The Supreme Court, in Husky International Electronics, Inc. v. Ritz, 578 U.S. _____ (2016), has seemingly handed a powerful weapon to creditors and creditors’ bankruptcy counsel, by ruling that a fraudulent conveyance can be the basis of a nondischargeability action in under Section 523(a)(2). As a creditors’ bankruptcy attorney, I applaud the continuing trend of the Court to prevent wrongdoers from using the narrow language of the Bankruptcy Code to shelter the profits of their mis-deeds. But while I can quibble about the Court’s reasoning (and I will), I do not believe that the decision will be as useful to creditors as it seems. The Court’s holding is that the term “actual fraud” in §523(a)(2) includes frauds other than misrepresentation. This is not a sweeping pronouncement that fraudulent conveyances are, ipso facto, grounds for an exception to discharge.
[Completely lost but intrigued? The goal of a personal bankruptcy is a “discharge” voiding debts. There are a handful of circumstances where a creditor is permitted to have its claim “excepted” from the bankruptcy discharge, including when the creditor can show that its claim arose because of fraud committed by the debtor. But the courts are extremely hesitant to permit exceptions to the discharge, because they essentially void the whole process.]
In the Husky case, the creditor – Husky – sold $160,000+ worth of material to Chrysalis Manufacturing. Ritz, director and major shareholder of Chrysalis, emptied the Chrysalis coffers by transferring large sums to other companies (coincidentally controlled by Ritz). When Husky couldn’t recover from Chrysalis, Husky sued Ritz under Texas’ corporate code, which allows creditors to hold certain corporate officers, directors and shareholders responsible for a corporate debt when the company is or becomes insolvent. Rather than (literally) pay the piper, Ritz filed a Chapter 7. Husky filed an adversary suit in the bankruptcy court to finish what it had started in the state court – a judgment against Ritz personally for the fraudulent transfer of Chrysalis assets – and also to have the claim excepted from any discharge that Ritz might receive.
The trial court found that Ritz was personally liable under the Texas law, but rejected Husky’s effort to have the claim excepted from discharge. The court found that the claim was not “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.” 11 U.S.C. §523(a)(2). Essentially the court said – “You win! Here’s your judgment; you can’t collect it. Thanks for playing.” Needless to say, Husky was unsatisfied by its Pyrrhic victory and asked the Fifth Circuit Court of Appeals to reverse. The Fifth Circuit, though, affirmed the trial court ruling, holding that “actual fraud” requires a false representation by Ritz, and there were not any representations in this case. Even if Ritz acted fraudulently to prevent Husky from recovering its claim, without a misrepresentation there is no “actual fraud.”
The Supreme Court reversed the Fifth Circuit. The Court found the idea that “actual fraud” in section 523(a)(2) requires a false representation to be nonsensical, because that section already uses the words “false representation” and the 1978 amendment to the Code added “actual fraud” to the existing language. The Court concluded, reasonably enough, that Congress meant to change the reach of the existing statute when it added the words “or actual fraud” to the language in 1978. The Court then went on to explain that the words “actual fraud” were added to address fraudulent conduct which is not necessarily based upon representations. This rather clear explanation was followed by a couple of pages on the history of fraudulent conveyances, going all the way back in English law to the “Statute of 13 Elizabeth.” [That is Elizabeth I, the Virgin Queen, monarch while Shakespeare was writing plays.] Why spend so much time going over the historical antecedents to the current fraudulent conveyance statutes? To show that fraudulent conveyances have been considered actual fraud for a very long time. When the Court reaches back to 1571, they are trying to say that the book is closed on disputing the conclusion. And so fraudulent conveyances they are exactly the kind of fraud that putting the phrase “actual fraud” into §523(a)(2) was meant to address. The Court described the long history of fraudulent conveyances to convince an audience, which needs no convincing, that fraudulent conveyances are bad and the miscreants who perpetrate them should not be allowed to use the bankruptcy code to protect them from their deserved comeuppance. So far, so good.
Ritz’ counsel raised a couple of weak alternative arguments that the Court delighted in shooting down. First, Ritz argued that extending “actual fraud” to include fraudulent conveyances was unnecessary because such conduct is already proscribed in §§523(a)(4) and 523(a)(6) – covering actions by fiduciaries and willful injuries, respectively. (The Court pointed out in a footnote that Husky had raised both of those code sections in the original action, but they were not part of the appeal. It is entertaining to consider that the Court could have agreed with Ritz about the actual fraud section, but held that the claim was nondischargeable under one of those other subsections instead. But cases almost never have Dickensian plot twists like that – a pity, really.). The Court batted this argument away by showing that there can be some overlap between these sections – after all, we don’t allege all three in our adversary pleadings just because we can. Avoiding any possible overlap, the Court said, is no reason not to define “actual fraud” to include conveyances. Ritz then asserted that defining “actual fraud” to mean, you know, genuinely fraudulent activity would be redundant because §727 applies when a debtor acts “with intent to hinder, delay or defraud a creditor” (the typical language in fraudulent conveyance statutes). The Court rejected this argument, because the distinctions between §§523 and 727 are pretty obvious to anyone who has actually read the statutes, [section 727 governs situations where the Court denies the debtor any discharge at all, rather than dealing with a single creditor’s claim] emphasizing that §523 is “a tailored remedy for behavior connected to specific debts.” (Slip op. p. 8).
At this point, we have a great opinion for creditors – fraudulent conveyances are actual fraud and actual fraud is a clear basis for nondischargeability of a debt. But that is not the end of the case. Section 523(a)(2) refers to “any debt . . . obtained by . . . actual fraud.” And so the final section of the opinion addresses these first few words. As Justice Thomas pointed out in his dissent, the problem is that the language of the statute simply does not fit the facts of this, or virtually any other, fraudulent conveyance case.
