SCOTUS Ponders ‘Actual Fraud' in Bankruptcy Discharge

A weekly news service that publishes case summaries of the most recent important bankruptcy-law decisions, tracks major commercial bankruptcies, and reports on developments in bankruptcy reform in...

By Diane Davis

March 1 — The U.S. Supreme Court March 1 heard oral argument on whether “actual fraud” requires a debtor in bankruptcy to have made a false representation.

The court's first bankruptcy case of the term will resolve a circuit split that pits the Fifth Circuit against the First and Seventh circuits interpreting Bankruptcy Code Section 523(a)(2)(A). Section 523(a)(2)(A) provides an exception from discharge for “any debt … for money, property, services, or … credit, to the extent obtained by … false pretenses, a false representation, or actual fraud.”

The justices didn't appear to favor either side based on the questions asked, but the court seemed to be looking for a way to reverse the Fifth Circuit's decision below and find a way to hold the respondent accountable for his bad conduct. Without Justice Antonin Scalia's presence on the bench, the justices may not focus as much on the wording of the statute—Scalia was a proponent of the method of statutory interpretation known as “textualism”—but what they view as the correct outcome.

Several justices' questions to counsel focused on the practical issues of the case, such as what the petitioner will have to prove in an adversary proceeding in the bankruptcy court to pierce the corporate veil under state law if the court were to reverse and remand the case.

In this case, the U.S. Court of Appeals for the Fifth Circuit held that the “actual fraud” exception to a bankruptcy discharge under Section 523(a)(2)(A) requires that the debtor make some kind of false representation to the creditor (Husky Int'l Elecs., Inc. v. Ritz (In re Ritz), 2015 BL 162947, 787 F.3d 312 (5th Cir. 2015)). Because the debtor/respondent's fraudulent transfer scheme didn't involve a misrepresentation, he wasn't barred from discharging $164,000 in debt to petitioner Husky International Electronics, Inc.

The petition for certiorari was granted Nov. 6, 2015 .

The Seventh Circuit's contrary interpretation of Section 523(a)(2)(A) came in McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000). That decision concluded that “actual fraud” “is not limited to misrepresentations and misleading omissions,” but also includes deliberate fraudulent-transfer schemes.

The First Circuit followed McClellan in (Sauer Inc. v. Lawson (In re Lawson)), 2015 BL 210888, 791 F.3d 214 (1st Cir. 2015), which is currently still pending before the Supreme Court (Lawson v. Sauer Inc., U.S., No. 15-113, 7/24/15).

Fraudulent Transfers?

The case arises out of a Chapter 7 bankruptcy filed by respondent/debtor Daniel Lee Ritz, Jr. In a Chapter 7 case, nonexempt assets are liquidated and the proceeds are distributed to creditors. Before filing for bankruptcy, Ritz was a director and partial owner of Chrysalis Manufacturing Corp., a circuit board manufacturer.

For four years, the petitioner sold and delivered electronic device components to Chrysalis. Chrysalis failed to pay Husky for some of the goods delivered. While some of that debt was outstanding, Ritz transferred a substantial amount of funds from Chrysalis to several other entities that he controlled.

Husky sued Ritz in Texas state court to hold him personally liable for the company's debt. After Ritz filed for bankruptcy protection, Husky initiated a proceeding to have Ritz's debt declared non-dischargeable because Chrysalis had not received any reasonably equivalent value for the funds transferred to Ritz's companies.

Give 1978 Amendment Meaning

Petitioner's counsel, Shay Dvoretzky of Jones Day, Washington, D.C., argued that Congress's amendment of the Bankruptcy Code in 1978 to add “actual fraud” as an additional ground for barring discharge must be given meaning. According to Dvoretzky, the Fifth Circuit's holding makes “Congress's amendment superfluous” because it “equates actual fraud with the preexisting terms, ‘false pretenses,' and ‘false representation.'”

The Fifth Circuit's interpretation nullifies Congress's amendment, he said. “When Congress added ‘or actual fraud' to the discharge bar it was legislating against the backdrop of hundreds of years of common-law usage of that term,” Dvoretzky said. Congress made it clear that it was adding an additional ground for discharge so it was expanding the scope of the discharge bar, he said.

The respondent's interpretation is even worse, Dvoretzky said, because it “merely restates a preexisting scienter requirement.”

Chief Justice John G. Roberts Jr. wanted to know why Congress took the term “fraud” out of the Bankruptcy Act of 1903.

Dvoretzky said that the legislative history doesn't tell us why, but when Congress took it out in 1903, at least one legislator expressed concern that this was leaving a category of frauds outside the discharge bar and that was a mistake. The purpose of the discharge bar is to “afford relief to the honest but unfortunate debtor and not to allow the Bankruptcy Code to be used for an engine for fraud,” Dvoretzky said.

