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Understanding “actual fraud” in Husky: false representation required or not? – Kristina Feher

by Kristina Feher, Feher Law PLLC

As the split among circuits deepened, the United States Supreme Court took up the case of Husky Intern. Electronics, Inc. v. Ritz, U.S. , 136 S. Ct. 1581 (2016) to determine 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 ultimately determined that 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. Judge Colton had an opportunity to apply Husky in Darras, et. al v. Nolan (In Re Andrew Nolan and Robin Nolan dba McDavid Public Relations), Adversary No. 8:16-ap- 00195 (Bankr. M.D. Fla. August 4, 2016).

Between 2003 and 2007, Husky International Electronics, Inc. sold electronic device components to Chrysalis Manufacturing Corp. and Chrysalis incurred a debt to Husky International Electronics, Inc. of nearly $164,000. Respondent, Daniel Lee Ritz, Jr., Chrysalis’ director and part owner at the time, drained Chrysalis of assets available to pay the debt by transferring large sums of money to other entities Ritz controlled. Husky sued Ritz in Texas state court to recover on the debt. Husky argued that Ritz’ intercompany transfer scheme was “actual fraud” under a Texas law that allows creditors to hold shareholders responsible for corporate debt.

Ritz then filed for Chapter 7 bankruptcy. Husky filed an adversary proceeding under 11 U.S.C. § 523(a) (2)(A), seeking to hold Ritz personally liable. Husky argued that the debt was not dischargeable because Ritz’ intercompany-transfer scheme constituted “actual fraud” under the Bankruptcy Code’s discharge exceptions. The District Court held that the debt was not “obtained by… actual fraud” under §523(a)(2)(A) and thus could be discharged in bankruptcy. The Fifth Circuit affirmed, holding that a misrepresentation from a debtor to a creditor is a necessary element of “actual fraud”. The Fifth Circuit found Ritz made no false representations to Husky regarding the transfer of Chrysalis’ assets. The Fifth Circuit stated that Ritz may have hindered Husky’s ability to recover its debt, but that Ritz did not make any false representations to Husky regarding those assets or the transfers and therefore did not commit “actual fraud.”

Historical perspective of “actual fraud”
Before 1978, the Bankruptcy Code prohibited debtors from discharging debts obtained by “false pretenses or false representations.”1 In the Bankruptcy Reform Act of 19782, Congress added “actual fraud” to that list. The prohibition now reads: “A discharge under [Chapters 7, 11, 12, or 13] of this title does not discharge an individual debtor from 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.”3 The Supreme Court historically construed the terms in § 523(a)(2)(A) to contain the “elements that the common law has defined them to include.”4 “Actual fraud” has two parts: actual and fraud. The word “actual” has a simple meaning in the context of common-law fraud: It denotes any fraud that “involv[es] moral turpitude or intentional wrong.”5

In Husky, the Supreme Court discussed that courts and legislatures have used the term “fraud” to describe a debtor’s transfer of assets that, like Ritz’ scheme, impairs a creditor’s ability to collect the debt. Common law also indicates that fraudulent conveyances, although a “fraud,” do not require a misrepresentation from a debtor to a creditor. Fraudulent conveyances are not an inducement-based fraud. Fraudulent conveyances

typically involve “a transfer to a close relative, a secret transfer, a transfer of title without transfer of possession, or grossly inadequate consideration.”6 The Husky Court maintained that fraudulent conduct is not in dishonestly inducing a creditor to extend a debt. It is in the acts of concealment and hindrance. The opportunities for a false representation from the debtor to the creditor are limited.

As the Supreme Court explained, the famous Twyne’s Case, which this Court relied upon in BFP7, illustrates this point.8 That principle underlies the now-common understanding that a “conveyance which hinders, delays or defrauds creditors shall be void as against [the recipient] unless… th[at] party … received it in good faith and for consideration.”9 That principle also underscores the point that a false representation has never been a required element of “actual fraud,” and the Supreme Court declined to adopt it in Husky.

“Actual Fraud” Analysis
The Supreme Court’s interpretation of “actual fraud” in
§ 523(a)(2)(A) also preserves meaningful distinctions between that provision and §§ 523(a)(4), (a)(6). Section 523(a)(4) covers only debts for fraud while acting as a fiduciary, whereas § 523(a)(2)(A) has no similar limitation. Section 523(a)(2)(A) covers only fraudulent acts. Given the clear differences between the provisions, the Supreme Court declined to craft an artificial definition of “actual fraud” merely to avoid narrow redundancies in
§ 523 that appear unavoidable.

