United States: What Constitutes Fraud In Bankruptcy? SCOTUS To Resolve First And Fifth Circuit Split In 2016

Earlier this month the Supreme Court granted certiorari to hear the Fifth Circuit case Husky International Electronics, Inc. v. Ritz, which originated in the United States Bankruptcy Court for the Southern District of Texas. The Fifth Circuit's decision interprets "actual fraud" in the context of an exception to a debtor's discharge that would require a creditor to prove that the debtor made a false representation. As the decision stands, this interpretation would make it more difficult for creditors to prove actual fraud when debtors transfer assets with the intent of hindering payments to creditors, making it easier for debtors to place assets out of creditors' reach.

The question presented to the Supreme Court focuses on the "actual fraud" exception to discharge under § 532(a)(2)(A) of the bankruptcy code, and whether this exception applies only when the debtor has made a false representation, or whether the "actual fraud" exception also applies if the debtor deliberately obtained money through a fraudulent transfer scheme that was actually intended to cheat a creditor.

In Husky, Husky International Electronics, Inc. ("Husky") sold and delivered goods to Chrysalis Manufacturing Corp. ("Chrysalis"), which the debtor, Daniel Lee Ritz, Jr. controlled.¹ Chrysalis failed to pay for the goods purchased from Husky, leaving $163,999.38 as the total amount of Chrysalis' unpaid debt to Husky.² Between November 2006 and May 2007, Ritz transferred millions of dollars from Chrysalis to seven other entities he controlled and owned.³ Husky sought to hold Ritz personally liable and sued him for the debt of Chrysalis in May 2009.⁴ Seven months later, Ritz filed a chapter 7 petition in the United States Bankruptcy Court for the Southern District of Texas.⁵ Husky then initiated an adversary proceeding and objected to the discharge of Ritz's alleged debt.⁶ The bankruptcy court held a trial on the matter and found that the transfers Ritz made "were not made for reasonably equivalent value" and that Husky suffered damages in the amount of the debt owed by Ritz.⁷ However, the court found that the "actual fraud" exception to discharge did not apply because Husky failed to show that Ritz made a false representation to Husky and therefore Ritz could not have perpetuated an "actual fraud."⁸ On appeal, the district court affirmed the bankruptcy court's decision, holding that "actual fraud under 11 U.S.C. § 523(a)(2)(A) . . . requires a misrepresentation."⁹

The Fifth Circuit agreed with the bankruptcy court and district court and held "that a representation is a necessary prerequisite for a showing of 'actual fraud'" and because there was no evidence of a representation, § 523(a)(2)(A) does not bar the discharge of the debt.¹⁰ The court rejected the Seventh Circuit's interpretation of § 523(a)(2)(A) in McClellan v. Cantrell,¹¹ which explained that because § 523(a)(2)(A) covers both actual fraud and false representations, the statute makes clear that the former is broader than the latter, and therefore a misrepresentation is not necessary for § 523(a)(2)(A) to bar the discharge of a debt. The Fifth Circuit explained that this interpretation is in tension with Supreme Court precedent and is inconsistent with previous decisions of the Fifth Circuit.¹² The court explained that both prior to and subsequent to McClellan, the Fifth Circuit has stated that "to prove nondischargeability under an 'actual fraud' theory, the objecting creditor must prove" that [] the debtor made misrepresentations.¹³

Husky presents a circuit split for the Supreme Court to review. After the Fifth Circuit issued its decision, the First Circuit issued its decision in Sauer, Inc. v. Lawson.¹⁴ In Sauer, the First Circuit joined the Seventh Circuit in finding that § 523(a)(2)(A) "extends beyond debts incurred through fraudulent misrepresentations to also include debts incurred as a result of accepting a fraudulent conveyance that the transferee knew was intended to hinder the transferor's creditors."¹⁵ In its petition for certiorari, Husky argued that the Fifth Circuit's decision "creates a roadmap for dishonest debtors to cheat creditors through deliberate fraudulent-transfer schemes, and then to escape liability through discharge in bankruptcy."¹⁶ In opposition to appellant's petition for certiorari, Ritz argued that the decision does not warrant the Supreme Court's review at this time, and that even if the Court resolved the question in Husky's favor, Husky would not get the relief it seeks because under Texas law, "actual fraud" requires a misrepresentation.¹⁷ Oral arguments are expected to be heard during the first half of 2016. Visit HHR's Bankruptcy Report for future updates on this case.

Footnotes

[1]. Husky International Electronics, Inc. v. Ritz, 787 F.3d 213, 314.

[2]. Id.

[3]. Id.

[4]. Id.

[5]. Id. at 315.

[6]. Id.

[7]. Id. at 315.

[8]. Id.

[9]. Id.

[10]. Id. at 316.

[11]. McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000).

[12]. 787 F.3d at 317, 319.

[13]. Id. at 319.

[14]. No. 14-2058, 2015 WL 3982395.

[15]. Id. at *1.

[16]. Petition for Certiorari, Husky International Electronics, Inc. v. Ritz, 15-145 (U.S. July 2015).

[17]. Respondent's Brief in Opposition to Petition for Certiorari, Husky International Electronics, Inc. v. Ritz, 15-145 (U.S. Sept. 30, 2015).

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