United States: Supreme Court Reverses Fifth Circuit's Interpretation Of "Actual Fraud"

Richard Lear is a Partner in Holland & Knight's Washington D.C. office

HIGHLIGHTS:

  • 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

Case History

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

Analysis

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.

Footnotes

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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions