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Argument preview: What did Congress mean by “actual fraud” in Bankruptcy Code?


Chrysalis Manufacturing Corp. was a Texas-based company that made circuit boards. Over a four-year period between 2003 and 2007, Chrysalis bought electric device components from Husky International Electronics, a Colorado distributor. Problems arose when Chrysalis failed to pay Husky all that it was owed, running up a debt of nearly $164,000. Husky then tried to recover the money from one of Chrysalis’s owners. Tomorrow the clash reaches the U.S. Supreme Court, where the Justices will hear oral arguments on the scope of the provision of the Bankruptcy Code at the heart of the dispute.

In May 2009, Husky filed a lawsuit in federal court against Daniel Lee Ritz, Jr., a partial owner of Chrysalis, seeking to recover from him the money that Chrysalis owed it. But before the federal district judge could rule in that lawsuit, Ritz filed for bankruptcy under Chapter 7 of the Bankruptcy Code, in which a debtor’s assets are sold to repay his creditors and the debts discharged.

The dispute before the Supreme Court involves the Bankruptcy Code’s treatment of money that Ritz moved from Chrysalis to other companies that he owned. In the bankruptcy court, Husky argued that Ritz’s debt was not dischargeable because of Section 523(a)(2)(A) of the Bankruptcy Code, which prohibits a debtor from discharging “any debt . . . for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by . . . false pretenses, a false representation, or actual fraud.”

The issue is whether this provision of the Bankruptcy Code only applies when the debtor makes a false representation to the creditor (under which Ritz wins), or whether it also bars discharge when the debtor has obtained money through a “fraudulent conveyance” to avoid paying the debt (under which Husky may win). The lower courts agreed with Ritz that the debt could be discharged because Husky had not alleged any misrepresentations made by Ritz to it. But – likely because that holding conflicted with a ruling by another federal court of appeals that the debtor need not have made misrepresentations to the creditor – the Justices agreed last fall to weigh in.

Arguing that the debt is not dischargeable, Husky emphasizes that Congress changed the Bankruptcy Code to limit discharges. Before 1978, Section 523(a)(2)(A) only prohibited the discharge of debts obtained by false pretenses or misrepresentations. Congress added the phrase “actual fraud” in 1978, Husky argues, to broaden the scope of the provision and ensure that it prohibited the discharge of debts “arising from all intentionally fraudulent conduct.” That understanding of the term “actual fraud,” Husky continues, is reflected in both the common law – going back as far as the sixteenth century – and the Court’s own cases. The common law and the Court also agree, Husky asserts, that “actual fraud” includes the kind of conduct at issue in this case, which Husky characterizes as a “fraudulent conveyance” – that is, the transfer of money when the person or entity to whom the money is transferred knows that the transfer is being made to defraud the transferor’s creditors.

In making this argument, Husky has the backing of the federal government, which filed a brief supporting it and will share Husky’s argument time tomorrow. The government tells the Justices that, to show that Ritz can be held responsible for Chrysalis’s debts under the Texas law governing corporations, Husky will have to demonstrate that Ritz “used the transferred funds for his direct personal benefit, by sending them to other corporations that he controlled.” If he can do so, the government contends, then Ritz’s debt is “correctly viewed as one for money ‘obtained by . . . actual fraud’” under Section 523(a)(2)(A).

For his part, Ritz defends the lower court rulings that the debt is dischargeable, telling the Court that the statute only encompasses “debts that are the product of a misrepresentation that induced the creditor to part with whatever it is that gave rise to the debt.” And it cannot apply to his case, he maintains, because his only contact with Husky was “a brief telephone conversation that took place more than four years into the contractual relationship.”

Ritz attributes a more limited meaning to the phrase “actual fraud”: rather than serving as a broader catch-all to define what constitutes fraud, as Husky suggests, it makes clear that Section 523(a)(2)(A) includes only intentional – as opposed to constructive – fraud. This interpretation is supported, Ritz asserts, by the legislative history, even if Congress’s use of the phrase “or actual fraud” to implement that change “may not have been the most precise way of going about that task.”

Ritz also disputes Husky’s insistence that, for purposes of Section 523(a)(2)(A), the term “actual fraud” extends to fraudulent conveyances. “Whether fraudulent conveyances are a form of common-law fraud is largely irrelevant,” he argues: “debts attributable to fraudulent conveyances do not fall within Section 523(a)(2)(A) because they are not debts for anything ‘obtained by’ the debtor from the creditor.” If Congress had wanted Section 523(a)(2)(A) to sweep in fraudulent conveyances, he continues, it could have said so directly. Nor is there any reason, he maintains, to worry that a ruling in his favor will leave “a creditor injured by a fraudulent conveyance . . . without recourse”: Congress has specifically addressed scenarios in which “a debtor attempts to use the Bankruptcy Code as a vehicle for evading his debts” in other provisions.

Supporters for each side warn that the other side’s interpretation of Section 523(a)(2)(A) will result in serious consequences for the bankruptcy system. The National Association of Bankruptcy Trustees, which represents the individuals appointed by the court to oversee bankruptcy cases, filed a “friend of the Court” brief backing Husky. It cautions that a ruling in Ritz’s favor which allows the lower court’s decision to stand will “create[] a dangerous loophole through which the boldest and most dishonest debtors can ‘game the system’” by racking up debts, transferring their assets to other entities, and declaring bankruptcy. But the National Association of Consumer Bankruptcy Attorneys, which filed a brief supporting Ritz’s position, disputes that contention, pointing out that Husky does not provide any “empirical evidence to suggest that there is widespread misconduct by business debtors [or] that the subset of the ‘ingeniously dishonest’ contains more than a few Bernie Madoffs.” Rather, NACBA asserts, a ruling in Husky’s favor would harm the self-employed and small-business owners who often file for bankruptcy under Chapter 7. For that particular group of debtors, NACBA explains, the transfers of money between personal and business accounts are both frequent and commonplace; by potentially placing such transfers under a cloud, Husky’s interpretation of Section 523(a)(2)(A) would give those debtors’ creditors “unjustified and unnecessary leverage.”

Recommended Citation: Amy Howe, Argument preview: What did Congress mean by “actual fraud” in Bankruptcy Code?, SCOTUSblog (Feb. 29, 2016, 1:23 PM),