Supreme Court Construes “Actual Fraud” Broadly, Resolving Circuit Split

Contributed by Yvanna Custodio
A decision from the United States Supreme Court penned by Justice Sonia Sotomayor adopted a broad reading of “actual fraud” in section 523(a)(2)(A) of the Bankruptcy Code, which excepts from discharge debts “obtained by . . . false pretenses, a false representation, or actual fraud.”  11 U.S.C. § 523(a)(2)(A).  The decision, Husky International Electronics v. Ritz, resolved a split in the Circuits regarding whether the phrase “actual fraud” required a false representation or whether the phrase could be more broadly construed as encompassing other forms of fraud such as a fraudulent conveyance. 
The scheme at issue involved the transfer by Ritz, the defendant and a director and owner of Chrysalis Manufacturing Corp., of assets that could have been used to pay Husky International Electronics, Inc., the petitioner.  Husky, a supplier of electronics components, sold products to Chrysalis; in turn, Chrysalis incurred a debt to Husky of approximately $164,000.  In the meantime, Ritz transferred Chrysalis’s funds to other entities he controlled.  With that debt unpaid, Husky filed a lawsuit against Ritz seeking to hold him personally liable for the amount, and Ritz subsequently commenced a chapter 7 case in the United States Bankruptcy Court for the Southern District of Texas.
Thereafter, Husky initiated an adversary proceeding in the bankruptcy court seeking to hold Ritz personally liable for the Chrysalis debt and contended that the debt could not be discharged in bankruptcy because the transfer amounted to “actual fraud.”  The lower courts, including the Fifth Circuit, held Ritz personally liable but rejected the “actual fraud” argument, holding that the debt was not “obtained by . . . actual fraud” because it did not involve a false representation to a creditor.
Reversing the Fifth Circuit, the Supreme Court observed that, in 1978, the phrase “actual fraud” was added to the list of acts that would taint a debt and except it from discharge (namely, “false pretenses or false representations”).  According to the Supreme Court, in light of the addition, it was “sensible to start with the presumption that Congress did not intend ‘actual fraud’ to mean the same thing as ‘a false representation.’”  More significantly, the Supreme Court relied on its past practice and its adoption of the common-law interpretations of the terms used in section 523(a)(2)(A), stating, “from the beginning of English bankruptcy practice, courts and legislatures have used the term ‘fraud’ to describe a debtor’s transfer of assets that, like Ritz’ scheme, impairs a creditor’s ability to collect the debt.”
Justice Clarence Thomas, the sole dissenter, disagreed with the expansive reading of section 523(a)(2)(A), stating that “‘actual fraud’ . . . does not encompass fraudulent transfer schemes.”  In the dissent, the justice explained that the subsection applies only when “fraudulent conduct occurs at the inception of the debt,” which would be inapplicable in this case because the fraudulent transfer at issue did not trick Husky into selling goods to the buyer, Chrysalis.  As a result, according to the dissent, the goods resulting in the debt were not obtained by “actual fraud.”
The Husky decision reduces a debtor’s ability to abuse the protections afforded by the Bankruptcy Code by utilizing it as a mechanism for fraud.  Without Husky’s resolution of the Circuit split, debtors could point to the rationale in decisions such as the Fifth Circuit’s to discharge debts that would have otherwise been tainted by fraudulent transfers.  Moreover, without the Husky decision, debtors could structure transfers aimed at shielding assets from the reach of creditors similar to Ritz’s scheme, yet still obtain the benefits of a discharge of debt.
Yvanna Custodio is an Associate at Weil Gotshal & Manges, LLP in New York.