Misrepresentation Not Required for “Actual Fraud”

The U.S. Supreme Court recently held that a debtor who transferred assets from one company he controlled to other related entities in order to protect the assets from creditors could not discharge the underlying debt in a subsequent bankruptcy. The debtor committed “actual fraud” by transferring the assets and, therefore, the debt was nondischargeable under Bankruptcy Code Sec. 523(a)(2)(A). Although the debtor did not make any false representations regarding the transfer, a misrepresentation by the debtor is not a necessary prerequisite for a showing of “actual fraud” under Sec. 523(a)(2)(A).

Fraudulent Conveyance Scheme

The debtor had an ownership interest in a company that was indebted to a supplier of electronic components. To avoid paying the debt, the debtor transferred assets that could have been used to pay the supplier to other business entities in which the debtor had an interest. The supplier sued the debtor directly to recover the debt. The supplier argued that the debtor’s inter-company transfers amounted to “actual fraud” for purposes of a state law that authorized the creditor to sue the debtor for company debts. The debtor then filed for bankruptcy. The supplier filed an adversary proceeding in the bankruptcy case, arguing that the debt could not be discharged in bankruptcy because it was “obtained by … actual fraud” within the meaning Sec. 523(a)(2)(A). The district court rejected the supplier’s argument, holding that the debt was not “obtained by … actual fraud” because the debtor never made any false representations to the supplier concerning the assets or the transfers. The Fifth Circuit affirmed.

False Representations

Section 523(a)(2)(A) declares debts nondischargeable to the extent the debts are based on false pretenses, a false representation, or actual fraud. A split of authority has developed regarding the forms of fraud encompassed in the phrase “actual fraud,” with some courts holding that regardless of the form of fraud involved a finding of actual fraud must include an express or implied misrepresentation by the debtor.

Other courts reject the requirement of a false representation. For example, in McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000), the Seventh Circuit held that although many courts assume that a finding of actual fraud requires proof of a false representation by the debtor, the language of Sec. 523(a)(2)(A) is not limited to fraudulent misrepresentations but includes acts intended to “circumvent and cheat another.” Under McClellan, a scheme to transfer assets to avoid the payment of debt would constitute an act to “circumvent and cheat” the creditor, and the debt would be nondischargeable as obtained by actual fraud within the scope of Sec. 523(a)(2)(A).

Fraud at Common Law

Prior to 1978, Sec. 523 did not include “actual fraud” as a basis for denying the dischargeability of certain debts. Only debts obtained by false pretenses or a false representation were nondischargeable under the original provision. The phrase “actual fraud” was added to the statute in 1978 and, as such, the Supreme Court reasoned that the phrase must mean something different than “false representation” or “false pretense.” To find the meaning, the Court turned to common law.

Although the elements of fraud have evolved over time with widely varying fact patterns, the Court noted that from very early bankruptcy practice, the common law description of “fraud” included transfers of assets that impaired a creditor’s ability to collect a debt. A false representation by the debtor was not required at common law as there was often limited opportunity for fraudulent inducement by the debtor where the fraud involved was the transfer of property.

The debtor argued that as used in Sec. 523(a)(2)(A) the phrase “actual fraud” must mean something other than a fraudulent transfer of property because other sections of the Bankruptcy Code already address wrongful property transfers. However, there are meaningful distinctions between the different types of transfers addressed by the other sections of the Code. For example, some fraudulent transfers involve debtors acting in a fiduciary capacity and others entail willful and malicious injury. Each type of transfer is easily distinguished from the other, and the Court found it unnecessary to attempt to create an “artificial” definition of “actual fraud” to avoid overlap. Meaningful distinctions between Sec. 523(a)(2)(A) and other sections of the Code that address fraudulent transfers are preserved despite any overlap.

“Obtained” by Fraud

The debtor also argued that the debt owed to the supplier was not “obtained by” fraud. The debtor transferred assets to avoid payment of the debt, but the debt itself did not result from the transfer. The Court agreed that the debtor did not “obtain” the debt in a fraudulent conveyance. However, the recipient of the assets may have committed fraud by participating in the transfer, and the recipient’s fraud would satisfy the “obtained by” requirement of Sec. 523(a)(2)(A). The Court also rejected the argument that the phrase “obtained by … actual fraud” requires that a creditor actually rely on the debtor’s fraud “at the inception of a credit transaction.” Reliance is a requisite element only if the fraud is based on misrepresentation.

Finally, the debtor argued that the phrase “actual fraud” modifies rather than adds to the exceptions to discharge listed in Sec. 523(a)(2)(A). According to the debtor, a debt obtained by either false pretenses or a false representation is nondischargeable only if actual fraud also is involved. However, the section reads in part that debts “obtained by … false pretenses, a false representation, or actual fraud” are nondischargeable. The debtor’s reading of the statute would involve replacing the word “or” with “by.” The Court could not find any support for “such an unusual statutory modification” and rejected the debtor’s argument.

Husky International Electronics, Inc. v. Ritz, 2016 U.S. LEXIS 3048, 578 U.S. ___ (2016)



About the Author:

George Basharis, JD

George Basharis, J.D. is a practicing bankruptcy attorney in the Northern District of Illinois. He has represented dozens of individuals and small businesses in federal bankruptcy proceedings and related matters. George also advises the CINgroup on a variety of aspects regarding bankruptcy law. He has authored books, white papers, customer newsletters and conducted speaking engagements regarding bankruptcy.