Supreme Court: “Actual Fraud” Exception to Discharge Is Not Limited to Cases in Which the Debtor Has Made a False Representation to the Creditor

A principal purpose of the Bankruptcy Code is to provide a fresh start to an “honest but unfortunate debtor.”  Under certain circumstances, a creditor may ask the bankruptcy court to determine that a particular debt is nondischargeable.  If the court agrees, the debtor will continue to owe that debt even after the case is over and all other debts are discharged.

Section 523(a)(2)(A) of the Bankruptcy Code provides that an individual debtor’s discharge does not cover any debt “for money, property [or] services . . . to the extent obtained by . . . false pretenses, a false representation, or actual fraud.”  Over the years, courts have disagreed about the meaning of “actual fraud.”  

fraudLong ago, the Ninth Circuit held that to establish a claim under § 523(a)(2)(A), a creditor must prove that (1) the debtor made a representation, (2) the debtor knew that the representation was false, (3) the debtor made the misrepresentation with the intention of deceiving the creditor, (4) the creditor justifiably relied on the representation, and (5) the creditor suffered damages as the result of the representation having been made.  See Britton v. Price (In re Britton), 950 F.2d 602, 604 (9th Cir. 1991).  Even in cases in which the average person might consider the debtor’s conduct to have been fraudulent, this narrow definition forced creditors (and courts) to frame the facts in a way that would satisfy the first element.  For example, in cases involving credit card abuse, courts held that when a card holder uses a credit card he impliedly makes a representation to the credit card company that he intends to repay the debt.  See Anastas v. Am. Savs. Bank (In re Anastas), 94 F.3d 1280 (9th Cir. 1996).

Some other circuit courts also held that § 523(a)(2)(A) applies only if the debtor made a representation to the creditor.  See Husky Int’l Elecs., Inc. v. Ritz (In re Ritz), 787 F.3d 312 (5th Cir. 2015).  Others interpreted “actual fraud” more broadly.  See McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000) (“actual fraud” is a more generic term, not limited to misrepresentations and misleading omissions); Sauer, Inc. v. Lawson (In re Lawson), 791 F.3d 214 (1st Cir. 2015) (“actual fraud” includes fraudulent conveyances intended to hinder a creditor).  On May 16, 2016, the Supreme Court resolved this disagreement in Husky Int’l Elecs. v. Ritz, 578 U.S. ___, 136 S.Ct. 1581 (2016).

Daniel Ritz was a director and shareholder of Chrysalis Manufacturing Corp., which purchased goods from Husky International Electronics and owed Husky about $164,000.  Instead of paying Husky, Chrysalis transferred money to other companies controlled by Ritz.  Husky sued Ritz, seeking to hold him personally liable under a Texas statute that allows creditors to hold shareholders liable for corporate debt.  Husky argued that Ritz’s intercompany-transfer scheme constituted “actual fraud” for purposes of that Texas statute.  After Ritz filed for bankruptcy, Husky also alleged that Ritz’s debt was nondischargeable because the intercompany-transfer scheme also constituted “actual fraud” for purposes of § 523(a)(2)(A).

The bankruptcy court determined that Ritz was not liable to Husky because Ritz’s actions did not constitute “actual fraud” under applicable Texas law; by extension, Husky also could not prevail on its nondischargeability claims.  On appeal, the district court disagreed as to the first point, and concluded that Ritz’s actions were sufficient to allow Husky to “pierce the corporate veil” and hold Ritz personally liable for Chrysalis’ debt to Husky.  However, the district court also held that while the fraudulent transfers qualified as “actual fraud” for purposes of the Texas veil-piercing statute, they did not qualify as “actual fraud” for purposes of § 523(a)(2)(A).  The Fifth Circuit affirmed.  Because Ritz did not make any false representations to Husky, the debt did not qualify as “actual fraud” for purposes of § 523(a)(2)(A).

The Supreme Court rejected the Fifth Circuit’s narrow interpretation of “actual fraud” and adopted the broader view.  Although it was a 7-1 decision, all of the justices rejected the notion that “actual fraud” requires a representation to have been made.  The majority held that the term “actual fraud” encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation.  Justice Thomas dissented only because, in his view, based on the text of § 523(a)(2)(A), “actual fraud” does not encompass fraudulent transfer schemes.

In many ways, the Supreme Court’s ruling makes sense.  From a statutory interpretation perspective, since § 523(a)(2)(A) already excepts debts arising from a “false representation,” why would the statute also except debts arising from “actual fraud” if “actual fraud” always requires a false representation to have been made?  From a policy perspective, why should a debtor who commits fraud be let off the hook just because he didn’t happen to make a representation to his victim?

Many view Ritz as a huge development.  Some believe that the Supreme Court’s ruling allows a creditor to obtain a nondischargeable judgment against a debtor who actively transfers assets prepetition to avoid paying creditors.  Some also believe that Ritz will deter debtors and their principals from fraudulently transferring assets to related entities.  Creditors certainly will push courts to interpret Ritz broadly, but obstacles remain.

For example, § 523(a)(2)(A) does not itself give rise to a claim for money damages – it merely renders an existing debt nondischargeable.  In Ritz, Husky was able to pierce the corporate veil, thereby making Ritz liable for Chrysalis’ contract debt.  But if Husky had not been able to pierce the corporate veil (as the bankruptcy court had originally ruled), § 523(a)(2)(A) would not have come into play.  Even if a debtor contributes to a fraud, § 523(a)(2)(A) can apply only if non-bankruptcy law imposes liability on the debtor in the first place.

In addition, the Supreme Court appears to acknowledge that a fraudulent transfer claim imposes liability upon the transferee, not the transferor.  Thus, “the recipient of the transfer – who, with the requisite intent, also commits fraud – can ‘obtai[n]’ assets ‘by’ his or her participation in the fraud. . . . If that recipient later files for bankruptcy, any debts ‘traceable to’ the fraudulent conveyance . . . will be nondischargeable under § 523(a)(2)(A).”  Ritz at p. 9 (emphasis added).  There is nothing in Ritz to suggest that a debt owed by the transferor becomes nondischargeable when the transferor files for bankruptcy.  And since it is the transferor’s intent that is relevant to determining whether an “intentional fraudulent transfer” occurred, the resulting debt owed by the transferee will only be nondischargeable if the creditor can show that the transferee also committed “actual fraud.”S

The one clear holding is that creditors no longer need to show that a representation has been made to establish “actual fraud” under § 523(a)(2)(A).  This should eliminate the need for creditors to contort the facts to fit within the narrow framework previously adopted by the Ninth Circuit.