United States: U.S. Supreme Court Holds That "Actual Fraud" Discharge Bar Encompasses Fraudulent Transfers

Last Updated: May 23 2016
Article by Shay Dvoretzky

On May 16, 2016, the U.S. Supreme Court decided Husky International Electronics, Inc. v. Ritz, No. 15-145, holding that the "actual fraud" bar to discharge under section 523(a)(2)(A) of the Bankruptcy Code encompasses an individual debtor's knowing receipt of fraudulently transferred property.

Statutory Background

The Bankruptcy Code embodies the basic policy of affording relief to only the honest but unfortunate debtor. To that end, although the Bankruptcy Code generally gives debtors a fresh start, it also bars discharge of debts for various kinds of wrongdoing, including fraud. Section 523(a)(2)(A), in particular, excepts from discharge "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." 11 U.S.C. § 523(a)(2)(A).

Congress added the term "actual fraud" to section 523(a)(2)(A) in 1978, when it enacted the current Bankruptcy Code. Before Congress's 1978 amendment, section 523(a)(2)(A)'s predecessor barred discharge of "liabilities for obtaining money or property by false pretenses or false representations." But that provision—unlike even earlier bankruptcy laws—did not bar discharge of debts arising from other types of fraud. Congress closed this gap in 1978, amending section 523(a)(2)(A) so that "'actual fraud' is added as a grounds for exception from discharge." S. Rep. No. 95-989, at 78 (1978). Congress accordingly restored the Code to align with earlier bankruptcy laws that had barred the discharge of debts arising from all intentionally fraudulent conduct, not just fraud that involved a misrepresentation.

Proceedings Below

This case arises from Husky International Electronics Inc.'s sale of goods to Chrysalis Manufacturing Corporation. Chrysalis never fully paid Husky because one of its owners, Daniel Lee Ritz, Jr., bankrupted Chrysalis, draining it of its assets and funneling them to other companies he controlled.

Husky sued Ritz, arguing that he was personally liable for Chrysalis's debt to Husky because he used Chrysalis to perpetrate a fraud for his own benefit. Ritz then filed for bankruptcy, and Husky initiated an adversary proceeding to bar discharge of his debt under section 523(a)(2)(A) because it was for property that Ritz obtained by actual fraud.

Ritz acknowledged that he personally benefitted from his fraudulent-transfer scheme, but he nevertheless claimed that his debt to Husky was dischargeable because he never made a misrepresentation to Husky. According to Ritz, the making of a misrepresentation was a necessary prerequisite to a finding of "actual fraud." Without a misrepresentation, there was no actual fraud, and section 523(a)(2)(A) was powerless against the resulting debt.

The U.S. Court of Appeals for the Fifth Circuit agreed with Ritz, and Husky (represented by Jones Day) filed a petition for a writ of certiorari in the U.S. Supreme Court. The Supreme Court granted certiorari to resolve a split among the courts of appeals as to whether the discharge bar applies only when the debtor has made a false representation, or whether it also applies when the debtor has knowingly obtained money through a fraudulent-transfer scheme that was actually intended to cheat a creditor.

The Supreme Court's Decision

The Supreme Court reversed the Fifth Circuit's judgment. By a vote of 7–1, the Court held that "[t]he term 'actual fraud' in §523(a)(2)(A) encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation."

The Court began by highlighting the significance of Congress's 1978 amendment adding the words "actual fraud" to the discharge bar. "When Congress acts to amend a statute," the Court explained, "we presume it intends its amendment to have real and substantial effect." Accordingly, the Court "presum[ed] that Congress did not intend 'actual fraud' to mean the same thing as 'a false representation.'"

According to the Court, the "historical meaning" of the phrase "actual fraud" confirms that it includes "anything that counts as 'fraud' and is done with wrongful intent." Fraudulent transfers intended to cheat creditors meet this definition. "[F]rom the beginning of English bankruptcy practice, courts and legislators have used the term 'fraud' to describe a debtor's transfer of assets that ... impairs a creditor's ability to collect the debt." Moreover, "both the debtor and the recipient of the conveyed assets were liable for fraud" even though neither one made a false representation to the debtor's creditor. And when that fraud was perpetrated with an intent to cheat creditors, courts referred to it as "actual fraud." Thus, by the time Congress added "actual fraud" to the discharge bar in 1978, the term had a settled meaning that encompassed "a transfer scheme designed to hinder the collection of debt"—exactly the sort of conduct in which Husky alleged that Ritz engaged here.

Against this centuries-old usage of "actual fraud," the Court rejected Ritz's argument that "§523(a)(2)(A)'s particular use of the phrase means something else." According to Ritz, "'actual fraud' was inserted as the last item in a disjunctive list—'false pretenses, a false representation, or actual fraud'—in order to make clear that the 'false pretenses' and 'false representation[s]' covered by the provision needed to be intentional." "That is an argument," the Court explained, "that defeats itself."

The Court was similarly unpersuaded by Ritz's assertion that a debt arising from a deliberately fraudulent conveyance is not a debt for property "obtained by" fraud. Because a debtor who receives property through what he knows to be a fraudulent transfer himself commits fraud, the Court concluded that "any debts 'traceable to' the fraudulent conveyance" are for money or property obtained by fraud.

Finally, the Court found Ritz's reliance on surrounding provisions of the Bankruptcy Code unavailing. Ritz asserted that a narrow definition of "actual fraud" was necessary to avoid overlap with other discharge bars. The Court recognized that some overlap is "inevitable" given that Congress used expansive language intended to bar discharge of an array of wrongful conduct. But it emphasized that there are still "clear differences between [the] provisions," and it saw "no reason to craft an artificial definition of 'actual fraud' merely to avoid narrow redundancies in §523."

Justice Thomas dissented. He agreed with the Court that "the common-law definition of 'actual fraud' included fraudulent transfers." He nevertheless would have held that, in the context of section 523(a)(2)(A), "actual fraud" does not include the receipt of fraudulently transferred property. This provision, in his view, "covers only those debts that result from fraud at the inception of a credit transaction" between the creditor and the debtor.

Significance of the Court's Decision

The Supreme Court's decision protects against the Bankruptcy Code becoming an engine for fraud. In the years leading up to this case, lower courts disagreed about whether the Bankruptcy Code allowed an individual debtor to discharge debts for receiving fraudulently transferred property. If the Supreme Court had adopted Ritz's interpretation of the Code, it would have created a high-profile blueprint for sophisticated debtors to transfer assets among corporate shells to shield them from creditors. Congress intended the discharge bar to do just the opposite—to foreclose, not encourage, such flagrant abuses of the Bankruptcy Code.

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