Husky International Electronics Inc. v. Daniel Lee Ritz, Jr.: Whether “Actual Fraud” Under 11 U.S.C. § 523(a)(2)(A) Requires a False Representation

On Nov. 6, 2015, the U.S. Supreme Court granted certiorari in Husky International Electronics Inc. v. Daniel Lee Ritz, Jr. and heard oral arguments in the case on March 1, 2016. The issue pending before the Supreme Court concerns whether “actual fraud” under 11 U.S.C. § 523(a)(2)(A) requires a finding that a false representation was made by the debtor to the objecting creditor.

The original dispute arose out of unpaid debt owed by Chrysalis Manufacturing Corporation (CMC) to Husky Electronics (Husky). From 2003-07, CMC bought electrical components from Husky, and in doing so incurred a debt of approximately $164,000 that it did not pay.[1] Husky tried to recover the money from one of CMC’s owners, Daniel Lee Ritz, Jr. (Ritz), by filing a federal lawsuit in 2009. While the suit was pending, Ritz filed a chapter 7 bankruptcy petition.

Prior to filing for bankruptcy relief, Ritz transferred money from CMC to other companies in which he also held an ownership interest, leaving CMC without assets to pay its debts.[2] In the bankruptcy case, Husky filed a dischargeability complaint in which Husky argued, inter alia, that (1) Ritz should be held personally liable for CMC’s breach of contract with Husky under applicable veil-piercing laws because of the pre-petition, fraudulent conveyances of property, and (2) the debt owed to Husky was nondischargeable as being obtained by “actual fraud” under § 523(a)(2)(A).[3]

The bankruptcy court found that the debt owed to Husky was dischargeable. It held that Ritz could not be held personally liable because the elements of actual fraud under applicable state law (Texas) were not met, as Husky had not alleged that Ritz made any false representation. The bankruptcy court went on to state that the elements of actual fraud under Texas law were “virtually the same” as the requirements for actual fraud under § 523(a)(2)(A).[4] The U.S. District Court and U.S. Court of Appeals for the Fifth Circuit affirmed the bankruptcy court’s decision. While the district court disagreed with the bankruptcy court that a fraudulent transfer under Texas law required a false misrepresentation,[5] allowing Ritz to be held personally liable for the corporate debt, it stated that it agreed that actual fraud under § 523(a)(2)(A) required a false representation based in part on the common law interpretation of that section.[6] Likewise, the court of appeals affirmed that § 523(a)(2)(A) requires a false representation.[7] This holding conflicts with a ruling by the U.S. Court of Appeals for the Seventh Circuit that no false representation is required for a debt to be held nondischargeable under § 523(a)(2)(A),[8] and this conflict could have prompted the Supreme Court to take up the issue.

In their briefs and at oral arguments, Husky argued that when Congress added “actual fraud” to the Bankruptcy Code in 1978, it intentionally broadened the scope of § 523(a)(2)(A) to prohibit the discharge of debts arising from intentionally fraudulent conduct and that “actual fraud” includes Ritz’s conduct of transferring money to corporations that he controlled in order to place the assets outside the reach of Ritz’s creditors. Ritz countered that § 523(a)(2)(A) only includes “debts that are the product of a misrepresentation that induced the creditor to part with whatever it is that gave rise to the debt.”[9] Ritz also argued that “actual fraud” does not include fraudulent conveyances: “[w]hether fraudulent conveyances are a form of common-law fraud is largely irrelevant as debts attributable to fraudulent conveyances do not fall within section 523(a)(2)(A) because they are not debts for anything ‘obtained by’ the debtor from the creditor.”[10]

Both the U.S. government[11] and the National Association of Bankruptcy Trustees[12] (NABT) filed amicus briefs siding with Husky. Specifically, the NABT expressed concern that such a ruling creates “a dangerous loophole through which the boldest and most dishonest debtors can ‘game the system’” by transferring all their property to insiders and co-conspirators prior to filing.[13] The National Association of Consumer Bankruptcy Attorneys (NACBA)[14] filed an amicus brief as well, disputing this concern and also warning that a ruling in favor of Husky could be “unduly punitive” to honest, small business owners, some of whom, NACBA claims, must frequently transfer money between personal and business accounts, thereby providing creditors with unjustified leverage in negotiations.

From a fair reading of the reported bankruptcy court decision, whether the bankruptcy court actually ruled on the issue of whether the debt satisfied “actual fraud” under § 523(a)(2)(A) is questionable. Arguably, the ruling that the debt was not dischargeable under § 523(a)(2)(A) was based on the finding that Ritz could not be held personally liable for the debt under Texas corporate law. For Ritz to have been personally liable for the debt of CMC, absent a personal guarantee, a preliminary analysis under Texas corporate law had to be conducted to determine whether the corporate veil of CMC could be pierced in order to hold Ritz personally liable. Also, whether the veil could be pierced depended on whether there had been “actual fraud” under Texas corporate law. The bankruptcy court performed that analysis and concluded that a false representation was required by Texas corporate law; a false representation was not alleged, therefore the veil could not be pierced to make CMC’s debt Ritz’s debt, subject to discharge in his individual bankruptcy case. Therefore, it is possible that any statement beyond the finding regarding personal liability for the debt, including the bankruptcy court’s statement that the requirements under § 523(a)(2)(A) for actual fraud were “virtually the same” as the requirements under Texas law, was dicta.

Regardless, the Supreme Court’s ruling in the pending case will likely impact the grounds on which dischargeability actions are filed in certain cases. While it is true that a bankruptcy trustee and creditors do have the remedy of filing complaints to avoid fraudulent transfers, these actions are subject to statutes of limitations that may pass before the transfers are discovered, particularly in cases converted from chapter 11, leaving such actions susceptible to a dismissal argument with a tolling counterargument. To the extent that the Supreme Court’s ruling in Ritz finds that fraudulent transfers without false representations are not a basis to deny discharge, and in cases where there are no other bases on which to deny the dischargeability of the subject debt or the debtor’s discharge, debtors that participated in such activities pre-petition may receive a discharge. However, the sum of these types of debtors could be relatively small, or at least smaller than all of the debtors that made fraudulent transfers. Typically, such debtors have also committed false oaths in connection with their fraudulent transfers that would form the basis to deny discharge under § 727, such as failing to disclose transfers outside the ordinary course of business or an ownership interest in the entities to which assets were transferred, or have taken actions that would form the basis of other grounds to deny dischargeability of debt under § 523.