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Kevin Schlosser Authors, "Establishing “Actual Fraud” to Bar Bankruptcy Discharge of Debts"

Jul 30, 2016Commercial LitigationLitigation & Dispute Resolution
Media Source: As noted in other posts, establishing claims of fraud provides powerful remedies. One such consequence is preventing the discharge of debts in bankruptcy. The recent decision of the United States Supreme Court in Husky International Electronics, Inc. v. Ritz, No. 15-145 (May 16, 2016) provides interesting insight. The Bankruptcy Code prohibits debtors from discharging debts “obtained by…false pretenses, a false representation, or actual fraud.” 11 U.S.C. § 523(a)(2)(A). In Husky, the Fifth Circuit held that a debt is “obtained by…actual fraud only if the debtor’s fraud involves a false representation to a creditor.” That ruling deepened an existing split among the circuits over whether “actual fraud” requires 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. The Supreme Court reversed the Fifth Circuit, ruling: “The term ‘actual fraud’ in § 523(a)(2)(A) encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation.” The Supreme Court noted that before 1978, the Bankruptcy Code prohibited debtors from discharging debts obtained by ‘false pretenses or false representations.’…” The Court then noted Congress added “actual fraud” to that list in 1978. In amending the statute, the Supreme Court presumed that Congress intended its amendment “to have real and substantial effect.” Thus, the Supreme Court found that it could presume that “Congress did not intend ‘actual fraud’ to mean the same thing as ‘a false representation.’” The Supreme Court then explained the context of fraud without fraudulent representations. Principally, fraudulent conveyances, long recognized by the common law, involve “a transfer to a close relative, a secret transfer, a transfer of title without transfer of possession, or grossly inadequate consideration.” For fraudulent conveyances, the Supreme Court recognized that: “In such cases, the fraudulent conduct is not in dishonestly inducing a creditor to extend a debt. It is in the acts of concealment and hindrance. In the fraudulent-conveyance context, therefore, the opportunities for a false representation from the debtor to the creditor are limited.” Thus, the Supreme Court concluded that in the context of fraudulent conveyances (as opposed to causes of action for common law fraud involving misrepresentation and reliance), “a false representation has never been a required element of ‘actual fraud,’ and we decline to adopt it as one today.” The Supreme Court’s decision in Husky underscores that “fraud” arises in different contexts with different rules and principles depending on the circumstances. A common law cause of action for fraud under New York law certainly requires a misrepresentation of some sort conveyed by the defendant or someone acting on its behalf to the plaintiff upon which plaintiff reasonably relied. In the context of fraudulent conveyances, the concept of representations and reliance do not apply. And this is the reason why “actual fraud” in the Bankruptcy Code also does not require representation or reliance in order to result in the non-discharge of debts thereunder.