On May 16, 2016, the United States Supreme Court in Husky International Electronics v. Ritz held that the phrase “actual fraud” under section 523(a)(2)(A) of the Bankruptcy Code may include fraudulent transfer schemes that were effectuated without a false representation. Section 523(a)(2)(A) provides that an individual debtor will not be discharged from certain debts to the extent that those debts were obtained by false pretenses, false representations or actual fraud. The Court’s decision in Husky resolved a conflict in the interpretation of actual fraud under section 523(a)(2)(A) between the Fifth and Seventh Circuits.
The case arose when Chrysalis Manufacturing Corp. (“Chrysalis”) could not satisfy approximately $164,000 in debt that it owed to Husky International Electronics, Inc. (“Husky”). Husky later discovered that Daniel Lee Ritz, Jr. (“Ritz”), a director and thirty percent owner of Chrysalis, transferred large sums of money to other entities that he controlled for several years.
When Ritz filed for bankruptcy protection under chapter 7, Husky commenced an adversary proceeding in the bankruptcy court. Husky sought a determination that Ritz was personally liable for Chrysalis’ debt under a Texas law that allows creditors to pursue shareholders for unpaid corporate debt and that the debt owed to Husky was non-dischargeable under section 523(a)(2)(A).
Following a trial on the issues, the district court determined that Ritz was personally liable under the Texas statute, but because the debt was not obtained by conduct that constituted actual fraud under section 523(a)(2)(A) the debt was dischargeable. The case was appealed to the United States Court of Appeals for the Fifth Circuit, which affirmed the district court. The Fifth Circuit determined that while Ritz may have hindered the ability of the Husky to collect its debt, Ritz did not make false representations and thus did not commit actual fraud as required by section 523(a)(2)(A).
The Majority Opinion
In a seven member majority opinion written by Justice Sonia Sotomayor, the Supreme Court reversed and remanded the Fifth Circuit decision. Justice Sotomayor began the analysis of the majority by noting that when Congress enacted the Bankruptcy Code in 1978, it added the phrase “actual fraud” to the types of conduct that were non-dischargeable under the Bankruptcy Act of 1898. Justice Sotomayor noted that the majority presumes that by amending the types of non-dischargeable conduct, Congress did not intend actual fraud to be the same type of conduct as false representation.
The majority opinion also reviewed the historical common law interpretation of the phrase “actual fraud.” The majority noted that as far back as the English Parliament’s enactment of the Statute of 13 Elizabeth in 1571, fraud did not require a misrepresentation and simply occurred when a person hid assets from creditors. Further, the majority observed that previous Court precedent, dating back to the nineteenth century, interpreted the phrase as involving any type of conduct done with “wrongful intent.” Based on this historical legacy, the majority concluded that false representations are not a required element of actual fraud.
Justice Sotomayor next examined the Ritz’s arguments against interpreting actual fraud to include fraudulent transfers under section 523(a)(2)(A). First, Ritz argued that doing so would render duplicative two other subsections of section 523(a) that address debts arising from fraud in a fiduciary capacity and from willful and malicious conduct. While the Court observed that some types of non-dischargeable conduct may overlap among the various subsections of section 523(a), adopting Ritz’s view would eliminate the meaningful distinctions between those subsections. The Court also rejected Ritz’s argument that including fraudulent conveyances into the type of non-dischargeable conduct at issue would render section 727(a)(2) of the Bankruptcy Code redundant. Again, the Court noted that while there may be some overlap, the two statutes are meaningfully different. Section 727(a)(2) makes non-dischargeable all debt if, in the one year prior to a bankruptcy, the debtor transferred, removed, destroyed, mutilated, or concealed property with the intent to hinder, delay, or defraud a creditor. Unlike section 727(a)(2), the majority noted, section 523(a)(2)(A) does not have a timing element and only renders certain debts non-dischargeable.
Further, the majority rejected Ritz’s argument, which was adopted by Justice Clarence Thomas in his dissent, that fraudulent transfers are not included under actual fraud because the debts were not “obtained by . . . actual fraud” as required by the language in section 523(a)(2)(A). The majority acknowledged that in fraudulent transfer schemes the transferor does not obtain debts; however, in certain “rare” instances a debt may be traceable to the fraudulent transfer and thus may be non-dischargeable. The Court declined to consider whether Ritz obtained his debts by fraudulent transfer and instead remanded that issue to the Fifth Circuit for further determination.
The majority’s view that actual fraud under section 523(a)(2)(A) may occur due to fraudulent transfers without misrepresentations is a limited one. The majority recognized that the instances where the debt was “obtained by” actual fraud are rare and usual. Until the lower courts determine whether the debt incurred by Ritz was “obtained by” fraudulent transfers, it is not clear whether the debt at issue is non-dischargeable.
It is significant, however, that the majority noted that “there is no need to adopt a definition for all times and all circumstances” with respect to what constitutes “actual fraud.” This statement leaves open the possibility that the Court may expand the definition in the future and thereby broaden the type of conduct that is not dischargeable in bankruptcy.
Alan H. Martin, Practice Group Leader
Edward H. Tillinghast, III, Practice Group Leader
Todd L. Padnos, Editor