Supreme Court Reverses Fifth Circuit's Interpretation of "Actual Fraud"
- In a resounding 7-1 decision, the U.S. Supreme Court ruled in favor of the petitioner in Husky Int'l Electronics, Inc. v. Ritz, reversing the decision of the U.S. Court of Appeals for the Fifth Circuit.
- The Supreme Court determined that "actual fraud" under Section 523(a)(2)(A) of the U.S. Bankruptcy Code does not require that a debtor make a false representation to a creditor in order for a debt to be nondischargeable under that section.
- As grounds for its decision, the Supreme Court considered the history of Section 523(a)(2)(A) and the historical meaning of "actual fraud," rejecting the need to precisely define "fraud" for all times and circumstances.
In a resounding 7-1 decision, the U.S. Supreme Court resolved an existing split among the U.S. Circuit Courts of Appeal, determining that "actual fraud" under Section 523(a)(2)(A) of the U.S. Bankruptcy Code does not require that a debtor make a false representation to a creditor in order for a debt to be nondischargeable under that section. In a decision written by Justice Sonia Sotomayor, the Supreme Court ruled in favor of the petitioner in Husky Int'l Electronics, Inc. v. Ritz1, reversing the decision of the U.S. Court of Appeals for the Fifth Circuit and remanding the case for further proceedings.2
In Husky, the petitioner, Husky International Electronics Inc., argued that "actual fraud" as used in Section 523(a)(2)(A) of the Bankruptcy Code does not require a false representation but instead encompasses other traditional forms of fraud, such as a fraudulent conveyance of property made to evade payment to creditors.3 The Supreme Court granted certiorari to resolve the split between the Circuit Courts.
Petitioner Husky is in the business of selling components used in electronic devices. For a number of years, Husky sold its product to Chrysalis Manufacturing Corp, and Chrysalis incurred a debt to Husky of approximately $164,000. During the relevant time period, Daniel Ritz Jr. was a director of Chrysalis and owned not less than 30 percent of the common stock in Chrysalis. There is no dispute that during the same period that Chrysalis incurred the debt to Husky, Ritz drained Chrysalis of assets it could have used to pay its debts to creditors, such as Husky, by transferring large sums of Chrysalis' funds to other entities Ritz controlled.
In May 2009, Husky filed a lawsuit against Ritz, seeking to hold him personally responsible for Chrysalis' debt to Husky. Husky argued that Ritz's intercompany transfer scheme was "actual fraud" for purposes of a Texas statute that allows creditors to hold shareholders liable for corporate debt. In December 2009, Ritz filed a Chapter 7 liquidation case in the U.S. Bankruptcy Court for the Southern District of Texas. Husky filed a complaint in Ritz's Chapter 7 case, seeking a ruling that Ritz was personally responsible for the debt owed by Chrysalis to Husky and that the debt should be determined to be nondischargeable; that is to say that the debt should survive the bankruptcy filing because the same intercompany transfer scheme was "actual fraud" under Bankruptcy Code Section 523(a)(2)(A).4
The U.S. District Court for the Southern District of Texas ruled that Ritz was personally liable for the debt under Texas law, but that the debt was not "obtained by ... actual fraud" under Section 523(a)(2)(A) and could be discharged in Ritz's Chapter 7 case. The Fifth Circuit affirmed the District Court's ruling, but it did not address whether Ritz was liable for Chrysalis' debt under Texas law because the appellate court agreed with the District Court that Ritz did not commit "actual fraud" under Section 523(a)(2)(A).
Husky argued before the Fifth Circuit that Ritz's asset-transfer scheme was effectuated through a series of fraudulent transfers – conveyances intended to hinder the collection of debt. Further, Husky argued that such transfers are a recognized form of "actual fraud." The Fifth Circuit disagreed, ruling that a necessary element of "actual fraud" is a misrepresentation from a debtor to a creditor, such as when a person applying for credit provides false information in support of the credit application. The Fifth Circuit recognized that in transferring Chrysalis' assets for little or no consideration, Ritz may have hindered Husky's efforts to collect on its debt, but the Fifth Circuit found that Ritz did not make any false representations to Husky regarding those assets or the transfers themselves, and so, did not commit "actual fraud."
Supreme Court Reverses Fifth Circuit Ruling
The Supreme Court reversed the Fifth Circuit ruling, holding that "actual fraud" in Section 523(a)(2)(A) encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation.
