Understand the complexities and nuances of the Bankruptcy Code to better advise clients and prepare for court.
By John C. Speer and Michael P. Kapellas
John C. Speer is a member in the Memphis, Tennessee, office of Bass, Berry & Sims PLC. For more than 30 years, John has worked with various financial institutions assisting them with disputes involving federal and state laws and regulations.
Michael P. Kapellas is an associate in the Memphis, Tennessee, office of Bass, Berry & Sims PLC. He works with broker-dealers and financial institutions to resolve various disputes and regulatory matters.
The U.S. Supreme Court has resolved a conflict among the First, Seventh and Fifth Circuits regarding the interpretation of Bankruptcy Code §523(a)(2)(A) that prevents debtors from discharging debts “obtained by … actual fraud.” In reversing the Fifth Circuit's decision in Husky Int'l Elecs., Inc. v. Ritz (U.S., No. 15-145, 5/16/16 ), the Court held that “actual fraud” does not require proof that a debtor made a false representation to a creditor (28 BBLR 629, 5/19/16).
Debts are often discharged in bankruptcy notwithstanding they result from a fraudulent conveyance because of the absence of a false representation made in connection with the conveyance. The Supreme Court held that “actual fraud” does not require a false representation and encompasses fraudulent conveyance schemes. The Bankruptcy Code defines “debt” as a debtor's “liability on a claim” (§101(12)) and “claim” as a “right to payment …” or “right to equitable remedy” (§101(5)). The Court rejected the Fifth Circuit's interpretation of “actual fraud,” which conflicted with the interpretation embraced by the Seventh Circuit in McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000), and the First Circuit in Sauer Inc. v. Lawson (In re Lawson)), 2015 BL 210888, 791 F.3d 214 (1st Cir. 2015).
In Husky, Husky International Electronic, Inc.’s (“Husky”) customer, Chrysalis Manufacturing Corp. (“Chrysalis”), incurred debt to Husky from the purchase of electronic devices over several years. Chrysalis' director and 30 percent shareholder, Lee Ritz, Jr. (“Ritz”), drained Chrysalis of assets needed to pay Husky by a series of transfers to other businesses he owned or controlled, without receiving reasonably equivalent value for the exchange. Eventually, Husky sued Ritz for the amount Chrysalis owed but could not pay, claiming Ritz's fraudulent transfer of Chrysalis' assets to entities he controlled made him personally liable for Chrysalis' debt under the Texas Business Operations Code's corporate veil-piercing statute.
Shortly thereafter, Ritz filed bankruptcy and Husky filed its adversary proceeding to prevent discharge of the debt it claimed was created by the transfer of Chrysalis' assets that Ritz knew that the transferor intended to defraud creditors, which Husky argued constituted “actual fraud” under § 523(a)(2)(A). The bankruptcy court determined that Ritz was not liable for Husky's damages caused by the transfer of Chrysalis' assets since Husky had not proved actual fraud under the Texas corporate veil-piercing statute. The court concluded the statute requires a misrepresentation of a material fact. By the same reasoning the bankruptcy court found that Husky did not prove “actual fraud” under §523(a)(2)(A). Following Husky's appeal of the bankruptcy court's decision, the district court relied on a recent Fifth Circuit case that held the corporate veil could be pierced if there was evidence of intent to hinder, delay or defraud a creditor even without a misrepresentation. The district court found that, while Ritz was liable under the Texas statute since a fraudulent conveyance may constitute actual fraud under it, the debt nevertheless was not obtained by “actual fraud” under §523(a)(2)(A) because no fraudulent misrepresentation was made to Husky. The Fifth Circuit affirmed, but did not address whether Ritz was liable under the Texas statute.
In rejecting Husky's argument that a false representation is unnecessary to trigger the “actual fraud” clause of §523(a)(2)(A), the Fifth Circuit explicitly rejected the reasoning in the Seventh Circuit's decision in McClellan v. Cantrell, which it found “to be in tension” with the U.S. Supreme Court's decision in Field v. Mans, 516 U.S. 59 (1995), as well as several bankruptcy courts. The Field opinion addressed the level of reliance required by a creditor to prevent discharge under §523(a)(2)(A) and considered what conduct was included in the concept of “actual fraud.” While acknowledging that Field did not directly address whether a false representation is necessary to establish actual fraud—probably because Field did involve a misrepresentation—the Fifth Circuit concluded that “the Court throughout its opinion in Field appeared to assume that a false representation is necessary to establish ‘actual fraud.’” In effect, the Fifth Circuit determined that Field indicates actual fraud, under §523(a)(2)(A), incorporates the common law elements of fraud, including intentional misrepresentation. The Fifth Circuit also relied on its previous decisions before and after Field and McClellan that require representations by a debtor to prove “actual fraud” to obtain non-discharge of a debt.
