Reversing the Fifth Circuit, the Supreme Court held in Husky International Electronics Inc. v. Ritz that 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.
Writing the majority opinion on May 16, Justice Sonia Sotomayor held that “actual fraud” subsumes “forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation.” A “fraudulent conveyance of property made to evade payments to creditors” is among the types of actual fraud that can result in a nondischargeable debt, she said.
Dissenting in the 7-1 decision, Justice Clarence Thomas argued that the majority’s opinion ignores the plain meaning of the statute. Citing the Norton and Collier treatises that agree with his interpretation, he said that the “context” of the subsection “dictates that ‘actual fraud’ ordinarily does not include fraudulent transfers.”
The majority’s decision means that the debt owing to a creditor who suffers an identical injury will be discharged if that creditor does not mount an objection or holds a debt so small that objecting to dischargeability would be foolish.
The Facts of the Case
A man caused his company to transfer funds to other companies that he owned or controlled. The man later went bankrupt. Husky, owed $164,000 by the company, sued the man in bankruptcy court to hold him liable for the corporate debt and to bar discharge of the debt under Section 523(a)(2)(A).
The bankruptcy judge found that property transferred from the company to the bankrupt was a constructive fraudulent transfer because it was made without adequate consideration. Nonetheless, the bankruptcy judge rejected the request to bar discharge of the $164,000 debt to Husky. Reversing the bankruptcy court in part, the district court held that Husky was entitled to pierce the corporate veil and make the man personally liable for the debt. Nevertheless, the district court agreed with the bankruptcy court by ruling that the debt was dischargeable because the man made no misrepresentation to Husky. In a May 2015 opinion penned by Circuit Judge Carolyn King, the Fifth Circuit upheld discharge of the debt because there was no misrepresentation to Husky.
Harkening back to the Prosser hornbook definition of “actual fraud,” the Fifth Circuit held that denial of discharge of a debt under the subsection requires misrepresentation made by the bankrupt to the creditor and reliance by the creditor. Judge King’s opinion said there was no authority for the proposition that actual fraud encompasses constructive fraudulent transfers.
Underpinning the Fifth Circuit’s holding was the fact that the bankrupt made no misrepresentations to the creditor.
Judge King spent the better part of her opinion explaining why a 2000 decision by Circuit Judge Richard A. Posner in McClellan v. Cantrell was wrong. In that case, Judge Posner held that a fraudulent misrepresentation was not the only form of fraud that renders a debt nondischargeable under subsection (a)(2)(A).
In July 2015, the First Circuit decided a similar case and agreed with Judge Posner’s conclusion. To resolve a 2-1 split, the Supreme Court granted certiorari and heard argument on March 1.
The Statute
Section 523(a)(2)(A) prohibits discharge of debts “obtained by ... false pretenses, a false representation or actual fraud.”
The former Bankruptcy Act barred discharge of a debt obtained by “false pretenses or false representation.” When it adopted the Bankruptcy Code in 1978, Congress added “actual fraud.” Justice Sotomayor said it was “therefore sensible” to interpret the new language as not meaning “the same thing as ‘a false representation.’”
The Majority Opinion
The majority opinion says it is “equally important” under common law that “fraudulent conveyances, though a ‘fraud,’ do not require a misrepresentation from a debtor to a creditor.” As an example, Justice Sotomayor pointed to a transfer to a relative, where the fraud occurs due to “concealment and hindrance,” not from “inducing a creditor to extend a debt.”
Summing up the first part of the opinion, Justice Sotomayor said that “false representation has never been a required element of ‘actual fraud,’ and we decline to adopt it today.”
Justice Sotomayor next dealt with the debtor’s argument that not requiring a misrepresentation would create overlap with subsections (a)(4) and (a)(6), which except debts from discharge for fraud or defalcation while acting in a fiduciary capacity and for willful and malicious injury to property. She admitted there is overlap, but said that “overlap is inevitable.” She saw “no reason to craft an artificial definition of ‘actual fraud’ merely to avoid narrow redundancies in Section 523 that appear unavoidable.”
The debtor also argued that a broader interpretation of (a)(2)(A) overlaps with Section 727(a)(2), which can result in denial of discharge of all debts if the debtor committed a fraudulent transfer with actual intent to hinder, delay or defraud within one year of bankruptcy.
Although the two sections “cover some of the same conduct, they are meaningfully different,” Justice Sotomayor said. A Section 727 violation is broader by preventing discharge of all debt, but is narrower than subsection (a)(2)(A) regarding timing.
The Dissent
Dissenting, Justice Thomas said that subsection (a)(2)(A) only covers situations where money or property was “obtained by” actual fraud. He said that a violation occurs “only when the fraudulent conduct occurs at the inception of the debt.” [Italics in original.] In the case on certiorari, the debtor’s fraudulent transfers to his companies “did not trick the creditor into selling his goods.”
The Application of Husky in Practice
Husky entailed fraudulent transfers for lack of adequate consideration that contributed to making the company unable to pay its debts. Even though the transfers were technically made by the debtor’s company, the debtor himself would have been denied a discharge of all his debt under established principles had he orchestrated the company’s fraudulent transfers within one year of his own bankruptcy with actual intent to hinder or delay the company’s creditors.
As a result of Husky, an individual who orchestrates his company’s fraudulent transfer more than a year before bankruptcy will forfeit dischargeability of debt owing to a particular creditor, so long as that creditor mounts an objection.
A similarly situated creditor who does not bother to object will see that debt discharged, despite suffering an identical injury.
To promote equality of treatment of creditors, will trustees now initiate proceedings on behalf of all similarly situated creditors to preclude the discharge of those debts? Or can one creditor mount a dischargeability objection on behalf of a class of similarly situated creditors?
In either instance, the result, if successful, would be equivalent to a denial of discharge even though the infringing fraudulent transfer occurred more than one year before bankruptcy.
Were he still alive, Justice Antonin Scalia might have agreed with Justice Thomas and lent a strong voice in favor of upholding the Fifth Circuit. As it is, the lower courts must now struggle with the task of crafting rules so that dischargeability objections do not morph into denials of discharge. They must also confront the task of ensuring that debts owing to deep-pocket creditors are not the only ones discharged when a debtor’s conduct could result in the denial of discharge of debts owing to many creditors.
Arguably, the Husky opinion finds the Supreme Court making what the majority see as a logical extension of the statute. Justice Scalia might have attacked Husky as judicial legislating. In any event, creditors now have a new weapon to use against debtors, and bankruptcy courts must begin crafting new rules to deal with problems created by Husky.