A Supreme Court ruling this week should give creditors a powerful tool to collect their debts from debtors who try to transfer assets before seeking bankruptcy protection. The primary reason an individual may turn to personal bankruptcy is to protect assets from creditor collection while obtaining a “discharge” from debts. Such protection is increasingly necessary where an individual is being pursued by one or more creditors, particularly where those creditors may have obtained (or are about to obtain) judgments against the individual. Once a debtor obtains a discharge in bankruptcy, creditors are prohibited from continuing to pursue collection efforts against the debtor. The Bankruptcy Code generally favors “fresh starts” for honest debtors, but there are several important exceptions to this general rule. Section 523(a) of the Bankruptcy Code contains at least 19 such exceptions, ranging from exceptions for unpaid taxes to exceptions for judgments arising from securities law violations. One of the more frequently litigated discharge exceptions is the “actual fraud” exception under section 523(a)(2)(A) of the Bankruptcy Code. That issue was front and center in Husky International, Inc. v. Ritz, 15-145 (May 16, 2016) (slip op.)

Under that exception, a discharge under the Bankruptcy Code does not discharge a debt “to the extent [the debt is] obtained by false pretenses, a false representation, or actual fraud… .”  11 U.S.C. § 523(a)(2)(A). The question is, what is required to prove “actual fraud?”

Two recent United States Circuit Court decisions highlighted a split on this issue. On one end of the spectrum was the Fifth Circuit, which held that for a debt to be non-dischargeable under the “actual fraud” component of § 523(a)(2)(A), the creditor had to show that the debtor made a false representation relating to the debt. See Husky Int’l Elecs., Inc. v. Ritz (In re Ritz), 787 F.3d 312 (5th Cir. 2015) (“For all of these reasons, we conclude that a representation is a necessary prerequisite for a showing of ‘actual fraud’ under Section 523(a)(2)(A).”). The rationale for this line of authority is that “actual fraud” under common law or state law requires a creditor to show that the debtor made a false representation or omission, that the representation was reasonably relied upon, and that the creditor was harmed as a result of its reliance on the debtor’s false statements.

On the end of the spectrum was the Seventh Circuit, which held that “actual fraud” could include other types of fraud, such as fraudulent transfer schemes, where there is no evidence of a false representation. Siragusa v. Collazo (In re Collazo), 2016 U.S. App. LEXIS 6240, Case No. 15-2324 (7th Cir. Apr. 5, 2016) (slip op.) (citingMcClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000) (holding that “actual fraud” as used in § 523(a)(2)(A) was not limited to “misrepresentations and misleading omission”)).

In Ritz, a creditor (Husky) had sued the debtor (Ritz) on the theory that the debtor had injured the creditor by fraudulently transferring his assets to other entities under his control to keep Husky from being able to collect from Ritz. The Fifth Circuit agreed that the debtor engaged in fraudulent transfers, but concluded that the debts could be discharged because the creditor could not prove that the debtor made any false representations. The Supreme Court granted certiorari to resolve the split.

On May 16, 2016, the Supreme Court, in a 7-1 decision penned by Justice Sotomayor (Thomas, J. dissenting), agreed with the Seventh Circuit that “actual fraud” can be shown without evidence of a false representation. To reach that decision, Justice Sotomayor began with the text of the statute, which contains the disjunctive “or” between the phrases “a false representation” and “actual fraud.” “It is therefore sensible to start with the presumption that Congress did not intend ‘actual fraud’ to mean the same thing as ‘a false representation,’ as the Fifth Circuit’s holding suggests.”

But the Court did not stop there. Next, Justice Sotomayor analyzed the historical context of “actual fraud,” explaining that since the earliest days of modern bankruptcy laws—i.e., the Statute of 13 Elizabeth in 1571—“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.” 

Finally, the Court explained that not all “actual fraud” is “inducement-based fraud.” While an inducement-based fraud would most certainly require proof of a fraudulent statement or omission, with reliance and resulting damages, the Court explained the key difference between inducement-based fraud and fraudulent transfer schemes: 

In [the fraudulent transfer] case, the fraudulent conduct is not in dishonestly inducing a creditor to extend a debt. It is in the acts of concealment and hindrance. In the fraudulent conveyance context, therefore, the opportunities for a false representation from the debtor to the creditor are limited. The debtor may have the opportunity to put forward a false representation if the creditor inquires into the whereabouts of the debtor’s assets, but that could hardly be considered a defining feature of this kind of fraud.

Justice Thomas’s dissent argued that the creditor still failed to trace its damages to the fraud, or show that the debt was “obtained… by actual fraud,” relying on Field v. Mans, 516 U.S. 59 (1995). But the majority found the dissent’s reliance on Field to be misplaced, again pointing out the distinction between inducement-based fraud and other kinds of actual fraud. While noting that a creditor’s damages arising from a fraudulent transfer scheme may not always result from the transferee’s participation in the fraud, the Court noted that (at least for this case) Ritz was alleged to have acted participated in the fraud as both the transferor and the transferee. Thus, the majority was satisfied that Husky could conceivably trace its damages to Ritz’s fraud, but deferred to the Fifth Circuit’s determination on remand.

Finally, the majority rejected Ritz’s argument that Congress meant to restrict (not expand) the discharge exception by adding the disjunctive or actual fraud. “In essence, [Ritz] asks us to change the word ‘or’ to ‘by.’ That is an argument that defeats itself. We can think of no other example, nor could petitioner point to any at oral argument, in which this Court has attempted such an unusual statutory modification.”

Because the “actual fraud” has a long-held history of including fraudulent transfer schemes such as the one presented in this case, the Court reversed the Fifth Circuit’s decision and remanded for the Fifth Circuit to consider in light of its ruling that a debt could be non-dischargeable in the absence of a false representation. 

This decision may greatly expand creditors’ collection rights in jurisdictions like the Fifth Circuit and others that previously required a showing of false representations to establish “actual fraud” under the dischargeability exception of § 523(a)(2)(A). Now, under this ruling, judgments obtained by banks, receiverships, trustees and other creditors against individuals involved in fraudulent transfer schemes may be non-dischargeable in a subsequent bankruptcy filing, provided the creditor files the appropriate papers.