Husky International and the Extension of Bankruptcy Court Jurisdiction over Nondebtor Transferors

Most of the recent commentary around the Supreme Court’s Husky International Electronics Inc. v. Ritz[1] opinion has centered on the holding that a debt may be nondischargeable under § 523(a)(2)(A), even if the debt was not obtained by a false representation.[2] The facts underlying Husky International reveal another issue that is unrelated to the actual fraud prong of § 523(a)(2), but that is core to fraud litigation and the jurisdictional reach of bankruptcy courts: the solvency of the non-debtor transferor.

Indeed, Husky International raises the jurisdictional issue of whether bankruptcy courts may also determine whether a transferor that is not a debtor in bankruptcy was insolvent. As is well known, bankruptcy judges have the authority to determine whether the debtor was insolvent at a given point in time. That, however, is not what was at issue in Husky International.

The facts underlying the Husky International case are fairly unusual for nondischargeability cases. Specifically, Ritz, the chapter 7 debtor, was a director and a minority owner of a Chrysalis Manufacturing Corp., which failed to pay its debts to Husky International Electronics Inc. Husky sued Ritz for Chrysalis’s debt to Husky under a Texas veil-piercing statute that allows creditors to hold shareholders personally liable for corporate debt. Ritz later filed a chapter 7 bankruptcy petition. In both the state and the bankruptcy litigation, Husky alleged that Ritz caused Chrysalis to transfer funds to other companies owned in whole or in part by Ritz at times when Chrysalis was not paying its debts as and when due and was balance-sheet insolvent. The bankruptcy court found that Chrysalis was insolvent at all relevant times and that Ritz had financial control over Chrysalis when the transfers occurred.[3]

Put simply, the Husky International transfers involved (1) funds transferred by an account debtor that was subject to the bankrupt debtor’s financial control, and (2) transferees that were partially or wholly owned by the bankrupt debtor. Neither the Supreme Court’s nor the Fifth Circuit’s opinions addressed the bankruptcy court’s authority to determine that the transferor was insolvent. The Fifth Circuit noted only that the bankruptcy court had found that Chrysalis was balance-sheet insolvent and was failing to pay its debts as and when due at all relevant times.[4]

However, the Supreme Court’s opinion that the debt might be nondischargeable[5] supports the principle that an account debtor’s officer or director may be liable for a nondischargeable debt if the bankruptcy court finds that the transferor — not the bankruptcy debtor — was insolvent when the transfers occurred. This is at least an implicit endorsement of a bankruptcy court’s authority to determine the solvency of a nonbankrupt transferor and possibly the issue of whether the nonbankrupt transferor had an intent to hinder, delay or defraud its creditors at the times of the transfers.[6] Further, Husky International made absolutely no distinction between a finding of fraud in a § 523(a)(2)(A) adversary proceeding and a finding of fraud in a § 548(a) adversary proceeding.

The Supreme Court’s failure to address this issue in Husky International creates fertile ground for chapter 7 trustees and litigation trusts to challenge the restrictions on bankruptcy courts’ authority to try fraudulent transfer cases where the transferor was arguably controlled by the bankrupt debtor. At first blush, this issue of the bankruptcy court’s authority is unlikely to be raised in cases where the transferor is no longer operational. However, what about nondischargeability actions involving transferors that are trying to restructure their finances and operations?

A company that is restructuring or that has just emerged from a restructuring generally has limited financial resources. The transferor thus is faced with a Hobson’s choice between allowing the bankruptcy court to make a solvency finding without the transferor’s direct involvement or incurring significant legal and professional fees to fight the allegation of insolvency. The choices are worse for directors of transferors that failed to carry director’s and officer’s insurance. Not only would a finding of insolvency in the bankruptcy litigation have evidentiary weight (and possibly preclusive effect) in veil-piercing litigation against these directors, the directors would have to (1) convince the bankruptcy court that they have standing to appear in the nondischargeability litigation, and (2) pay their own legal and professional fees and expenses.

The stakes are raised even further if the transferor’s solvency or intent is determined by a bankruptcy court’s valuation of the transferor’s contingent or unliquidated liabilities at the time(s) of the transfers. In those cases, the bankruptcy court makes its own evaluation of the facts known to the transferor at the time(s) of the transfer(s).[7] It is well-established that it is a proper exercise of the bankruptcy court’s jurisdiction to determine a transferor’s solvency in cases where the bankrupt debtor is the transferor. The same cannot be said for cases in which there was a finding that a nonbankrupt transferor was insolvent whereby bankruptcy courts, at least indirectly, can subject other officers and directors of the transferor to veil-piercing liability.

Although Husky International resolved the split in authority over whether the actual fraud prong of § 523(a)(2)(A) requires a false representation, it creates new issues by inviting bankruptcy courts to make solvency decisions — and possibly fraudulent-intent decisions — regarding nonbankrupt transferors. The risk of constitutionally prohibited litigation regarding these issues is likely to occupy the courts for some time.