Husky International Electronics, Inc. v. Ritz

Issues 

Does the term "actual fraud" require that, to obtain an exemption from discharge of a debtor's bankruptcy debts under 11 U.S.C. § 523(a)(2)(A), a creditor show that a debtor made a fraudulent misrepresentation, or does it include a debtor's fraudulent transfer as an exception to discharge?

Oral argument: 
March 1, 2016

The Supreme Court will decide whether "actual fraud" under 11 U.S.C. § 523(a)(2)(A) ("section 523(a)(2)(A)") of the Bankruptcy Code includes fraudulent transfers as an exemption to the discharge of debts owed to a creditor, or whether it requires that the creditor show a fraudulent misrepresentation. Husky International Electronics, Inc., a component manufacturer, argues that a creditor has shown actual fraud by a debtor if that debtor was knowingly involved in a fraudulent transfer of funds, regardless of whether the debtor made a misrepresentation to the creditor. Husky argues that, given the longstanding common law use of "actual fraud" to include any kind of intentional fraud, including fraudulent transfers, Congress intended to expand the scope of section 523(a)(2)(A) beyond mere misrepresentations. David Lee Ritz, owner of Chrysalis Manufacturing Corp. and one of Husky’s customers, contends that the term "actual fraud" only adds a requirement of intention on behalf of the debtor. He maintains that Congress would have clearly stated that fraudulent transfers would bar a debtor's discharge if it had wanted to expand the Bankruptcy Code in that way. Instead, Ritz maintains that a creditor must show that the debtor intentionally made a fraudulent misrepresentation. The Court's decision could pose a concern to debtors who have made transfers of funds before filing for bankruptcy, and may restrict creditors’ remedies to recover debts.

Questions as Framed for the Court by the Parties 

Does the “actual fraud” bar to discharge under § 523(a)(2)(A) of the Bankruptcy Code apply only when the debtor has made a false representation, or whether the bar also applies when the debtor has deliberately obtained money through a fraudulent-transfer scheme that was actually intended to cheat a creditor?

Facts 

Between 2003 and 2007, Husky International Electronics, Inc., a supplier of electronic device components, sold and delivered electronic device components to Chrysalis Manufacturing Corp., an electronic circuit board manufacturer controlled, directed, and partially owned by Daniel Lee Ritz, Jr. Chrysalis failed to pay for goods that Husky had sold and delivered to Chrysalis that were worth a total of $163,399.38. Chrysalis’ failure to pay its bills on time resulted in the company’s debts being worth more than its assets. Between November 2006 and May 2007, Ritz encouraged the transfer of funds from Chrysalis to various other companies, most of which Ritz also owned common stock in and which had not given reasonably equivalent value in exchange for the funds. The transfers included $677,622.00 to ComCon Manufacturing Services, Inc., $121,831.00 to CapNet Securities Corporation, $52,600.00 to CapNet Risk Management, Inc., $172,100.00 to Institutional Capital Management, Inc. and Institutional Insurance Management, Inc., $99,386.90 to Dynalyst Manufacturing Corp., $26,500.00 to Clean Fuel International Corp., and $11,240.00 to CapNet Advisors Inc.

On December 31, 2009, Ritz filed a voluntary Chapter 7 bankruptcy petition. The Chapter 7 Trustee affirmed that Ritz did not have any available assets for distribution to his creditors. The Bankruptcy Court closed the case on February 25, 2011. The Trustee filed a motion to reopen the case on June 2, 2011, stating that he had learned that Ritz had not disclosed all of his financial assets and that the Bankruptcy Court should reopen the case. The Bankruptcy Court granted the Trustee's motion on June 9, 2011.

On March 31, 2010, Husky filed a complaint seeking to deny Ritz's debt dischargeability under 11 U.S.C. § 523. Specifically, Husky alleged actual fraud under 11 U.S.C. § 523(a)(2)(A) ("section 523(a)(2)(A)"), with the understanding that actual fraud includes a transaction in which the recipient of property knows that the transferor of that property intends to defraud creditors. Although the Bankruptcy Court did not find Ritz to be a credible witness, it held that Husky had not proved actual fraud by Ritz and therefore, could not be held liable for the debt owed by Chrysalis. The Bankruptcy Court held that Texas Business Organizations Code § 21.223(b) ("section 21.223(b)") defines actual fraud as "the misrepresentation of a material fact," and that Ritz had not made such a misrepresentation and therefore, did not commit actual fraud. Using the same reasoning, the Bankruptcy Court also held that Husky did not prove that Ritz committed actual fraud under § 523(a)(2)(A). The Bankruptcy Court further concluded that Husky could not prevail under 11 U.S.C. § 523(a)(4), for fraud in breach of a fiduciary duty, or under 11 U.S.C. § 523(a)(6), for willful and malicious injury.

