CheatThe United States Supreme Court issued its decision in Husky International Electronics, Inc. v. Ritz, eliminating some ambiguity behind what constitutes “actual fraud” in the bankruptcy context.  The issue in this case was whether “actual fraud” requires a false representation or whether it encompasses other traditional forms of fraud that can be accomplished without a false representation.

Between 2003 and 2007, Husky sold its products to Chrysalis.  As a result, Chrysalis incurred a debt to Husky of almost $164,000.  During the same period, Ritz, the director of Chrysalis, drained the company of assets it could have used to pay its debts to creditors like Husky by transferring large sums of Chrysalis’ funds to other entities under his control.  In May 2009, Husky filed a lawsuit against Ritz seeking to hold him personally responsible for the entire debt.  Six months later, Ritz filed for bankruptcy which incited Husky to initiate an adversarial proceeding in Ritz’ bankruptcy case again seeking to hold Ritz personally liable for Chrysalis’ debt.  Husky contended Ritz could not discharge the debt in bankruptcy because this type of inter-company-transfer scheme constituted “actual fraud” under 11 U.S.C. §523(a)(2)(A).  The Fifth Circuit held that a necessary element of “actual fraud” is a misrepresentation from the debtor to the creditor and found that Ritz did not make any false representations to Husky regarding those assets or transfers and therefore did not commit “actual fraud.”

In making its decision, the Supreme Court first looked back into the history of U.S. bankruptcy law and found that from the beginning of English bankruptcy practice, courts and legislatures have used the term “fraud” to describe schemes similar to Ritz’, in which a debtor’s transfer of assets impairs a creditor’s ability to collect the debt.  The court also looked at the legislative history of §523(a)(2)(A) and found that Congress amended the statute in 1978 to add “actual fraud” to a list that already included “false pretenses or false representations.”  Acting under the presumption that when Congress amends a statute, it intends its amendment to have real and substantial effect, the court concluded that Congress did not intend “actual fraud” to mean the same thing as “a false representation.”

11 U.S.C. §523(a)(2)(A) provides for an exception to discharge of bankruptcy debt where the debt is obtained by the false pretenses, actual fraud, etc.  Traditionally, “obtained by” described the initial time the debt was incurred.  But while this case did not consist of misrepresentation from a debtor to a creditor at the time the debt was incurred, the court held that fraudulent conveyances are not entirely incompatible with the “obtained by” requirement in the statute.  Although the transferor does not “obtain” debts in a fraudulent conveyance, the recipient would “obtain” assets by his participation in the fraud.  If that recipient later filed for bankruptcy, his debts would be nondischargable under the statute.  It follows that at least sometimes a debt “obtained by a fraudulent conveyance scheme could be nondischargable under §523(a)(2)(A).”

In a 7-1 ruling, the Supreme Court reversed the Fifth Circuit, but remanded the case to for a decision of whether the debt to Husky was “obtained by” Ritz’ asset-transfer scheme.  The main takeaway from this case is that “actual fraud” in §523(a)(2)(A) of the Bankruptcy Code could encompass a fraudulent conveyance scheme.  As a result, SCOTUS closed up a large loophole that allowed debtors to discharge debts under the Bankruptcy Code.

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