One of the goals of the Bankruptcy Code is to provide a debtor with a fresh start. The discharge of prepetition debts at the conclusion of a bankruptcy case is one of the most important ways to attain this fresh start.  On May 16, 2016, the Supreme Court made it harder for debtors to obtain a fresh start by broadening an exception to discharge.

Section 523(a)(2)(A) of the Bankruptcy Code provides that an individual debtor is not discharged from any debt “for money, property [or] services … to the extent obtained by false pretenses, a false representation, or actual fraud[.]” Circuits split as to whether actual fraud under Section 523(a)(2)(A) requires an affirmative misrepresentation; the Fifth Circuit had held that this was a necessary element to prevent discharge, but the Seventh Circuit had held that “actual fraud” encompassed a broader range of behaviors.

The Supreme Court resolved this split, rejecting the Fifth Circuit’s narrow interpretation and finding that the term “actual fraud” does not need to include an affirmative misrepresentation by the debtor. With this broader reading, debtors will be unable to discharge prepetition debts where there is evidence that they inappropriately siphoned of their assets prior to filing for bankruptcy. Husky Int’l Elecs., Inc. v. Ritz, No. 15-145, 2016 WL 2842452 (U.S. May 16, 2016).

Background.

Husky International Electronics, Inc., a Colorado-based supplier of electrical device components, sold products to Chrysalis Manufacturing Corp over a four-year period. Chrysalis, under the guidance of Daniel Lee Ritz, Jr. (a director and 30% owner of the company), purchased nearly $164,000 worth of components from Husky.  During the latter part of this four-year period, Ritz drained Chrysalis of its assets by transferring large sums of money to other entities that he controlled and never paid Husky for the components it supplied.

In May 2009, Husky filed a lawsuit against Ritz, seeking to hold him personally responsible for the debt and claiming that his transfer constituted “actual fraud” under Texas law. Six months later, Ritz filed for bankruptcy under Chapter 7 of the Bankruptcy Code.  Husky continued to pursue its claim by initiating an adversarial proceeding in Ritz’s bankruptcy case.  Husky argued that the debt should not be discharged in the bankruptcy because the intercompany transfer scheme also constituted “actual fraud” under 11 U.S.C. § 523(a)(2)(A) and thus was not subject to discharge.

The United States Bankruptcy Court for the Southern District of Texas held that Ritz was personally liable for the debt under Texas law, but that he had not engaged in “actual fraud” under the Bankruptcy Code. It found that the debt could be discharged in the bankruptcy.  The Fifth Circuit affirmed that there was no “actual fraud” under section 523(a)(2)(A) of the Bankruptcy Code, holding that a necessary element of “actual fraud” is a misrepresentation from the debtor to the creditor.  Because Ritz did not make any affirmative false representations to Husky regarding the assets, it reasoned, there was no “actual fraud.”

Analysis.

In a 7-1 decision reversing the Fifth Circuit, the Supreme Court considered the legislative intent behind Section 523 as well as the historical meaning of “actual fraud.”

Legislative Intent

The pre-1978 Bankruptcy Code prohibited debtors from receiving a discharge of their debt if the debt was obtained by “false pretenses or a false representation.” With the Bankruptcy Reform Act of 1978, Congress further prohibited debtors from receiving a discharge of debts obtained by “actual fraud.”  Writing for the majority, Justice Sotomayor pointed out that when Congress acts to amend a statute, the amendment is presumably meant to have real and substantial effect.  She therefore questioned the Fifth Circuit’s interpretation that “actual fraud” was meant to have the same meaning as “false representation.”

Historical Meaning

Justice Sotomayor asserted that it has been clear since the beginning of English bankruptcy practice that the term “fraud” has been used widely to include transfers that impair a creditor’s ability to collect a debt—not just transfers where the debtor has made a misrepresentation to the creditor and induced him to engage in a transaction. She also cited to the common law, which further indicates that “fraudulent conveyances, although a ‘fraud,’ do not require a misrepresentation from a debtor to a creditor.”

Impact.

Noting that “there is no need to adopt a definition for all times and all circumstances,” the Supreme Court left the door open to further broaden the definition of “actual fraud” and make exceptions to granting debtors a discharge.

On its face, this ruling applies to an individual bankruptcy in chapter 7. However, section 523 applies expressly to the discharge under section 1141 of the Bankruptcy Code.  This could benefit creditors in cases involving actual fraud where the creditors could continue to pursue recoveries for the fraud even after confirmation of the plan.  This could also increase leverage for creditors in cases with actual fraud, in that the knowledge those claims won’t be discharged could facilitate greater negotiation.