For many Supreme Court
watchers, yesterday’s decision in Husky International
Electronics v. Ritzmay 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.
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