On May 16, 2016, the U.S. Supreme Court issued its opinion in Husky International Electronic, Inc. v. Ritz. The opinion is a favorable development for creditors because it expands the types of fraudulent conduct that can prevent a debtor from discharging debts in bankruptcy. Specifically, the court held that the discharge exception for “actual fraud” under §523(a)(2)(A) of the Bankruptcy Code includes fraudulent conveyance schemes in which the debtor participates, even when those schemes do not involve a false representation to the creditor.
Facts of the Case
Husky provided electronic device components to Chrysalis Manufacturing Corp., accumulating indebtedness of nearly $164,000.00 for unpaid goods. The owner of Chrysalis, Daniel Ritz, drained assets available to pay Husky by transferring large sums of cash to at least seven other entities. When this came to light, Husky sued Ritz directly in federal court seeking to “pierce the corporate veil” and hold him personally liable for his actions. Ritz then filed Chapter 7 bankruptcy, attempting to discharge any liability to Husky without accounting for his actions or the fraudulently conveyed assets.
Issue Presented and Court’s Ruling
The issue before the court was the scope of the Bankruptcy Code provision barring discharge of “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.” Ritz’s argument, which was accepted by the lower courts, turned on an inducement-based definition of “actual fraud” that requires a false representation to the affected creditor. The fraud Husky alleged was based on Ritz’s fraudulent conveyance of assets, which although a form of fraud, did not involve any false representation to Husky. Ritz argued that his liability to Husky was dischargeable because he did not make any false representation to Husky.
The court rejected Ritz’s argument and found that “actual fraud” does not require a false representation. The court found that the “actual fraud” component of §523(a)(2)(A) was added by Congress to broaden the provision beyond debts incurred under false pretenses or by false representations. The court further found that the common law definition of “actual fraud” includes fraudulent conveyances. Accordingly, the court reversed the lower court and held that “actual fraud” includes fraudulent conveyance schemes designed to defraud creditors irrespective of whether the debtor makes any false representation to the creditor.
Relevant Policy Interests
The policy interests underlying the court’s consideration were the subject of several “friend of the court” briefs filed by parties including the National Association of Bankruptcy Trustees (NABT) and an esteemed group of bankruptcy law professors. These parties noted that the restrictive interpretation of “actual fraud” advocated by Ritz rewards dishonest conduct in a way that conflicts with the fundamental purpose of the Bankruptcy Code. The NABT warned of creating “a dangerous loophole through which the boldest and most dishonest debtors can ‘game the system’” by accruing debts and then silently transferring their assets before filing bankruptcy. The court’s holding avoids this result by interpreting §523(a)(2)(A) to include fraudulent conveyance schemes.
Caveat and Conclusion
The protections of §523(a)(2)(A) are not automatic. A creditor must file an adversary proceeding or “dischargeability” action in the debtor’s bankruptcy case seeking a judgment that the debt is not dischargeable. Creditors who fail to do so may find their debts discharged despite the debtor’s fraudulent conduct. The attorneys in Poyner Spruill’s Creditors’ Rights and Bankruptcy practice group have expertise in representing clients in these proceedings.