The United States Supreme Court recently held in Husky International Electronics, Inc., v. Ritz1 that the term actual fraud, as used in 11 U.S.C. § 523(a)(2)(A), encompasses all forms of fraud and does not require a false representation. Several commentators tout this holding as a good result for lenders, as it may except certain debts from discharge in bankruptcy when there is evidence of intentional misconduct by the individual debtor. However, lenders should proceed with caution, as dischargeability litigation can be expensive and in many instances result in only a pyrrhic victory at best.
The Supreme Court relied on the following facts. Dan Ritz caused Chrysalis, an entity in which he owned a significant interest, to make transfers to other entities partially owned by Ritz. Husky International sold on credit to Chrysalis, but was not aware of the transfers made by Chrysalis to other Ritz-owned entities, and did not receive or rely upon any overt representations.
Ritz and Chrysalis each filed chapter 7 cases in close proximity. No fraudulent transfer actions were brought in either Ritz’s or Chrysalis’s case to avoid the transfers. Ultimately, Husky sought to pierce the corporate veil as against Ritz to make him liable for its claims against Chrysalis and to determine such claims non-dischargeable as against Ritz under 11 U.S.C. § 523(a)(2)(A) (and other subsections). Section 523(a)(2)(A) provides that “a discharge…does not discharge an individual debtor from any debt for money, property, services…to the extent obtained by false pretenses, a false representation, or actual fraud…”
Following an evidentiary trial, the bankruptcy court found that Ritz had committed multiple, uncommendable acts and that Ritz’s testimony was inconsistent and unreliable. Nonetheless, the bankruptcy court determined that Husky had not met the strict factual and legal burdens under the Texas statute for piercing the corporate veil. Moreover, because Ritz had made no misrepresentations to Husky and Husky did not rely on any false statements in connection with its decisions to sell on credit, the bankruptcy court likewise found that Husky’s goods had not been “obtained by” fraud, as contemplated in § 523(a)(2) of the Bankruptcy Code.
On appeal, the District Court found that Husky had established a veil piercing claim against Ritz, notwithstanding the strict requirements of the Texas statute, but affirmed the bankruptcy court’s ruling that, absent a misrepresentation and reliance, the elements of non-dischargeability had not been met.
The Supreme Court granted certiorari to resolve a Circuit split over the meaning of “actual fraud” in § 523(a)(2), i.e., whether the phrase requires a false representation or whether it encompasses other traditional forms of fraud, such as a fraudulent conveyance of property made to evade payment to creditors, where misrepresentations are sometimes lacking.
Justice Sotomayor, for the 7-1 majority, stated, “[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.” Justice Thomas dissented, reasoning that, “[t]he logical conclusion then is that ‘actual fraud’—as it is used in the statute—covers only those situations in which some sort of fraudulent conduct caused the creditor to enter into a transaction with the debtor. A fraudulent transfer generally does not fit that mold, unless, perhaps, the fraudulent transferor and the fraudulent transferee conspired to fraudulently drain the assets of the creditor. But the fraudulent transfer here, like all but the rarest fraudulent transfers, did not trick the creditor into selling his goods to the buyer…” The case was remanded for further determinations using the new standard.
The Supreme Court holding was perhaps intended to be more limited than initially reported in some bankruptcy industry headlines. The Court did not hold, for example, that nondischargeability will per se result upon the entry of a judgment avoiding a transfer only under “constructive fraud” provisions (such as 11 U.S.C. § 548(a)(2) or similar state statutes, typically requiring only that the transferor was insolvent or rendered insolvent by the transfer and that the transfer was not in exchange for “reasonably equivalent value” (or, under some state statutes, “fair value”)). However, the Court conversely did not say that mere “constructive fraud” will never result in non-dischargeability.
The Court also did not expressly say that the “actual fraud” element of Bankruptcy Code § 523(a)(2) necessarily requires a finding of intent to commit fraud, such as the element of “intent to hinder, delay, or defraud creditors” under Bankruptcy Code § 548(a)(1). Notably, however, there was an “intent to hinder, delay or defraud” finding against Ritz. Even though the opinion stretches some boundaries of the traditional notions of fraud, one might suspect that later opinions may still identify “intent to defraud” in some form as a required element. The opinion does make it clear however, in addressing points made by the dissent, that an overt misrepresentation and overt, classic reliance on such misrepresentation are no longer required. Timing now also matters less – the party seeking non-dischargeability does not necessarily need to establish that its claim resulted from or was “traceable to” “fraud at the inception of a credit transaction.”
As a result, the outer boundaries to the new standard for “actual fraud” remain unclear for now. Perhaps the intended take away is that, because the capacity of human imagination to create novel forms of fraud often seems boundless, the parameters of the nondischargeability remedy for “actual fraud” should also be more flexible. At least until illuminated by further case law, entrepreneurs struggling to manage their businesses through the shoals of financial distress and potential personal liability may need to be more circumspect than usual in deploying intercompany assets and cash across corporate lines, in compensating themselves and other owners, and in entertaining survival plans that may err towards the cutting edge. Lenders should also use caution when filing a dischargeability complaint based on this new standard, as the likelihood of success is uncertain and often of questionable value, while potentially adding significant expense to an already costly bankruptcy case