The Court acknowledged that the transferor – who is the debtor in the case – does not obtain debts in a fraudulent conveyance. Justice Thomas argued that because the debto was not “obtained” that is the end of the issue. The statute says one thing, the facts of the case say another. But the Court slid past this problem with a syllogism – the transferee of a fraudulent conveyance obtains assets; if that transferee then files bankruptcy, debts “traceable to” the fraudulent conveyance would be nondischargeable; therefore, some debts obtained by a fraudulent conveyance can be nondischarageable, and so §523(a)(2) can apply to fraudulent conveyances. The problem with this approach is that it doesn’t squarely address Justice Thomas’ argument that “obtained by” should be read to mean “obtained from the creditor” (Thomas, J., dissenting, p. 3) and that debts “traceable to” an actual fraud are not the same as debts “obtained by” actual fraud. As hard as it is to write these words, I agree with Justice Thomas – fraudulent conveyances don’t fit in this textual interpretation.
Justice Thomas very logically pointed out that Husky extended credit to Chrysalis, not Ritz, and there was no fraud in that extension of credit. Chrysalis did not pay Husky and that is where the debt arose. The subsequent conduct by Ritz does not really have anything to do with the original, non-fraudulent transaction. So what is Justice Thomas missing (you didn’t really think I was going to agree with him, did you)? The key fact in this case that the “debt” owed by Ritz to Husky exists only because of the fraudulent conveyance – that Husky’s claim and therefore the debt that Ritz would like to have discharged came about solely because there is a Texas statute that made Ritz personally liable for conveying Chrysalis’ assets. Justice Thomas’ rejoinder would likely be that even where the debt “arises from” actual fraud, it still is not a debt “obtained by” actual fraud. I believe, though, that this is a distinction without a difference, because the debt – defined as “liability on a claim” [11 U.S.C. §101(12)] was created by, traceable to, arises from and therefore was obtained by actual fraud.
So does Husky stand for the proposition that any debtor who fraudulently conveys property will have the claims held nondischargeable where a creditor can claim to be harmed by that transfer? If so, then it would be as I described it in the first paragraph – “a powerful weapon” for creditors. But I do not believe that bankruptcy courts will apply Husky in such a broad, and creditor-friendly, fashion. One reason is that fraudulent conveyances are very often intended to hinder not just a single creditor’s claim but a whole raft of creditors. Ritz’ actions in draining Chrysalis’ assets were fraudulent as to Husky, but how would the Court apply §523(a)(2) to whatever other creditors of Chrysalis who were also unsuccessful in collecting against the company as a result of the fraudulent transfers? Are all of those claims nondischargeable? There are a number of bankruptcy cases pending today with several creditors circling around some highly questionable asset transfers; can they all be held nondischargeable? Where there are a number of creditors similarly situated, nondischargeability under §523 become more like the blanket nondischarge of §727 – not the “tailored remedy for behavior connected to specific debts” but a broad remedy for behavior unconnected to any specific debt, limited only to the number of creditors who will file the necessary adversary case to challenge the discharge. And once we step away from the narrow purpose of §523(a)(2), it seems less likely that the bankruptcy court will except those claims.
How about when these multiple creditor claims total more than the value of the assets transferred? If all the claims can be held nondischargeable, then there is a potential for claims to be nondischargeable even though each creditor would have been paid at less than 100 cents if the debtor had simply liquidated the now- conveyed assets and paid his creditors. In my experience, bankruptcy judges are loath to grant exceptions to discharge in any but the clearest cases. Where my creditor client is just one of many who didn’t get paid and the only basis for the exception is that the debtor conveyed away some property I hoped to levy and sell, I think it likely that the judge will find a way to argue around Husky and deny the exception.
And I believe that there is another, larger problem with Husky as authority for exceptions for discharge where there was a fraudulent conveyance – which is why I highlighted Justice Thomas’ argument in the dissent. The facts in Husky are not very typical. Ritz’ liability to Husky exists solely because of the Texas law proscribing transfers by certain stakeholders in a corporation. And as a result, the rationale the Court uses to overcome Justice Thomas’ textual analysis is correct in this case, but doesn’t really work in the more garden-variety fraudulent conveyance case. In most fraudulent conveyance claims, the creditor has a claim against the debtor for money and along the way to collection it is discovered that the debtor has fraudulently conveyed assets to avoid collection (either before the claim arose or, more classically, while the suit is pending). When the debtor files bankruptcy, the debt owed by this debtor to this creditor was not “obtained by” nor “arises from” nor is “traceable to” the fraudulent conduct. Instead, as Justice Thomas points out, the debt was part of an entirely separate transaction and the creditor’s right to recovery from the debtor is wholly unrelated to the fraudulent transfer. As a creditors’ attorney, I would love for Husky to mean that my client has a nondischargeable claim as soon as I prove the fraudulent conveyance. But thirty years of experience watching the bankruptcy courts find ways to deny my nondischargeability actions, I doubt it will be so.
At the end of the day, I expect that bankruptcy courts will not read Husky to stand for anything other than the narrow holding that “actual fraud” in §523(a)(2) is not limited to misrepresentations. Where the claim being pursued exists solely because of the fraudulent conveyance – as in the claim against Ritz or a claim against the recipient of a fraudulent conveyance – then the decision will allow creditors to except that particular claim from discharge. For all those trade creditors who find that their guarantor has conveyed the million-dollar house to his mother as a “gift,” however, it is most likely that this decision changes nothing.