As grounds for its decision, the Supreme Court first considered the history of Section 523(a)(2)(A), looking at the revision made to the antecedent section under the prior Bankruptcy Act as part of the enactment of the Bankruptcy Reform Act of 1978. Prior to 1978, the previous Bankruptcy Act prohibited debtors from discharging debts obtained by "false pretenses or false representations." In the Bankruptcy Reform Act of 1978, Congress added "actual fraud" to that list. Noting that there is a presumption that when Congress amends a statute, it intends that the amendment have a "real and substantial effect," the Supreme Court presumed that Congress did not intend "actual fraud" to have the same meaning as "false representation," a pre-existing basis for nondischargeability of a debt under the pre-1978 Bankruptcy Act, as suggested by the Fifth Circuit's holding.5
The Supreme Court cited the historical meaning of "actual fraud" as even stronger evidence that the phrase includes the conduct that Husky alleged Ritz to have undertaken. First, the Supreme Court observed that it has historically construed the terms in Section 523(a)(2)(A) to contain the "elements that the common law has defined them to include."6 After considering its applicable precedent, the Supreme Court concluded, "Thus, anything that counts as "fraud" and is done with wrongful intent is 'actual fraud.'"7
Although acknowledging that "fraud" is difficult to define precisely, the Supreme Court rejected the need to do so, stating that "[t]here is no need to adopt a definition for all times and all circumstances here because, from the beginning of English bankruptcy practice, courts and legislatures have used the term "fraud" to describe a debtor's transfer of assets that, like Ritz's scheme, impairs a creditor's ability to collect the debt."8 Further, the Supreme Court recognized that the common law indicates that although fraudulent conveyances are "fraud," fraudulent conveyances do not require a misrepresentation from a debtor to a creditor, fundamentally because fraudulent conveyances are not "an inducement-based fraud."9 As far back as 16th Century England, both the debtor and the recipient of the fraudulently conveyed assets were liable for fraud, even though the recipient of a fraudulent conveyance made no representation to the debtor's creditor. According to the Supreme Court, that principle "underscores the point that a false representation has never been a required element of 'actual fraud' ..."10
The Supreme Court was unquestionably decisive in its decision to reverse the Fifth Circuit's interpretation of "actual fraud" in Bankruptcy Code Section 523(a)(2)(A). By requiring "actual fraud" to include a false representation, a separate basis for nondischargeability also in the statute, the Fifth Circuit's definition of the term was inherently unsound because it created a "how-to" manual for intentional wrongdoers to be rewarded for their deception. Under such a definition, a fraudster could use Bankruptcy Code Section 523(a)(2)(A) as shelter – evading liability for intentional wrongdoing – simply by structuring the fraud to use multiple entities and multiple people to avoid making a false representation directly to a creditor. The Fifth Circuit's definition of "actual fraud," therefore, would have rewarded dishonest conduct in a way likely not contemplated by the text or legislative history of the Bankruptcy Code. As some modern Ponzi schemes illustrate, technology enables the commission of fraud on a massive scale, in remote ways, using hard-to-detect devices. For these reasons, the Fifth Circuit's requirement of a false representation by the debtor to the creditor was considered by many to be bad economic and social policy – bad economic policy because the requirement of a false representation hindered the victims of intentional wrongdoers from being made whole and bad social policy because the requirement of a false representation rewarded intentionally fraudulent behavior that attacked the integrity of the bankruptcy system.
1 Husky Int'l Electronics, Inc. v. Ritz (Slip Op., No.15-145 May 16, 2016).
2 Justice Clarence Thomas filed a dissenting opinion.
3 Holland & Knight LLP filed a brief in support of petitioner on behalf of bankruptcy law professors from the University of Chicago Law School, Columbia Law School, University of Southern California Gould School of Law, Yale Law School and the University of Pennsylvania Law School as amici curiae solely to address the Fifth Circuit's narrow reading of "actual fraud" in Bankruptcy Code Section 523(a)(2)(A).
4 Section 523(a)(2)(A) prohibits debtors from discharging debts "obtained by ... false pretenses, a false representation, or actual fraud." 11 U.S.C. §523(a)(2)(A).
5 Husky, Slip Op., at *4.
6 See Field v. Mans, 516 U.S. 59, 69 (1995).
7 Husky, Slip Op., at *4.
8 Id., at *5.
9 Id., at *5-6.
10 Id., at *6.
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