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Opinion analysis: Justices adopt broader reading of the phrase “actual fraud” in bankruptcy law

For many Supreme Court watchers, yesterday’s decision in Husky International Electronics v. Ritz may have been overshadowed by some of the other, higher-profile rulings in cases involving (among other things) the Affordable Care Act’s birth-control mandate and Article III standing.  But the ruling in Husky proved to be an important one for bankruptcy lawyers. By a vote of seven to one, the Court closed what a group of bankruptcy trustees had described as a “dangerous loophole” that might have allowed “the boldest and most dishonest debtors” to “game the system” by racking up debts, transferring their assets to other entities, and declaring bankruptcy. 

The case arose after Husky International, a Colorado-based distributor, sold electronic device boards to Chrysalis Manufacturing Corp., a Texas-based company that made circuit boards.  After making purchases over a four-year period, Chrysalis ran up a debt to Husky of $164,000.  During that same time, one of Chrysalis’s directors, Daniel Lee Ritz, Jr. (who also owned at least thirty percent of the company’s common stock), transferred money from Chrysalis to other companies that he controlled.

When the Chrysalis debt went unpaid, Husky tried to recover its debt personally from Ritz, who filed for bankruptcy.  Husky argued that Ritz could not wipe out the Chrysalis debt through bankruptcy because Section 523(a)(2)(A) of the Bankruptcy Code bars debtors from discharging debts “obtained by false pretenses, a false representation, or actual fraud.”  According to Husky, this provision applied because Ritz had engaged in a “fraudulent transfer” of the money from Chrysalis, which owed that money to creditors.

But the lower courts rejected that argument, ruling that Section 523(a)(2)(A) does not apply to these facts because a debt can only be “obtained by actual fraud” if “the debtor’s fraud involves a false representation to a creditor” – which, the lower courts concluded, Ritz’s conduct towards Husky did not.

The Supreme Court agreed to review the issue last fall, and yesterday it reversed the lower court’s decision.

For purposes of Section 523(a)(2)(A), Justice Sonia Sotomayor explained in her opinion for the Court, the term “actual fraud” includes forms of fraud, like the fraudulent transfers in this case, that do not involve a false representation.  This conclusion, the Court emphasized, is supported by the history of the U.S. bankruptcy laws.  In particular, the Court noted, although the Bankruptcy Code had once barred the discharge of debts obtained by “false pretenses” or “false representations,” Congress specifically amended the law to add the phrase “actual fraud” – a change suggesting that Congress would not have intended “actual fraud” to have the same meaning as “false representation.”

Going back even further in the history of bankruptcy law, the Court observed that yesterday’s ruling is also bolstered by the history of the phrase “actual fraud” – dating back to 1571.  That history, the Court emphasized, “provides even stronger evidence that the phrase has long encompassed the kind of conduct alleged to have occurred here:  a transfer scheme designed to hinder the collection of debt.”  And the same is true for the common law, the Court added, which has never required a false representation as part of “actual fraud.”

Justice Clarence Thomas was the lone dissenter.  He agreed with the majority that, under the common law, the phrase “actual fraud” includes fraudulent transfers.  But, he continued, courts interpreting a statute like Section 523(a)(2)(A) must also look at the broader context of the law to determine whether the phrase “actual fraud” fits.  Here, he contended, Section 523(a)(2)(A) requires that the debts must be “obtained by false pretenses, a false representation, or actual fraud.”  Congress’s use of the phrase “obtained by,” he said, means that the fraudulent conduct must occur when the debt is first incurred, and it must have “caused the creditor to enter into a transaction with the debtor.”  A fraudulent transfer, he reasoned, will not “generally fit that mold,” and indeed it does not here:  Husky sold its products to Chrysalis, and Ritz never spoke with anyone at Husky until after the products had been shipped to Chrysalis.  Moreover, Thomas added, the bankruptcy court “found that there was no evidence that Ritz transferred the funds to avoid” paying the money that Chrysalis owed to Husky.

Yesterday’s ruling settled a split among the lower courts on the question of whether, for purposes of Section 523(a)(2)(A), the phrase “actual fraud” requires a false representation.  The decision also reduced the likelihood that the Bankruptcy Code can be used – as Husky and its supporters put it – as an “engine of fraud.”  It remains to be seen whether the decision will affect debtors who are self-employed or own small businesses, who (as a group of consumer bankruptcy attorneys supporting Ritz warned) often transfer money between their personal and business accounts.

Recommended Citation: Amy Howe, Opinion analysis: Justices adopt broader reading of the phrase “actual fraud” in bankruptcy law, SCOTUSblog (May. 17, 2016, 5:57 PM),