In McClellan, decided after Field, the Seventh Circuit, in an opinion by Judge Posner, observed that “[n]o learned inquiry into the history of fraud is necessary to establish that it is not limited to misrepresentations and misleading omissions.” Thus, the Seventh Circuit reversed the district court that affirmed the bankruptcy court's dismissal of McClellan's complaint to prevent discharge of a debt. McClellan, the creditor, sold his business assets to a purchaser who ultimately defaulted on installment payments while still owing McClellan more than $100,000. McClellan sued the purchaser in state court. Undeterred, the purchaser sold the machinery for $10 to Cantrell, his sister, who McClellan alleged knew of the lawsuit. The sister subsequently sold the machinery for $160,000 and McClellan added her as a defendant in the state-court lawsuit, asserting that the transfer of the machinery to her was a fraudulent conveyance. After the sister filed her Chapter 7 bankruptcy petition, McClellan filed an adversary proceeding to recover the debt she owed as the recipient of a fraudulent transfer of assets. The bankruptcy court determined that the debt was dischargeable under §523(a)(2)(A), relying on the Supreme Court's decision in Field.
Judge Posner explained in McClellan that the bankruptcy court's reliance on Field was misplaced. He wrote that, while it was true that the fraud at issue in Field involved a misrepresentation, “[n]othing in the Supreme Court's opinions suggests that misrepresentation is the only type of fraud that can give rise to a debt that is not dischargeable under section 523(a)(2)(A).” Ultimately, while “[p]lenty of cases … assume that fraud equals misrepresentation,” by distinguishing between “a false representation” and “actual fraud,” the court determined that §523(a)(2)(A) “makes clear that actual fraud is broader than misrepresentation.” The court reasoned that the debt at issue in McClellan arose from the fraud the sister allegedly committed against the creditor through her full and equal participation in her brother's fraud. The fact that her fraud involved no false representation did not prevent it from being actual fraud, and therefore did not render it non-dischargeable under §523(a)(2)(A).
When the Fifth Circuit issued its Husky decision on May 22, 2015, it declared that “[n]o subsequent appellate court has adopted the interpretation of Section 523(a)(2)(A) endorsed by the McClellan majority.” However, some five weeks later, the First Circuit did exactly that when it issued its Lawson decision.
The circumstances in Lawson were similar to McClellan, although the fraudulent conveyance at issue was between a father and daughter in Lawson, rather than a brother and sister. In Lawson, Sauer Incorporated won a judgment against the father for $168,351.59 based on fraudulent business transactions. The daughter formed a shell company before the judgment was entered, and, after judgment was entered, a transfer of $100,150 was made to the shell company by her father. Over the next year, she transferred $80,000 from the company to herself.
Sauer traced portions of the funds transferred from the father to his daughter. After the court found the transfers to the shell company and the subsequent transfers to the daughter to be fraudulent, it issued executions against both. The daughter filed for Chapter 13 bankruptcy the same month that the execution was issued against her. Sauer then initiated an adversary proceeding, objecting under §523(a)(2)(A) to her attempt to discharge the $80,000 judgment.
Relying heavily on the McClellan court's reasoning, the First Circuit found that, in the context of Chapter 13 bankruptcy, a debt for money or property “obtained by … actual fraud” extended beyond debts incurred through fraudulent misrepresentations to “include debts incurred as a result of knowingly accepting a fraudulent conveyance that the transferee knew was intended to hinder the transferor's creditors.” Following the Supreme Court's guidance from Field, the First Circuit reasoned that its decision depended upon the common law understanding of “actual fraud” in 1978, the year Congress amended the Bankruptcy Code to add “actual fraud” to the list of discharge exceptions in §523(a)(2)(A). The exceptions to dischargeability in that section of the Bankruptcy Code were limited to “false pretenses” or “false representations” prior to the 1978 amendments.
In Lawson, the court first turned to the Restatement (Second) of Torts to interpret the meaning of actual fraud. It determined that the Restatement offered a broad interpretation of “fraud” that “extend(ed) beyond fraudulent misrepresentations to at least include fraudulent conveyances.” The First Circuit concluded that this broad interpretation comported with the definitions offered by other sources, including Collier on Bankruptcy, which explained that “[a]ctual fraud, by definition, consists of any deceit, artifice, trick, or design involving direct and active operation of the mind, used to circumvent and cheat another.” This analysis led the First Circuit to agree with the Seventh Circuit's determination that, because §523(a)(2)(A) explicitly listed both actual fraud and false representations as grounds for denying discharge, “the distinction must have meaning, and that the most obvious meaning is the one that comports with common law understanding: actual fraud is broader than misrepresentation.”
Confronted with this Circuit split—the Fifth Circuit finding that actual fraud under §523(a)(2)(A) required false representations and the First and Seventh Circuits coming to the opposite conclusion—the question as to what “actual fraud” means in the context of §523(a)(2)(A) presented the Supreme Court with the opportunity to resolve the dispute. Parties in both Husky and Lawson filed petitions for writs of certiorari. The Supreme Court granted certiorari in Husky and heard oral arguments in March 2016. (The Court formally denied the Lawson petition the week after issuing its Husky opinion in mid-May.)