Husky appealed the Bankruptcy Court's decision to the District Court for the Southern District of Texas, arguing that actual fraud under section 523(a)(2)(A) is not limited to fraudulent misrepresentation and that a debtor's fraudulent transfer should also prevent that debtor from being able to discharge debts in bankruptcy. The district court held that although a fraudulent transfer itself may constitute actual fraud under section 21.233(b), it is insufficient to prove actual fraud under section 523(a)(2)(A) without a fraudulent misrepresentation, and therefore affirmed the Bankruptcy Court's decision to discharge Ritz's debts to Husky.

Husky then appealed the district court's decision to the Fifth Circuit Court of Appeals. The Fifth Circuit affirmed, holding that actual fraud under section 523(a)(2)(A) requires a misrepresentation by the debtor, and refused to use its equitable powers to expand the exceptions to discharge available to Husky. Husky filed a petition for writ of certiorari on July 30, 2015, and the Supreme Court granted certiorari on November 6, 2015.

Analysis 

The Court must determine the scope of the term “actual fraud” under section 523(a)(2)(A) in the Bankruptcy Code. On the one hand, Husky contends that “actual fraud” expands the scope of section 523(a)(2)(A) to include all intentional fraudulent transfers in addition to false pretenses and false representations. . On the other hand, Ritz argues that “actual fraud” adds a scienter requirement to section 523(a)(2)(A). Ritz maintains that a misrepresentation must be made in order to apply section 523(a)(2)(A) properly.

COMMON-LAW MEANING OF “ACTUAL FRAUD”

Husky contends that “actual fraud” includes fraudulent transfers done without a misrepresentation. Husky relies on Neal v. Clark, 95 U.S. 704 (1887) to contend that actual fraud means intentional fraud regardless of whether the fraud was perpetrated via misrepresentation. Husky concedes that there are some forms of fraud that do require misrepresentation. Husky argues that actual fraud, however, is like other types of fraud that do not require misrepresentations such as transfers that “defraud another of his property rights, including transfers that diminish an estate; . . . transfers intended to defeat a divorcing spouses interest; and transfers that hindered or delayed creditors.” According to Husky, actual fraud may therefore be shown via showing intent to fraud.

But Ritz argues that “actual fraud” simply means intention and does not describe any particular form of conduct. According to Ritz, section 523(a)(2)(A) has always had an element of fraudulent misrepresentation and therefore, “actual fraud” only adds the element of intent. Ritz points out that none of the cases that Husky relies on demonstrate that section 523(a)(2)(A) does not require a misrepresentation. Furthermore, Ritz argues that Neal does not demonstrate that fraudulent transfers come under actual fraud. Ritz contends that Neal instead holds that actual fraud is positive fraud (fraud committed with intent). Ritz also relies on § 871 of the Restatement (Second) of Torts and the Uniform Transaction Act to point out that fraudulent transfers are not the same thing as common-law fraud. Ritz argues that common-law fraud requires a misrepresentation that is used to injure the creditor. Therefore, according to Ritz, since section 523(a)(2)(A) requires an element of misrepresentation, it is referring to common-law fraud, not fraudulent transfers. Ritz argues that a misrepresentation that induces reliance must be shown for a successful section 523(a)(2)(A) claim.

CONGRESS’ INTENTION IN AMENDING SECTION 523(a)(2)(A)

Husky claims that the “ordinary meaning of [the] language accurately expresses the legislative purposes.” Therefore, Husky claims that Congress must have meant the common-law meaning of the term “actual fraud” when they amended section 523(a)(2)(A) to include the term. Husky argues that actual fraud under common-law means “any intentional fraud.” Before the amendment, section 523(a)(2)(A) already included false pretenses and false representations. Husky claims that these categories already cover all forms of intentional criminal and tortious misrepresentation. According to Husky, the inclusion of “actual fraud” would be superfluous if it did not add anything new to section 523(a)(2)(A). Husky relies on Cohen v. de la Cruz, 523 U.S. 213 (1998) and Archer v. Warner, 538 U.S. 314 (2003) to demonstrate that actual fraud is committed via intentional fraudulent transfer. Therefore, Husky argues that “actual fraud” must mean intentional fraudulent transfers and consequently, Congress expanded the scope of section 523(a)(2)(A) to reflect that.

