual intent to induce the creditor to part with its money.
Finally, Ritz argued the Fifth Circuit's misrepresentation requirement does not run afoul of the Bankruptcy Code's policies as it is clear there are numerous other avenues for enforcing debts arising from a fraudulent conveyance or other intentional wrongdoing.
The Supreme Court's forthcoming Husky decision could have significant consequences for individual Chapter 7 debtors. Affirmance of the Fifth Circuit decision would make it harder for creditors to hold dishonest debtors accountable, while reversal could significantly reduce a creditor's burden of proof in opposing discharge. Either way, the outcome will be interesting. Stay tuned for the court's decision on this important issue.
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