Until the recent U. S. Supreme Court’s decision in Husky International Electronics, Inc. v. Ritz, __ U.S. __, 136 S.Ct. 1581, 194 L.Ed.2d 655, 84 U.S. L.W. 4270 (2016), there was disagreement in the circuit courts regarding whether a debtor in bankruptcy could be denied a discharge under 11 U.S.C. § 523(a)(2)(A) where the evidence of wrongdoing proved the debtor committed actual fraud, but there was no evidence that the debtor made a misrepresentation to the creditor seeking to bar the discharge. For example, assume you represent a supplier who has a judgment against an insolvent company. Assume further that you discover that the company’s major shareholder fraudulently transferred assets of the company to other entities which resulted in the company’s insolvency. Accordingly, you file a piercing-the-corporate-veil claim against the shareholder and obtain a judgment. However, before you can collect on the piercing claim, the shareholder files for bankruptcy protection. You file an adversary proceeding seeking an order denying the discharge of the shareholder’s debt based on the fraudulent transfer scheme and the piercing-the-corporate-veil claim. The shareholder counters and argues that the debt is nevertheless subject to discharge because § 523(a)(2)(A) requires evidence that the debt was obtained by actual fraud. In the normal piercing case, a creditor will be hard pressed to present evidence that the debt was obtained by actual fraud, because the evidence usually is limited to showing that the ability of the company to pay its legitimate debt was hindered or delayed by the fraudulent acts of the shareholder. Thus, the District Court of Texas and the Fifth Circuit Court ruled in favor of the shareholder and allowed the piercing debt to be discharged in bankruptcy. This decision was in direct conflict with the Seventh Circuit’s decision in McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000) and the First Circuit’s decision in In Re Lawson, 791 F.3d 214 (1st Cir. 2015). In McClellan and Lawson, the Courts followed the contrary rule holding that § 523(a)(2)(A) is not limited to misrepresentations and misleading omissions, but includes deliberate fraudulent-transfer schemes. Such was the conflicting state of the law until the Supreme Court rendered its decision in Husky.
On May 16, 2016, the Supreme Court resolved the conflict and thereby enhanced the rights of creditors to prohibit a debtor in bankruptcy (including a shareholder liable based on piercing) from walking away from a debt arising from a fraudulent transfer scheme. The Court held that the term “actual fraud” in § 523(a)(2)(A) encompasses fraudulent conveyance schemes, even when those schemes do not involve a false representation.
Here are seven take-aways from the Husky case:
- There is a presumption that Congress did not intend “actual fraud” in § 523(a)(2)(A) to mean the same thing as a false representation;
- Actual fraud has long encompassed the kind of conduct involving a transfer scheme designed to hinder the collection of a debt;
- Anything that counts as fraud and is done with wrongful intent is “actual fraud” under § 523(a)(2)(A);
- Fraudulent conveyances, although fraudulent, do not require a misrepresentation from the debtor to the creditor;
- Fraudulent conveyances are not inducements based on fraud, but typically involve a transfer to a close relative, a secret transfer, a transfer of title without a transfer of possession, or a transfer based on grossly inadequate consideration;
- The fraudulent conduct is not in dishonestly inducing a creditor to extend the credit, but in the act of concealment and hindrance; and
- Nothing in the text of § 523(a)(2)(A) supports the position that the phrase “obtained by . . . actual fraud” requires not only that the relevant debts result from or be traceable to fraud, but also that the debts result from fraud at the inception of a credit transaction.
The Husky case will become an invaluable tool for creditors-rights attorneys who are able to establish sufficient evidence supporting a piercing-the-corporate- veil claim against a shareholder. Even if the shareholder were to file for bankruptcy protection, a debt based on actual fraud, without a misrepresentation, will survive the bankruptcy discharge, because it is now understood that a false representation is not a necessary element of actual fraud and the Supreme Court in Husky refused to adopt such a requirement.