Ritz maintains that Congress would have clearly identified fraudulent transfers in section 523(a)(2)(A) had they wanted to include that in the subsection. Ritz agrees with Husky that “actual fraud” must add something non-superfluous to section 523(a)(2)(A). Ritz, however, disagrees with Husky on the meaning of “actual fraud.” According to Ritz, Congress wanted to narrow the scope of section 523(a)(2)(A) and therefore used the term “actual fraud” to include a scienter (intent) requirement. Ritz argues that the terms “false pretenses” and “false representations” do not require scienter by themselves. Congress’ addition of “actual fraud,” according to Ritz, clarifies the scienter requirement and a clarification is not superfluous. Ritz argues that if Husky is correct in assuming that actual fraud means any intentional fraud, then the terms “false pretenses” and “false representations” would themselves be superfluous. Ritz contends that actual fraud therefore could not mean any intentional fraud. Ritz further argues that Husky’s reliance on Cohen and Archer is faulty. Ritz contends that these cases solely support that section 523(a)(2)(A) requires a misrepresentation. Additionally, Ritz maintains that these cases do not demonstrate that actual fraud means intentional fraudulent transfers.

PURPOSE & BROADER CONTEXT SURROUNDING SECTION 532(a)(2)

Husky asserts that the broader basic policy of the Bankruptcy Code is to deny debt relief to those who have been dishonest. Therefore, according to Husky, from a policy perspective, those who obtained funds via intentional fraudulent transfers should not be given relief. Husky argues that the inclusion of actual fraud in section 523(a)(2)(A) therefore expands the scope to address situations where funds are obtained via intentional fraudulent transfers. Husky argues that other sections in the Bankruptcy Code do not address this particular formulation of actual fraud. Husky claims that § 727(a)(2) applies in cases where property is fraudulently transferred. Husky therefore maintains that section 523(a)(2) addresses cases where property is fraudulently obtained. According to Husky, section 727(a)(2) applies to the entirety of the debt, whereas section 523(a)(2) applies to only a specific debt. Husky therefore argues that “actual fraud” in section 523(a)(2)(A) is a new addition to the Code. Husky also maintains that § 525(a)(4) and section 525(a)(6) do not overlap with section 523(a)(2). Husky argues that section 525(a)(4) covers fiduciary fraud and defalcation and section 525(a)(6) covers intentional torts.The amendment of “actual fraud” to section 523(a)(2), according to Husky covers a new area, namely intentional fraudulent transfers.

Ritz argues that several other sections deal with fraudulent transfers and it would be against the policy of the Bankruptcy Code to allow “creditors to smuggle” those claims under section 523(a)(2)(A). Ritz maintains that fraudulent transfers are already addressed in the Bankruptcy Code by section 727(a)(2) and section 548(a)(1)(A). Ritz further contends that if section 523(a)(2)(A) were to cover all fraudulent conduct, then many other sections would become superfluous. Ritz explains that section 523(a)(4) deals with intentional fraud by a fiduciary and if Husky is correct and actual fraud means all intentional fraud, then section 523(a)(2)(A) would include section 523(a)(4) claims as well. Ritz contends that the same type of argument could be made for section 523(a)(11) and § 523(a)(19) claims. Ritz additionally points out that section 523(a)(2)(A) is one of many exceptions to discharging a debtor of his or her debt and therefore, section 523(a)(2)(A) should not be read to encompass all types of exceptions. Furthermore, Ritz argues that section 523(a)(6) deals directly with intentional fraudulent conduct and was even previously invoked by Husky. However, according to Ritz, Husky failed to show intent under section 523(a)(6) and is now trying to bring the same claim under section 523(a)(2)(A).

Discussion 

The Court’s decision could expand the exceptions to bankruptcy discharge currently available to creditors, or could strengthen the "fresh start" policy that the Bankruptcy Code seeks to embody.

