Watch Out Where The Huskys Go… Supreme Court Broadens The Definition Of Bankruptcy Fraud Under Section 523(a)(2)(A)

DonaldCram

Author:
Donald H. Cram III

Under 11 U.S.C. § 523(a)(2)(A), a bankruptcy discharge does not apply to 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.”  The United States Supreme Court recently determined that a false representation by a debtor is not required to satisfy the “actual fraud” exception to the bankruptcy discharge under Section 523(a)(2)(A).  Husky Int’l Elecs., Inc. v. Ritz, 136 S.Ct. 1581 (2016).  The Court ruled that the term “actual fraud” in Section 523(a)(2)(A) did not necessarily require that the debt must be “obtained by” fraud of some kind.  Id. at 1589-90.  But it held actual fraud encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation and without dishonestly inducing a creditor to extend a debt.  Id. at 1590.

Facts and History.  Chrysalis Manufacturing Corp. incurred a debt to the seller of electronic device components, Husky International Electronics, Inc., of nearly $164,000.  Daniel Lee Ritz, Jr., Chrysalis’s director and part owner at the time, drained Chrysalis of assets available to pay the debt by transferring large sums of money to other entities Ritz controlled.  Husky sued Ritz to recover on the debt.  Ritz then filed for Chapter 7 bankruptcy, prompting Husky to file a complaint in Ritz’s bankruptcy case, seeking to hold him personally liable and contending that the debt was not dischargeable because Ritz’s intercompany-transfer scheme constituted “actual fraud” under the Bankruptcy Code’s discharge exceptions.  11 U.S.C. § 523(a)(2)(A).

The district court held that Ritz was personally liable under state law but also held that the debt was not “obtained by . . . actual fraud” under Section 523(a)(2)(A) and therefore could be discharged in Ritz’s Chapter 7 bankruptcy.  The Fifth Circuit affirmed, holding that a misrepresentation from a debtor to a creditor is a necessary element of “actual fraud” and was lacking in this case, because Ritz made no false representations to Husky regarding the transfer of Chrysalis’s assets.

In acknowledging the circuit split on whether the discharge bar applies only when a debtor knowingly makes a misrepresentation to creditors or whether it encompasses other traditional forms of fraud accomplished without a false representation, the Court, in a 7-1 decision, reversed and remanded the case back to the Fifth Circuit, adopting a broader view of Section 523(a)(2)(A).

Supreme Court’s Reasoning.  Writing for the majority, Justice Sonia Sotomayor concluded that parties do not need to present evidence that a wrongdoer made a false representation for purposes of establishing fraud under Section 523(a)(2)(A) of the Bankruptcy Code.  In arriving at this result, she harkened back to nineteenth century Supreme Court precedent (Neal v. Clark, 95 U.S. 704, 709 (1878)), stating that at common law, “actual fraud” meant fraud committed with wrongful intent.  136 S.Ct. at 1586.  Further, the opinion noted that the term “fraud” has, since the beginnings of bankruptcy practice, been used to describe asset transfers that, like Ritz’s scheme, impair a creditor’s ability to collect a debt.  Actual fraud “encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation,” Justice Sotomayor wrote.  Id.

In addressing Justice Thomas’s dissent, where he argues that the broadened reading of “actual fraud” all but eliminates the “obtained by” language of Section 523(a)(2)(A), Justice Sotomayor wrote, “[i]n such cases, the fraudulent conduct is not in dishonestly inducing a creditor to extend a debt.  It is in the acts of concealment and hindrance.  In the fraudulent-conveyance context, therefore, the opportunities for a false representation from the debtor to the creditor are limited.  The debtor may have the opportunity to put forward a false representation if the creditor inquires into the whereabouts of the debtor’s assets, but that could hardly be considered a defining feature of this kind of fraud.”  Id. at 1587.

Impact.  Some commentators have asserted that the Court’s decision is very narrow.  In Husky, the particular debt at issue was the $163,999.38 that Chrysalis owed for the goods that Husky delivered, not any debt that Ritz owed as the recipient of a fraudulent transfer.  136 S.Ct. at 1585.  Arguably, all the Court actually decided was that a fraudulent transfer could be an example of actual fraud, not whether Ritz’s particular obligation was actually nondischargeable.

Others believe the Court’s decision will be used in the future by creditors to argue that bankruptcy courts can take into consideration conduct of the debtor that occurs after a debt is incurred in making a decision as to whether a particular debt should be dischargeable.  Prior to Husky, the inquiry was largely limited to what was done or said at the time the debt was incurred.

Husky likely changes the law of the Ninth Circuit.  Prior to Husky, a creditor was required to demonstrate “misrepresentation, fraudulent omission or deceptive conduct by the debtor” in order to “prevail on any claim arising under § 523(a)(2)(A).”  Turtle Rock Meadows Homeowners Ass’n v. Slyman (In re Slyman), 234 F.3d 1081, 1085 (9th Cir. 2000).

The Husky ruling may embolden creditors to bring adversary proceedings objecting to the discharge of certain debts because of debtor’s fraud under Section 523(a)(2)(A).  However, consumer creditors should tread cautiously.  If the debt is a consumer debt, and the debtor prevails, the creditor may very well be obligated to pay the debtor’s attorneys’ fees and costs in defending the action pursuant to the cost shifting provision of Section 523(d).  One would do well to heed Nanook’s Mama’s sage advice and watch out where the huskies go!

For more information about the dischargeability of debts under Section 523(a)(2)(A) in general, or the Husky case in particular, please contact
Donald H. Cram, III at dhc@severson.com.

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