Parsing two decisions from the U.S. Supreme Court, the Tenth Circuit Bankruptcy Appellate Panel decided that nondischargeability for actual fraud under Section 523(a)(2)(A) demands justifiable reliance by the creditor, although reliance is not laid out as a requirement in the statute.

The relevant facts boil down to this: The debtors had insurance on their home, which burned to the ground. The insurer paid about $355,000 for the home. Presumably, the proceeds went to the holder of the mortgage in whole or in part.

The debtors had other claims for loss of use of the home and personal property, including claims for loss of a ring and a lawn mower. The insurer delivered a check of about $2,800 to the debtors, including some $1,200 for the mower. The basis for the remainder of the check was unclear from the record.

When all was said and done, the insurer paid almost $580,000 for the losses.

After tendering the check for $2,800, the insurer discovered that the debtors had submitted fraudulent documents showing ownership of the ring and the mower. However, the debtors never chased the $2,800 check, since they evidently knew the insurer suspected fraud.

The insurer sued the debtors in Colorado state court for insurance fraud. On summary judgment, the insurer won a judgment for the entire $580,000. The judgment was upheld in the state supreme court.

To prove a claim for insurance fraud under Colorado law, the insurer was only required to prove that the insureds submitted claims based on fabricated documentation. The proof entitled the insurer to void the policy and recover everything paid under the policy.

After the debtors filed a chapter 7 petition, the insurer filed an adversary proceeding to declare the $580,000 debt nondischargeable for actual fraud under Section 523(a)(2)(A). On summary judgment, the bankruptcy court ruled that the $580,000 debt was nondischargeable.

The debtor appealed, with notable success as shown in the BAP’s July 11 opinion by Bankruptcy Judge Robert H. Jacobvitz.

Reliance Required for Actual Fraud

The state court judgment for $580,000 established there was a debt. Judge Jacobvitz was tasked with deciding whether the debt was nondischargeable under Section 523(a)(2)(A) for actual fraud. A debt is nondischargeable under the subsection “for money . . . to the extent obtained by — (A) false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor’s or an insider’s financial condition.”

The bankruptcy court had decided that the subsection did not require the insurer to prove reliance, because state insurance law on insurance fraud only required a false statement with intent to deceive and to induce the insurer to pay more than the loss sustained by the insured.

In substance, Judge Jacobvitz was faced with deciding whether dischargeability for actual fraud under Section 523(a)(2)(A) requires more proof than state law for insurance fraud. To find the answer, he examined two prominent cases from the Supreme Court.

In Field v. Mans, 516 U.S. 59 (1995), Judge Jacobvitz said that the Supreme Court “held that excepting a debt from discharge under § 523(a)(2)(A) based on a false representation requires proof of justifiable reliance.”

Perhaps confusingly, Husky International Electronics, Inc. v. Ritz, 578 U.S. 355 (2016), might point in the other direction. Judge Jacobvitz described Husky as resolving “a circuit split regarding whether ‘actual fraud’ in § 523(a)(2)(A) necessarily requires a misrepresentation.” Notably, Husky involved a constructively fraudulent transfer, not actual fraud.

Judge Jacobvitz interpreted Husky as holding that “proof of reliance is not required to except a debt from discharge under § 523(a)(2)(A) based on a fraud that is not an inducement-based fraud, such as a fraudulent conveyance scheme.” Or, as we said in ABI’s report on Husky, “a debt can be nondischargeable for ‘actual fraud’ under Section 523(a)(2)(A) of the Bankruptcy Code in the absence of a fraudulent misrepresentation to the creditor.” To read ABI’s report on Husky, click here.

“Read together,” Judge Jacobvitz said,

Husky and Field stand for the proposition that proof of reliance is not required by § 523(a)(2)(A) if the fraud at issue is not of a type that induces reliance, but proof of justifiable reliance is required if the fraud at issue is a false representation because that is a form of fraud that induces a creditor’s reliance.

Judge Jacobvitz held that “[p]roof of justifiable reliance, therefore, is required to except a debt from discharge based on a false representation even if the creditor alleges the misrepresentation constituted ‘actual fraud.’” He cited five other bankruptcy courts for reaching the same conclusion.

Judge Jacbovitz ruled that the bankruptcy court had employed the “incorrect standard” by not requiring reliance by the insurer.

Applying the standard to the case on appeal, Judge Jacobvitz divined that state insurance law required proof of a false representation. Although the record proved that the debtors had made a false representation, he found that the record did not show the insurer’s reliance. Indeed, Judge Jacobvitz said there were material factual disputes precluding summary judgment regarding the insurer’s justifiable reliance.

Also precluding summary judgment, Judge Jacobvitz said there was a factual dispute as to whether the insurer had incurred a loss because the debtors never cashed the check for $2,800.

Finally, the debtors argued that nondischargeable debt should be no more than $2,800, rather than the entire $580,000, because the insurer had not incurred an actual loss of $580,000. Judge Jacobvitz did not reach the question because he reversed the grant of summary judgment and remanded for further proceedings.