CREDITORS' ABILITY TO RECOVER MONEY OWED BY DEBTORS

Bankruptcy law professors, in support of Husky, argue that Congress intended that the Bankruptcy Code make creditors who have been subject to fraud by their debtors whole. The National Association of Bankruptcy Trustees ("NABT"), contends that in bankruptcy situations similar to this case, section 523(a)(2)(A)'s "actual fraud" exception often offers the only possible exemption from the debtors' discharge of the money owed to the creditor. Therefore, the NABT suggests that creditors who have been victims of their debtors' fraud will be left without a remedy if the Court decides that such creditors must show that they received a fraudulent misrepresentation. The United States insists that, as reflected by section 523(a)'s list of nondischargeable debts, Congress values creditors' ability to collect payment on their debts over debtors' receipt of a fresh start.

The National Association of Consumer Bankruptcy Attorneys ("NACBA"), supporting Ritz, maintains that allowing creditors to exempt debtors’ debts from discharge without requiring proof of a fraudulent misrepresentation would unjustly favor creditors. The NACBA claims that creditors who no longer have to show a fraudulent misrepresentation by the debtor will target small businesses which often receive pre-bankruptcy transfers by their very nature on a daily basis. Furthermore, the NACBA argues that creditors will be able to present a prejudicial case against a debtor who has received pre-bankruptcy transfers, even without evidence of financial harm to that creditor and even if the transfer took place years after the debtor first received the credit.

DEBTORS' ABILITY TO DISCHARGE THEIR DEBTS IN BANKRUPTCY

In support of Husky, bankruptcy law professors argue that requiring a creditor to show a fraudulent misrepresentation would create a "safe harbor" for debtors to commit fraud, and would reward dishonest debtors at the expense of creditors. They also suggest that a debtor could develop a strategy of avoiding direct communication with creditors so as to not make any kind of misrepresentation and thus avoid a possible exemption to discharge under section 523(a)(2)(A). The law professors assert that such a debtor would receive an undeserved "fresh start" in bankruptcy despite having committed fraud. The United States agrees, maintaining that the Bankruptcy Code's fresh start policy does not carry as much weight in the case of a dishonest debtor. In addition, the United States claims that reading "actual fraud" to include a fraudulent transfer would not weaken the Bankruptcy Code protections available to honest debtors.

In opposition, the NACBA argues that expanding "actual fraud" to include fraudulent transfers would unfairly punish debtors and would especially harm small business owners who often receive transfers of funds before filing for bankruptcy. The NACBA asserts that such a reading would significantly restrict the ability to discharge debts in bankruptcy and would result in increased litigation with unfair results. The NACBA also contends that Husky's reading of section 523(a)(2)(A) would be particularly harmful to entrepreneurs, who often find the need to file for bankruptcy but whose personal assets are typically exposed to creditors.

Furthermore, the NACBA maintains that requiring creditors to show a fraudulent misrepresentation by the debtor sustains the corporate veil between corporation and individual, and that removing this requirement would have a negative impact on limited liability as it currently exists.

Conclusion 

The Supreme Court will address whether "actual fraud" under section 523(a)(2)(A) of the Bankruptcy Code includes fraudulent transfers, or whether it requires that the creditor show a fraudulent misrepresentation. Husky argues that actual fraud is demonstrated if the debtor was knowingly involved in a fraudulent transfer of funds, regardless of whether the debtor made a misrepresentation to the creditor. Husky argues that Congress intended to expand the scope of section 523(a)(2)(A) beyond mere representations and pretenses to fraudulent transfers. On the other hand, Ritz contends that the term "actual fraud" only adds a requirement of intention on behalf of the debtor. Ritz argues that to obtain an exemption from discharge under section 523(a)(2)(A), a creditor must show that the debtor intentionally made a fraudulent misrepresentation. The Court’s decision could have potential implications for debtors who have made transfers of funds before filing for bankruptcy. The Court’s decision in this case may restrict the remedies available to creditors to recover the debts owed to them.

Edited by 

Acknowledgments 

Additional Resources 

  • Katherine Doorley, Supreme Court Grants Cert to Consider Actual Fraud Bar in Section 523(a)(2)(A), Weil Gotshal & Manges LLP Bankruptcy Blog (Nov. 17, 2015).

  • Donna Higgins, 2 Petitions Ask Supreme Court to Resolve Bankruptcy Fraud Circuit Split, Thomson Reuters (Aug. 18, 2015).

  • Lauren Lipari, What Constitutes Fraud in Bankruptcy? SCOTUS to Resolve First and Fifth Circuit Split in 2016, Hughes Hubbard & Reed LLP Bankruptcy Report (Nov. 18, 2015).