A Win for Creditors: Supreme Court Expands the Meaning of Actual Fraud for Bankruptcy Discharge

The United States Supreme Court recently decided a case that will be a powerful tool for lenders dealing with borrowers who engage in schemes to avoid payment of their debts, such as an improper transfer of their assets before they file bankruptcy, and who then attempt to get a discharge of any claim against them resulting from their scheme.  

The case, Husky International Electronics, Inc. v. Ritz, involved the meaning of the phrase “actual fraud” under the Bankruptcy Code.  In Husky, the Supreme Court held that “actual fraud” under the Bankruptcy Code does not require proof of a borrower's specific fraudulent misrepresentation.  If a lender seeks to deny a debtor’s discharge in bankruptcy based on fraud, the lender can do so by proving the debtor's fraudulent scheme-even if the debtor has not made any false statements.

Under the Bankruptcy Code, a debtor filing for bankruptcy protection is entitled to a “fresh start.”  This fresh start includes a discharge of most pre-bankruptcy debts.  But a discharge in bankruptcy is not absolute.  Section 523 of the Bankruptcy Code includes several exceptions to discharge, everything from unpaid taxes to certain student loan obligations.  The exceptions also include debts obtained by “false pretenses, a false representation, or actual fraud.”  Before the Supreme Court decided Husky, lower courts were split as to whether actual fraud required a false representation or omission made by the debtor and relied upon by the creditor.

In Husky, Daniel Ritz was a director and part owner of a company that owed $162,000 to Husky for electronic components sold to Ritz’s company.  Over several years, during a period when Ritz's company wasn't paying Husky, Ritz initiated several large cash transfers from the company to other companies he controlled.  

Husky sued Ritz personally to collect the debt.  Ritz responded by filing a Chapter 7 bankruptcy petition to discharge any debt he owed to Husky.  Husky filed a complaint in Ritz's bankruptcy action and objected to his discharge.  The lower courts held that Ritz was personally liable to Husky, but reasoned that because Ritz had made no misrepresentations to induce Husky into extending credit to his company or about the transfer of his company's assets, he had not engaged in actual fraud and therefore the debt was dischargeable.

The Supreme Court disagreed.  In a 7-1 decision, it held that actual fraud under the Bankruptcy Code includes inducement-based fraud and a fraudulent transfer scheme.  Acts of “concealment and hindrance” can constitute actual fraud, even if there are no false representations by the debtor to the creditor.  The Court determined that historically the meaning of actual fraud encompassed schemes that did not require false inducements or misrepresentations.  Although the Court held that the transfer constituted actual fraud, it left open the question as to whether the debt to Husky was “obtained by” Ritz’s fraudulent transfer scheme, as is required by the Bankruptcy Act exception to discharge, and remanded the case for further findings on that issue.  

The Supreme Court’s expansive definition of “actual fraud” in Husky will allow creditors to avoid a debtor’s discharge when a debtor moves assets pre-petition to avoid or hinder payment to the creditor.  The decision should also deter sophisticated debtors from transferring assets before filing bankruptcy.  Notably, however, the burden is on the creditor to object to a debtor’s discharge and prove the fraudulent scheme.  Creditors cannot expect the bankruptcy court or a bankruptcy trustee to do this work for them.

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