Justices Reverse 5th Circ. Bankruptcy Decision

(CN) — The Supreme Court ruled Monday that an actual fraud exception to bankruptcy debt discharge includes fraudulent asset transfers that don't involve a false representation to a creditor.

Husky International Electronics says Chrysalis Manufacturing Corp. owed the electronic device components seller $163,000 for goods delivered under a written contract. Daniel Ritz was Chrysalis' director and controlled the company's finances, court records show.

Between 2006 and 2007, Ritz transferred money from Chrysalis to other entities he owned, according to a Fifth Circuit ruling. A bankruptcy court then found that Chrysalis' debts were greater than its assets.

Husky sued Ritz in 2009, trying to hold him personally liable for the $163,000 debt, but Ritz filed for Chapter 7 bankruptcy later that year.

In a separate action, the Colorado-based electronics company claimed in bankruptcy court that Ritz's alleged debt was not dischargeable.

The bankruptcy court ruled against Husky in 2011, finding that Ritz did not make a false representation to the electronic components dealer - meaning he did not perpetrate "actual fraud" against the company, a requirement for piercing the corporate veil under Texas law.

A Southern Texas district court upheld the bankruptcy court's decision, ruling that Husky did not establish actual fraud on the part of Ritz because it did not show that he made a misrepresentation.

The Fifth Circuit affirmed the district court in May of this year. The New Orleans-based appeals court ruled that no exceptions apply that would prevent the alleged debt from being discharged by bankruptcy.

Judge Carolyn King also noted that Husky did not raise a fraudulent transfer argument that could have helped its case.

"The statutory exceptions to discharge raised by Husky are inapplicable, and Husky cannot rely on general principles of equity to expand those exceptions," King wrote for a three-judge panel in the May ruling. "Another provision of the bankruptcy code...may have applied to redress the conduct of which Husky complains - but Husky failed to raise that provision."

Husky filed a petition for writ of certiorari with the U.S. Supreme Court on last July. The high court agreed to take the case in November.

On Monday, the justices reversed the Fifth Circuit, ruling 7-1 that the term "actual fraud" includes fraudulent conveyance schemes, even when those schemes don't involve a false representation.

"Just as a fiduciary who engages in a fraudulent conveyance may find his debt exempted from discharge under [bankruptcy code], so too would a fiduciary who engages in one of the fraudulent misrepresentations that form the core of Ritz' preferred interpretation of [the law]," Justice Sonia Sotomayor wrote for the majority. "We see no reason to craft an artificial definition of 'actual fraud' merely to avoid narrow redundancies in [bankruptcy code] that appear unavoidable."

The majority also disagreed with Ritz' view that Congress added "actual fraud" to federal bankruptcy code to restrict the reach of debt discharge exceptions.

"In Ritz' view, 'actual fraud' was inserted as the last item in a disjunctive list—'false pretenses, a false representation, or actual fraud' —in order to make clear that the 'false pretenses' and 'false representation[s]' covered by the provision needed to be intentional," Sotomayor wrote. "Ritz asks us, in other words, to ignore what he believes is Congress''im­prudent use of the word 'or,'' ...and read the final item in the list to modify and limit the others. In essence, he asks us to change the word 'or' to 'by.' That is an argument that defeats itself."

Justice Clarence Thomas dissented, disagreeing with the majority's interpretation of the bankruptcy code.

"[The discharge exception] applies only when the fraudulent conduct occurs at the inception of the debt, i.e., when the debtor commits a fraudulent act to induce the creditor to part with his money, property, services, or credit. The logical conclusion then is that "actual fraud"—as it is used in the statute—covers only those situations in which some sort of fraudulent conduct caused the creditor to enter into a transaction with the debtor," Thomas wrote. (Emphasis in original).

"A fraudulent transfer generally does not fit that mold, unless, perhaps, the fraudulent transferor and the fraudulent transferee conspired to fraudulently drain the assets of the creditor. But the fraudulent transfer here, like all but the rarest fraudulent transfers, did not trick the creditor into selling his goods to the buyer, Chrysalis Manufacturing Corporation. It follows that the goods that resulted in the debt here were not 'obtained by' actual fraud," he wrote.

Subscribe to Closing Arguments

Sign up for new weekly newsletter Closing Arguments to get the latest about ongoing trials, major litigation and hot cases and rulings in courthouses around the U.S. and the world.

Email *

Submit