The United States Supreme Court Expands Discharge Exception to Include Fraudulent Transfers

Bankruptcy Code Section 523(a)(2)(A) provides that a debtor may not receive a discharge for a debt for "money, property, services… to the extent obtained by: (A) false pretenses, a false representation or actual fraud… ." In Husky Int’l. Elec. Inc. v. Ritz, Justice Sotomayor, writing for a majority of the Supreme Court, held that the discharge exception of 11 U.S.C § 523(a)(2)(A) for "actual fraud" does not require the debtor to make a misrepresentation to the creditor and may include the debtor’s receipt of fraudulent transfers.

Husky International Electronics, Inc. (Husky) was a creditor of Chrysalis Manufacturing Corp. (Chrysalis) of which Daniel Ritz, Jr. (Ritz or the Debtor) was a director and partial owner. In 2006 and 2007, Chrysalis engaged in a series of asset transfers to other business entities also partially owned by the Debtor. In 2009, Husky filed suit against Ritz under Texas state corporate law, asserting claims for piercing the corporate veil and seeking to hold Ritz personally liable for $164,000 debt as a shareholder of the recipients of the transfers. While that case was pending, Ritz filed a Chapter 7 bankruptcy petition.

In the bankruptcy case, Husky filed an adversary proceeding against the Debtor, asserting a similar claim under Texas law and seeking, among other things, a determination that the debt owed to Husky was not dischargeable under Sections 523(a)(2)(A) of the Bankruptcy Code.

The bankruptcy court denied Husky’s claims on the basis that both the state law veil-piercing claim and the discharge bar under Section 523(a)(2)(A) required "actual fraud," which, in turn, required a misrepresentation to the creditor. The bankruptcy court so held even though the court found that there were other characteristics of fraudulent transfers present in the transaction. The district court reversed the state law claim, but affirmed the holding of the bankruptcy court on the discharge issue due to the absence of any misrepresentation.

The Fifth Circuit Court of Appeals agreed that the "actual fraud" exception to discharge under Section 523(a)(2)(A) requires a misrepresentation. Finding this issue to be determinative, the Fifth Circuit did not address the merits of the state law claim. The Fifth Circuit rejected the Seventh Circuit Court of Appeals’ decision in McClellan v. Cantrell, 217 F.3d 890 (7th Cir 2000), which found that the "actual fraud" requirement of Section 523(a)(2)(A) does not necessarily require a misrepresentation. The Seventh Circuit in McClellan found that "actually fraudulent" conveyances – i.e., transfers made with the intent to hinder, delay or defraud creditors – would constitute "actual fraud" under Section 523(a)(2)(A) of the Code.

The United States Supreme Court granted certiorari to resolve the dispute between the Circuits, ultimately reversing the holding of the Fifth Circuit and concluding that a misrepresentation is not required to satisfy the "actual fraud" exception to discharge under Section 523(a)(2)(A).

In support of its conclusion, the majority analyzed the language of Section 523(a)(2)(A). Initially, the Court noted that the phrase "actual fraud," which was added to Section 523(a)(2)(A) of the Code in 1978, must not mean the same thing as "false representations" which is an alternative ground to deny discharge under Section 523(a)(2)(A). The Court also analyzed the meaning of the words "actual" and "fraud." The Court found that “actual” denotes wrongful intention, and the common law meaning of "fraud" included fraudulent conveyances under laws originating with the Statute of 13 Elizabeth. The Court found that the law of fraudulent conveyances was so firmly embedded in the law of fraud that a fraudulent conveyance would satisfy the meaning of "actual fraud." Fraudulent conveyance law does not require a showing of a misrepresentation, and therefore, the Court reasoned that a misrepresentation is not a requirement to establish "actual fraud" under Section 523(a)(2)(A).

The Supreme Court rejected the Debtor’s argument that interpreting “actual fraud” to include fraudulent transfers would render Sections 523(a)(4) (discharge bar for fraud while acting in a fiduciary capacity), 523(a)(6) (willful and malicious injury to property) and 727(a)(2) (absolute discharge bar if the debtor engaged in fraudulent transfers within one year of the petition date) superfluous. The Court reasoned that some redundancy is inevitable in the Code, and Section 523(a)(2)(A) would necessarily encompass some conduct covered by 523(a)(4) and (a)(6) even under the Debtor’s reading of the statute. Further, the purpose and scope of Section 727(a)(2) differs from 523(a)(2)(A), which is a creditor-specific remedy and would not be limited by the temporal limitation of 727(a)(2).

Further, the majority rejected the Debtor’s argument that the words “obtained by” in Section 523(a)(2)(A) requires that the debt "result from" or be "traceable to" the actual fraud. The majority held that, by receiving a fraudulent transfer and having the requisite intent, the recipient does, in fact, obtain property by virtue of their participation in the fraud.

Justice Thomas dissented, concluding that the "actual fraud" language in 523(a)(2)(A) does not encompass fraudulent transfers because it does not make sense in the context of 523(a)(2)(A). First, Justice Thomas emphasized that the “money, property or services” must be "obtained by" the actual fraud, requiring the actual fraud to occur at the inception of the debt, which is not the case in a fraudulent transfer scenario. Second, there is an "inherent element of causation," and a reliance component of a claim under 523(a)(2)(A). Ultimately, Justice Thomas concluded that, if Congress intended Section 523(a)(2)(A) to include fraudulent transfers, it would have expressly said so.

At first glance, the Husky holding appears to significantly expand the scope of the discharge bar under Section 523(a)(2)(A) of the Bankruptcy Code. However, the scope of the holding of Husky should be limited by the facts of the case. A creditor should still be required to establish that the transferee engaged in "actual" (i.e., with wrongful intent) "fraud" (i.e., transfer to hinder, delay, or defraud the transferor’s creditors). At oral argument in Husky, all parties acknowledged that the creditor would be required to overcome numerous hurdles to ultimately establish Ritz’ personal liability. Also, in the Seventh Circuit McClellan case, there was a clear factual scenario of a transferee knowingly and willfully participating in a scheme to thwart a particular creditor’s collection efforts. Not all fraudulent transfer cases will have such facts.

The holding of Husky also raises procedural questions. Will every creditor with a cause of action for fraudulent transfer be required to file suit to prevent discharge, even though a fraudulent transfer claim by a trustee would inure to the benefit of all creditors? Can a trustee file dischargeability actions on this ground? Further, what will a claim under Section 523(a)(2)(A) require? Will a creditor be required to meet the same requirements of a fraudulent transfer under Section 548 of the Code, applicable state law? Time will tell.

Finally, the Supreme Court relied heavily upon the common parlance of "actual fraud" (i.e., a fraudulent transfer made with the intent to hinder, delay or defraud creditors) and "constructive fraud" (i.e., transfers made while the debtor was insolvent for less than reasonably equivalent value) in its analysis. It is noteworthy that many states, following the lead of the Uniform Law Commission, have been, to an extent, distancing fraudulent transfer concepts from common law fraud. For example, the recent Uniform Voidable Transactions Act, which has been proposed and/or enacted in more than 15 states, is no longer using the term "fraudulent transfer" in favor of "voidable transaction." Also, the UVTA establishes statutory standards and burdens of proof with the stated purpose of clarifying that higher burdens of proof typically associated with fraud cases (i.e., clear and convincing evidence) are not required to make a claim for "fraudulent" conveyances.