Supreme Court Makes It Easier to Show “Actual Fraud” in Bankruptcy Dischargeability Actions

For individual debtors, obtaining a discharge of their debts in bankruptcy is a prime objective.  That discharge is, however, subject to a number of exceptions designed to prevent abuse of the bankruptcy process.

Among those exceptions is 11 U.S.C § 523(a)(2)(A) which states that an individual debtor is not discharged of any debt –

“… for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor’s or an insider’s financial condition…”

Thus, a creditor who successfully proves conduct by an individual debtor involving false pretenses, a false representation or actual fraud can have that debt ruled non-dischargeable.

Federal circuit courts have disagreed on the necessary elements of “actual fraud” in this context.  The Seventh Circuit has taken a broad view, finding that misrepresentation is not the only type of fraud that is non-dischargeable under § 523(a)(2)(A).  See McClellan v Cantrell, 217 F.3d 890, 893 (7th Cir. 2000).  But the Fifth Circuit (which covers Texas, Louisiana and Mississippi) held that a creditor seeking to block the discharge of a debt for “actual fraud” had to prove that the creditor’s justifiable reliance in extending credit resulted from a false representation by the debtor.  See Gen. Elec. Capital Corp. v Acosta, 406 F.3d 367, 372 (5th Cir. 2005).

The Fifth Circuit last followed its prior approach in 2015. In Husky Int’l Electronics v Ritz, 787 F.3d 312 (5th Cir. 2015), a Chapter 7 debtor transferred his company’s funds to other entities he controlled without receiving equivalent value in return and after incurring a debt to the petitioning creditor.  The Fifth Circuit held that these transfers did not constitute “actual fraud” in the absence of any false representation by the debtor to the creditor.

The United States Supreme Court granted certiorari in Husky and acted to resolve the split between the circuits on this issue.  In an 7-1 decision, the Supreme Court reversed the Fifth Circuit to hold that the term “actual fraud” as used in § 523(a)(2)(A) encompasses fraudulent conveyance schemes—even in the absence of a false representation by the debtor.  Husky Int’l. Electronics v Ritz, 136 S. Ct. 1581 (May 16, 2016).

Writing for the majority, Justice Sotomayor concluded that “[t]he term ‘actual fraud’ in § 523(a)(2)(A) encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a fraudulent representation.”  The Court noted that, before the 1978 amendment of the Bankruptcy Code, debtors were prohibited from discharging debts that were obtained by “false pretenses or false representations.” Therefore, the Court reasoned, Congress’ later addition of “actual fraud” to the language of § 523(a)(2)(A) was not intended to be duplicative of “false representation.”  Going all the way back to the Statute of 13 Elizabeth (one of the first bankruptcy acts) and subsequent English bankruptcy practice and tracing forward, the Court added that “fraud” can include debtor transfers that impair a creditor’s ability to collect on a debt and circumstances where the debtor and the recipient of assets conveyed were held liable even in the absence of representations to the debtor’s creditors.

Significantly, the Court also rejected the notion that § 523(a)(2)(A) should be restricted only to cases where debt or credit is “obtained by” the transferor of a fraudulent conveyance; instead, it suggested that any transferee who receives a fraudulent conveyance with knowledge could also be subject to a non-dischargeability claim under §5 23(a)(2)(A) for any debts traceable to the fraudulent conveyance.  While Justice Thomas argued that the phrase “obtained by” requires fraud at the point that credit was obtained and should not include fraudulent transfers, his dissent did not carry the day.

By adopting a broad definition of “actual fraud” in the context of 11 U.S.C. § 523(a)(2)(A), the Supreme Court has resolved the circuit split and appears to have now made matters a little easier for creditors seeking to have debts incurred by bad acing debtors ruled non-dischargeable in bankruptcy.

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