Bar News - July 20, 2016
Federal Practice & Bankruptcy: The Red Sox, Mr. Ritz, and Fraudulent Transfers
By: Christopher M. Dube
On May 16, 2016, the Red Sox were rained out in Kansas City. A few unscheduled hours that evening presented an opportunity to read the latest United States Supreme Court decisions and, as luck would have it, a decision addressing bankruptcy law was issued earlier that day (and that coincidence is where the eye-catching Red Sox aspect of this story ends).
In Husky International Electronics Inc. v. Ritz (2016), the Court decided 7-1 that “actual fraud” under Section 523(a)(2)(A) of the Bankruptcy Code encompasses fraudulent conveyance schemes, even when those schemes do not involve false representations.
Husky International Electronics Inc. supplied components used in electronic devises to Chrysalis Manufacturing Corp. between 2003 and 2007. During that time, Chrysalis fell in arrears to the tune of nearly $164,000. When Husky was unable to collect from Chrysalis, it sued Daniel Lee Ritz Jr., a director and shareholder of Chrysalis during the period Husky supplied the goods (Ritz held at least 30 percent of the company’s stock).
Husky alleged that Ritz engaged in an intercompany fraudulent transfer scheme involving the transfer of large sums of money to other entities in which he held a controlling or substantial equity interest, thereby draining Chrysalis of assets that would otherwise have been available to satisfy debts owed to Husky. Ritz then filed a petition for relief under Chapter 7.
Husky filed a complaint under Section 523(a)(2)(A) objecting to the discharge of Ritz’s personal liability for the debt owed to Husky. Section 523, which sets forth numerous bars to discharge, reads, in relevant part: “(a) A discharge under [Chapters 7, 11, 12, or 13] … does not discharge an individual debtor from any debt… (2) for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by: (A) false pretenses, a false representation, or actual fraud…”
The District Court held that Ritz was personally liable under a Texas statute that permits creditors to recover from insiders of a corporation that engage in fraudulent transfers that directly benefit the insider, but also held that the debt was dischargeable because it was not obtained by actual fraud. The Fifth Circuit affirmed, holding that a misrepresentation by a debtor directly to a creditor is a necessary element of “actual fraud” under Section 523(a)(2)(A); it found that Ritz made no such false representations to Husky regarding the transfer of Chrysalis’s assets.
Husky, with the support of the United States Solicitor General, argued that Section 523(a)(2)(A) applied to Ritz because he engaged in fraudulent transfers of money from Chrysalis in a scheme to conceal assets from Chrysalis’s creditors. Husky further argued that Section 523(a)(2)(A) requires only that a debtor obtain money or property as a result of actual fraud, not that the debtor obtain anything directly from a creditor, or make a reliance-inducing misrepresentation to the creditor. Husky sought to have the bar to discharge applied to cases where there is a transfer of money and the transferee knows that the transfer is being made for the purpose of hindering, delaying, or defrauding the transferor’s creditors, thereby conspiring with the transferor.
Ritz, on the other hand, argued that the phrase “actual fraud” should be interpreted in the context of Section 523(a) to require a misrepresentation made to the creditor on which the creditor relied. Ritz reasoned that Section 523(a) is focused on fraudulent inducement (e.g. false statements, false representations, false financial statements) and that when Congress added the phrase “actual fraud” to that section alongside other terms that by their nature speak of inducement, it did not intend to expand Section 523(a)(2)(A) to encompass transferee liability for fraudulent transfers.
Had it intended to do so, Ritz argued, Congress would have specifically referred to fraudulent transfers, fraudulent conveyances, or transfers made with the intent to hinder, delay, or defraud a creditor as it did in other legislation addressing fraudulent transfers. Ritz further noted that Section 523 offers creditor-specific remedies, that Congress has traditionally addressed fraudulent-conveyance remedies in a manner consistent with the principle of equitable distribution amongst the creditor body as a whole, and that to adopt Husky’s interpretation would enable one creditor to jump the line.
The Court first established that it is reasonable to presume that when Congress amended the Bankruptcy Code in 1978 to add “actual fraud” to Section 523(a)(2)(A), it intended the phrase to have meaning that expanded upon the already existing “false representation.” The Court then examined the historical meaning of the term “actual fraud,” beginning with the Fraudulent Conveyances Act of 1571, 13 Eliz., Ch. 5., concluding that “from the beginning of English bankruptcy law, courts and legislatures have used the term ‘fraud’ to describe a debtor’s transfer of assets that, like Ritz’s scheme, impairs a creditor’s ability to collect the debt.” Justice Sonia Sotomayor, writing for the majority, stressed that, “[C]ommon law also indicates that fraudulent conveyances, although a ‘fraud,’ do not require a misrepresentation from a debtor to a creditor.”
The Court acknowledged that there is overlap among the provisions of the Bankruptcy Code addressing bars to a debtor’s discharge, but that such overlap is inevitable and does not require a conclusion, as Ritz argued, that “actual fraud” should be interpreted to encompass only those frauds that include a misrepresentation.
Supreme Court Justice Clarence Thomas, in his dissent, agreed with the majority that “actual fraud” under common law encompasses fraudulent transfers. He explained, however, that the phrase must be read in the context of the statute which requires that, in order for discharge to be barred, the debt must be “obtained by… actual fraud.” He reasoned that by using the phrase “obtained by,” Congress intended that the fraud must occur at the outset – when the debt was incurred – and caused the creditor to enter into the transaction with the debtor, a mold that a fraudulent transfer will generally not fit within and certainly did not in this case.
The majority, however, expressly rejected the suggestion that there is a basis in the statute for concluding that reliance at the outset is required. In holding to the common law interpretation of “actual fraud,” the majority noted that fraudulent conveyance statutes focus on the effort of concealment, not the inducement to the creditor. It reasoned that the “obtained by” requirement can be satisfied by the receipt of the benefit of a fraudulent transfer by a transferee who operates with the requisite intent to conspire with the transferor.
The majority reached a conclusion that will make it more difficult for debtors to use bankruptcy as an engine for fraud by accumulating debt through an entity, transferring the entity’s assets to third parties from whom the debtor derives a benefit, and dispensing of any personal liability. The Supreme Court has clarified that Section 523(a)(2)(A) does not require a false representation to establish actual fraud. In circumstances where personal liability can be established against corporate insiders for fraudulent transfers executed by the corporation, creditors may avail themselves of Section 523(a)(2)(A) to seek to bar discharge of their claim against the insider.
Christopher M. Dube is Of Counsel in the Corporate Department at McLane Middleton. He can be reached by email or at (603)628-1437.