Consistent With Bankruptcy Code's Purpose

Sarah E. Harrington, Assistant to the Solicitor General, U.S. Department of Justice, Washington, D.C., represented the U.S., which filed an amicus curiae brief in support of the petitioner and was granted permission to participate in oral argument. Harrington argued that for centuries the term “fraud” has been used at common law to refer to schemes where property is “transferred with the intent to hinder, delay, or defraud a creditor.”

According to Harrington, there is no reason to give the text any different meaning than in Section 523(a)(2)A). She contended that the petitioner's view is the only interpretation that gives any meaning to the 1978 amendment. The petitioner's view is also consistent with the Bankruptcy Code's overarching purpose that dishonest debtors not be permitted to use the Code to get rid of their debts, she said.

Harrington said that the phrase “obtained by” in Section 523(a)(2)(A) really focuses on the recipient and gets at the recipient's mental state and fraudulent activity.

Justice Stephen G. Breyer brought up a case he had on fraudulent conveyances about 30 years ago and asked both Dvoretzky and Harrington whose debt we are talking about in various hypothetical questions involving fraud.

Harrington pointed out that there are two distinct debts: the original debtor—the original debt from the creditor to debtor one. If debtor one transfers property to a friend with the intent to defraud his creditor and the friend shares that intent, then state or federal law gives the creditor a cause of action to go after the recipient, she said. If that is successful, then there's a new debt that's created to the creditor from the friend, she said. The second overarching purpose of the Bankruptcy Code is to “let creditors get their money back when they can,” Harrington said. “It makes sense that Congress would have wanted to give maybe a stronger remedy against the person who actually has the stuff at the end of the day,” she said.

Fraudulent Conveyances Not Covered

Respondent Ritz's counsel, Erin E. Murphy of Bancroft PLLC, Washington, D.C., argued that Section 523(a)(2) applies to a specific type of debt, “a debt for something with which the debtor has fraudulently induced the creditor to part.” According to Murphy, the statute doesn't apply to a debt for receiving money through a fraudulent conveyance. “That may be a form of fraud. It may well be a form of actual fraud, but it's not a form of fraud that gives rise to a debt that is subject to exception from discharge under 523(a)(2),” Murphy said.

How should Congress have written the statute to cover a scheme like this? Justice Ruth Bader Ginsburg queried.

According to Murphy, the most natural way would be to say “fraudulent conveyance” or “fraudulent transfer” or a “fraud that involves intent to delay, defraud, or hinder a creditor.” There isn't a single fraudulent conveyance statute that uses the term “actual fraud,” she said.

Respondent doesn't dispute that fraudulent conveyance is a form of actual fraud, Murphy said. “It's just not a form of actual fraud that falls within the scope of this particular exception because this exception says more than just the words “actual fraud,” she said.

In response to a question from Justice Anthony M. Kennedy, Murphy explained that the fraud that comes within Section 523(a)(2) is inducement and it doesn't have to be direct. “[W]e're not saying that there has to be a direct relationship here,” Murphy said.

Language Seems Simple

Looking at the words of the statute, Justice Elena Kagan told Murphy, “the language just seems a lot more simple than you're making it, because you add inducement to the language, you add from the creditor to the language. But the language doesn't say any of those things.” “[W]hether or not the creditor has been induced and whether or not the money has come from the creditor seems to be irrelevant under this very simple statutory phrase,” Kagan said.

Murphy said she didn't agree that the fraud is how you obtained the money. “You obtained money, and by doing so helped someone else commit a fraud on their creditor. But you did not use fraud to obtain the money in a fraudulent conveyance. You have been a participant in a fraud on someone else,” she said.

‘Dogs and Cats.'

In his rebuttal, Dvoretzky picked up an earlier line of questioning and said that a veterinarian's office that treats dogs, cats, or domesticated animals would surely also treat guinea pigs and hamsters. The “domesticated animals” phrase has something in common with dogs and cats, just as “fraudulent transfers” has something in common with false pretenses and false representations, he said.

“These are all schemes to cheat creditors,” Dvoretzky said. “But by adding `or actual fraud,' Congress was expanding upon the pre-existing terms, expanding dogs and cats to cover something additional,” he said. The respondent doesn't have any theory for what Congress was doing through this language to expand upon the previous term, Dvoretzky said.

Shay Dvoretzky of Jones Day, Washington, D.C., represented the petitioner Husky International Electronics, Inc.; Erin E. Murphy of Bancroft PLLC, Washington, D.C., represented the respondent Daniel Lee Ritz, Jr.; Sarah E. Harrington, Assistant to the Solicitor General, U.S. Department of Justice, Washington, D.C., represented the U.S.

To contact the reporter on this story: Diane Davis in Washington at ddavis@bna.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bna.com

For More Information

The Supreme Court's transcript of oral argument is available at: http://www.supremecourt.gov/oral_arguments/argument_transcripts/15-145_2co3.pdf