Client Alert
"Fraud as defined by
the US Bankruptcy Code"
On May 16, 2016, the Supreme Court of the United States issued its opinion, in Husky International v. Daniel Ritz, ___ S. Ct. ___ (2016). The Court reviewed a case where Chrysalis Mfg. Corp. incurred a debt with Husky International. Ritz, a Chrysalis director and part owner, drained the company of assets sufficient to pay the debt by transferring sums of money to other entities controlled by him, only to later file for Chapter 7 bankruptcy. Husky sued him to make him personally liable and contended that the debt was not dischargeable because the scheme Ritz had followed constituted "actual fraud" under the Bankruptcy Code.   The District Court held Ritz personally liable under state law, but also held that the debt was not obtained by actual fraud and, therefore, could be discharged in bankruptcy. The Fifth Circuit affirmed, holding that a finding of "actual fraud" required for Ritz to have made a false representation to Husky, the creditor.

The Court, in an opinion delivered by Justice Sonia Sotomayor, rejected that a debt is "obtained by... actual fraud" only if the debtor's fraud involves a false representation to a creditor. The Supreme Court held that the term "actual fraud" in §523(a)(2)(A) of the Bankruptcy Code encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation. There was an existing split among the Circuits over whether "actual fraud" required a false representation or whether it encompasses other traditional forms of fraud that can be accomplished without a false representation, such as a fraudulent conveyance of property made to evade payment to creditors.

Before 1978, the Bankruptcy Code prohibited debtors from discharging debts obtained by "false pretenses or false representations," but in the Bankruptcy Reform Act of 1978, Congress added "actual fraud" to that list. Congress did not intend "actual fraud" to mean the same thing as "a false representation," as the historical meaning of "actual fraud" provides stronger evidence that the phrase has long encompassed a transfer scheme designed to hinder the collection of debt.

"Actual" fraud stands in contrast to "implied" fraud, which describe acts of deception that "may exist without the imputation of bad faith or immorality." Thus, anything that counts as "fraud" and is done with wrongful intent is "actual fraud." Common law indicates that fraudulent conveyances, although a "fraud," do not require a misrepresentation from a debtor to a creditor.

In fraudulent conveyances, which typically involve "a transfer to a close relative, a secret transfer, a transfer of title without transfer of possession, or grossly inadequate consideration," the fraudulent conduct is not dishonestly inducing a creditor to extend a debt. The fraudulent conduct is in the acts of concealment and hindrance.  Conveyance which hinders delays or defrauds creditors shall be void against the recipient unless that party received it in good faith and for consideration. This principle underscores the point that a false representation has never been a required element of "actual fraud."

The Court stated that §523(a)(2)(A) is not incompatible with §727(a)(2), which prevents a debtor from discharging all of his debts if, within the year preceding the bankruptcy petition, he "transferred, removed, destroyed, mutilated, or concealed" property "with the intent to hinder, delay or defraud a creditor or an officer of the estate charged with custody of property." The Court noted that §727(a)(2) is broader than §523(a)(2)(A) in scope, preventing an offending debtor from discharging all debt in bankruptcy, but is narrower than §523(a)(2)(A) in timing, applying only if the debtor fraudulently conveys assets in the year preceding the bankruptcy filing. In short, the Court concluded that while §727(a)(2) is a blunt remedy for actions that hinder the entire bankruptcy process, §523 (a)(2)(A) is a tailored remedy for behavior connected to specific debts.

The importance of the word "or" in the addition of "actual fraud" in §523(a)(2)(A) is that that this final item in the list is not intended to modify or limit the others. The Opinion of the Court states that the phrase "actual fraud" has the meaning that has been long held, which encompasses fraudulent conveyance schemes, even when those schemes do not involve a false representation.

Justice Thomas dissented, stating that the majority's opinion departed from the "plain language of §523 (a)(2)(A) as interpreted by" the Court's prior precedents and without support in the text of the Bankruptcy Code.

For further information you may contact any of the attorneys in the Litigation & Trial Practice Department.

Rossell M. Barrios-Amy 
Solymar Castillo-Morales
Edgardo Colón-Arrarás
Thaïs Passerieu dit Jean-Bernard 
Rosanna Rivero-Marín
Carlos A. Rodríguez-Vidal 
Wilda Rodríguez-Plaza

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