The Supreme Court's Husky decision mirrored, in many ways, the rationale embraced by the circuit courts in McClellan and Lawson. In determining that actual fraud in §523(a)(2)(A) did not require a false representation, the Supreme Court reasoned that Congress' 1978 amendment to the Bankruptcy Code that added “actual fraud” to the list of discharge exceptions in §523(a)(2)(A) for debts obtained by “false pretenses” or “false representations” reflected Congress' intention that “actual fraud” differed from “false representations” and was consistent with a scheme designed to hinder the collection of a debt by a fraudulent conveyance. The Court observed that the common usage of the term “actual fraud” is broad enough to include fraudulent conveyances without a false representation by a debtor with the intention to hinder the collection of debt by a creditor.
The Supreme Court also dismissed the Fifth Circuit's suggestion that Husky could have challenged Ritz's discharge under §727(a)(2)(A) of the Bankruptcy Code, which bars discharge of a debtor who has made a transfer of property to hinder, delay or defraud a creditor. In its Husky decision, the Fifth Circuit characterized as odd that Congress would have intended that actual fraud in §523(a)(2)(A) include the same fraudulent transfers covered by §727(a)(2)(A). Ritz embraced this argument before the Supreme Court, suggesting that to find otherwise would be to create a redundancy in the Bankruptcy Code.
Yet, as the Supreme Court pointed out, “[a]lthough the two provisions could cover some of the same conduct, they are meaningfully different.” Section 727(a)(2) is broader than §523(a)(2)(A) in scope, as it prevents an offending debtor from discharging all debt in bankruptcy, but it is also narrower than §523(a)(2)(A) in timing, as it only applies to transfers perpetrated in the year preceding the filing of the bankruptcy petition. The transfers Husky complained of occurred between November 2006 and May 2007. Ritz filed his petition December 31, 2009. In other words, the timing of Ritz's bankruptcy petition would have likely prevented Ritz's discharge from being denied under §727(a)(2).
The Supreme Court's decision comes with one important limitation: like the courts in McClellan and Lawson, the Supreme Court emphasized that, just as actual fraud differed from false representations, it also differed from constructive or implied-by-law fraud. Both of the circuit courts and the Supreme Court refused to read actual fraud under §523(a)(2)(A) to include any such form of quasi-fraud. The Supreme Court's reasoning was based in part on one of the first bankruptcy acts, the Statute of 13 Elizabeth—also known as the Fraudulent Conveyances Act of 1571—which remains embedded in laws related to fraud today, and the famous Twyne's Case, decided in the Star Chamber in 1601. The Supreme Court explained that the principle to be derived from both is that “a conveyance which hinders, delays or defrauds creditors shall be void as against [the recipient] unless … th[at] party … received it in good faith and for consideration.”
Centuries after Twyne was convicted of fraud as the recipient of a fraudulent conveyance, the First Circuit explained that, in order for a debt to be non-dischargeable under §523(a)(2)(A), “the debtor-transferee must herself be ‘guilty of intent to defraud’ and not merely be the passive recipient of a fraudulent conveyance.” Or, as the Supreme Court succinctly put it: “anything that counts as ‘fraud’ and is done with wrongful intent is ‘actual fraud.’” The transferees in both McClellan and Lawson clearly fell within the ambit of having committed “actual fraud.”
While Ritz conceded that fraudulent conveyances are a form of “actual fraud,” he argued the use of the phrase has a different meaning when read with the entirety of §523 and §523(a)(2)(A). Ritz argued the requirement that the debt incurred must be “for money, property, services, or … credit … obtained by … actual fraud” does not result from a fraudulent conveyance since no “debt” is obtained or created but is simply a transfer of assets. Further, Ritz argued the “obtained by” requirement is incompatible with a fraudulent conveyance since the debtor/transferor does not obtain a debt in a fraudulent conveyance. While Justice Thomas agreed with Ritz in his dissenting opinion, the Court rejected those arguments by observing that a transferee could become a debtor in bankruptcy and with the requisite intent would have committed fraud by receiving assets from a fraudulent conveyance, the precise scenario at issue in the McClellan and Lawson cases, and also the kind of transfer Husky asserted created Ritz's debt to it based on the Texas statute. Judge Posner in McClellan addressed the “obtained by” phrase, concluding that it goes with “money, property [or] services” not a “debt,” because debt is not something you obtain but is incurred from obtaining something of value.
Ultimately, the Supreme Court determined that a debt for money, property or services “obtained by” a transferee in a fraudulent conveyance could be non-dischargeable under §523(a)(2)(A), but declined to address whether “the debt to Husky was ‘obtained by’ Ritz's asset-transfer scheme” as Husky alleged, remanding that issue to the Fifth Circuit for determination. Whether the statute requires the “debt” or the “money, property [or] services” to be obtained by “actual fraud” remains to be decided by the Fifth Circuit.
The Supreme Court's decision expands the exceptions to discharge of debts in bankruptcy available to creditors and shifts the balance between the “fresh start” goal of bankruptcy and the non-dischargeability of a debt that results from a fraudulent conveyance or similar scheme that constitutes “actual fraud.”
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