Supreme Court Expands “Actual Fraud” Discharge Exception

If a debtor has received a fraudulent transfer, he or she may also have incurred a nondischargeable debt. According to a recent ruling by the Supreme Court, the discharge exception for “actual fraud” is now broad enough to include the liability imposed, if any, on the recipient of fraudulent transfer. The Court resolved a circuit split in Husky International Electronics Inc. v. Ritz and held that a debtor need not make a “false representation” for a fraud to be nondischargeable in bankruptcy.[1] One practical ramification is that it may be easier for complaints alleging “actual fraud” to survive motions to dismiss.

Factual Background

The facts in Husky arose from a fraudulent transfer scheme orchestrated by the debtor, Daniel Ritz. The debtor was a director and 30 percent owner of Chrysalis Manufacturing Corp.[2] Between 2003 and 2007, Chrysalis purchased goods from Husky International Electronics Inc. and incurred a debt of $163,999.38 to Husky (the “Husky claim”).[3] The parties agreed that between 2006 and 2007, the debtor “drained Chrysalis of assets it could have used to pay debts to creditors like Husky by transferring large sums of Chrysalis’ funds to other entities” that the debtor controlled.[4]

Husky sued the debtor in state court, arguing that the debtor committed “actual fraud” under Texas law by siphoning assets out of Chrysalis to other companies controlled by him to avoid paying Chrysalis’ creditors.[5] The debtor filed a chapter 7 bankruptcy petition in the U.S. Bankruptcy Court for the Southern District of Texas.[6] Husky filed an adversary proceeding challenging the dischargeability of the Husky claim under § 523(a)(2)(A).[7]

Lower-Court Proceedings

After trial in the district court, the court held that the debtor was personally liable for the Husky claim under Texas law, but further held that the Husky claim did not fall under the “actual fraud” exception to discharge under § 523(a)(2)(A).[8]

On appeal, the Fifth Circuit affirmed. According to the Fifth Circuit, a “necessary element of ‘actual fraud’ is a misrepresentation from the debtor to the creditor.”[9] The fraudulent intercompany transfers did not involve false statements by the debtor to Husky, and therefore any resulting debt was not excepted from discharge under § 523(a)(2).[10]

The SCOTUS Majority Opinion

After granting certiorari, the Supreme Court reversed the Fifth Circuit 7-1 in an opinion by Justice Sotomayor.[11]

Section 523(a)(2)(A) of the Bankruptcy Code provides in part as follows:

A discharge under section 727 … of this title does not discharge an individual debtor from any debt ... for money ... or an extension ... of credit, to the extent obtained by false pretenses, a false representation or actual fraud, other than a statement respecting the debtor’s or an insider’s financial condition.

In its opinion, the Court focused on the meaning of the word “fraud” at common law, noting that the Court has “historically construed the terms in § 523(a)(2) to contain the elements that the common law has defined them to include.”[12] After reviewing the Statute of 13 Elizabeth, the English common law and various state and Supreme Court precedents, the Court reached two conclusions: First, courts use the word “fraud” to describe a “transfer of assets that ... impairs a creditor’s ability to collect a debt.”[13] Second, courts consistently hold that “both the debtor and the recipients of the conveyed assets [are] liable for fraud even though the recipient of the fraudulent conveyance made no representation ... to the debtor’s creditor.”[14]

Consistent with the common law, the Court concluded that it would not imply a “false representation” element into the meaning of “actual fraud” under § 523(a)(2)(A). Accordingly, “at least sometimes a debt obtained by a fraudulent conveyance scheme could be nondischargeable under § 523(a)(2)(A).”[15]

At bottom, the Court held that it was irrelevant whether the debtor had made a misrepresentation to Husky. If the debtor was liable to Husky under applicable law as a recipient of a fraudulent transfer, that debt was excepted from discharge under § 523(a)(2)(A). The majority noted that the case was “unusual” because Husky alleged that the debtor “transferred Chrysalis assets to other companies he controlled,” and was therefore “both the transferor and transferee.”[16] The Supreme Court instructed the Fifth Circuit to determine on remand “whether the debt to Husky was obtained by [the debtor’s] asset-transfer scheme.”[17]

Justice Thomas’ Dissent

In dissent, Justice Thomas focused on the “plain meaning” of the phrase “to the extent obtained by” in § 523(a)(2)(A). According to Justice Thomas, that phrase suggests that § 523(a)(2)(A) requires “a causal nexus between the fraud and the debt” and “refers to the manner in which such money ... is obtained and the creditor defaulted.”[18] The dissent further argued that the majority was ignoring the Supreme Court’s own precedent in Field v. Mans, in which the Court held that “one of the elements of actual fraud ... is reliance on some sort of false statement, misrepresentation, or omission” (emphasis in original).[19] According to the dissent, § 523(a)(2)(A) should only apply to debts that result from fraud “at the inception of a credit transaction” — not from a fraudulent transfer.[20]

Turning to the facts of the case, the dissent found that the debtor’s fraudulent intercompany transfers did not constitute “actual fraud” under § 523(a)(2)(A) and that the Husky claim was dischargeable. “Because Husky does not contend that [the debtor] fraudulently induced it to sell goods ... Husky has not established that § 523(a)(2)(A) covers any debt owed to it.”[21]

Responding to the dissent, the majority disagreed that its analysis conflicted with the phrase “obtained by” in § 523(a)(2)(A). The majority pointed out that the recipient of a fraudulent transfer “obtain[s] assets by his or her participation in the fraud.”[22] The majority also disagreed with the dissent’s reading of Field. According to the majority, that case did not address liability for a fraudulent transfer under § 523(a)(2)(A), and thus did not impose a “reliance requirement” on every complaint under § 523(a)(2)(A). Rather, Field held that a creditor must prove reliance only when alleging that “fraud [was] perpetrated through a misrepresentation.”[23]

Conclusion

In sum, a debtor need not make a false representation for a fraud to be nondischargeable under § 523(a)(2). The opinion has at least two implications for bankruptcy practitioners. First, because a § 523 complaint need not allege misrepresentation, it may be easier for plaintiffs to state a claim for “actual fraud” under § 523(a)(2)(A). More complaints may meet the heightened pleading standard for fraud allegations under Rule 7009 and survive motions to dismiss. Second, debtors who are recipients of fraudulent transfers may owe a nondischargeable debt, provided that they had the requisite intent at the time of the transfer.