It is of course true that the transferor does not “obtai[n]” debts in a fraudulent conveyance. But the recipient of the transfer — who, with the requisite intent, also commits fraud — can “obtai[n]” assets “by” his or her participation in the fraud.10 If that recipient later files for bankruptcy, any debts “traceable to” the fraudulent conveyance, will be nondischargable under § 523(a)(2)(A). Thus, at least sometimes a debt “obtained by” a fraudulent conveyance11 scheme could be nondischargeable under
§ 523(a)(2)(A).

Judge Colton’s Application of Husky
Judge Colton included a discussion of Husky in her Memorandum Decision and Order12 in Darras, et. al v. Nolan. In the adversary proceeding, the Plaintiffs sought a declaration that certain unliquidated statutory and tort claims were nondischargeable under 11 U.S.C.
§§1328(a)(2) and 523(a)(2), and/or §§1328(a)(4).

The Plaintiffs included Frank Darras, Natasha Marie Darra, and the Darra Law Firm, Inc. dba DarrasLaw. The Defendant in the adversary proceeding was Robin Nolan. All the Plaintiffs’ claims were for unliquidated personal injury claims. The Plaintiffs hired Ms. Nolan to serve as an internet public relations consultant for DarrasLaw. Mr. Darras terminated Ms. Nolan’s employment on December 3, 2014. Ms. Nolan responded with an electronic and internet campaign to defame and discredit Mr. Darras, his law firm, and his daughter Natasha Darras. Ms. Nolan allegedly refused to turnover login information and improperly accessed, tampered with, and posted to the DarrasLaw Twitter account.13

The Plaintiffs argued that Husky expanded § 523(a)(2)
(A) to include claims for defamation resulting from false statements. Judge Colton disagreed and stated that Husky holds that “actual fraud” is separate and distinct from “false pretenses” or “false representation” as a matter of statutory construction. Husky, 136 S. Ct. at 1590. In essence, Judge Colton held, the Supreme Court ruled that § 523(a)(2)(A) expressly recognizes three distinct ways to fraudulently obtain a debt for “money, property, services, or an extension, renewal or refinancing of credit” and, in doing so, render that debt nondischargeable. Id.

The Supreme Court not only remanded Husky for further evaluation in light of its ruling14, but also went to great lengths to describe how assets can be “obtained” in a fraudulent transfer:

It is of course true that the transferor does not “obtain[n]” debts in a fraudulent conveyance. But the recipient of the transfer—who, with the requisite intent, also commits fraud—can “obtain[n]” assets “by” his or her participation in the fraud. If that recipient later files for bankruptcy, and debts “traceable to” the fraudulent conveyance…will be nondischargeable under § 523(a)(2)(A). Thus, at least sometimes a debt “obtained by” a fraudulent conveyance scheme could be nondischargeable under § 523(a)(2)(A). Such circumstances may be rare because a person who receives fraudulently conveyed assets is not necessarily (or even likely to be a debtor on the verge of bankruptcy, but they make clear that fraudulent conveyances are not wholly incompatible with the “obtained by” requirement.

In contrast to the claims asserted by the Darras Parties, the fraudulent transfer scheme in Husky involved assets transferred by Daniel Ritz from an insolvent company to “other entities Ritz controlled.”15 Under Texas law, Ritz’s fraudulent acts rendered him personally liable for the debt owed to the vendors,16 and Ritz arguably obtained the benefit of the fraudulent transfers by way of his holdings in the transferee companies.

Another distinction in the Nolan case is that the Debtors filed a Chapter 13 bankruptcy case. The Plaintiffs did not allege that Ms. Nolan obtained anything as a result of the alleged online rants and social media hacks, other than a measure of revenge. Judge Colton held that the Adversary Complaint failed to state a claim under § 523(a)(2)(A), made applicable by § 1328(a)(2). On the other hand, Judge Colton stated that injuries to real or personal property may be discharged in a Chapter 13 case, even if the injuries are the result of willful and malicious conduct. Personal injury within the meaning of § 1328(a)(4) “should be defined in contradistinction to injury to property; the emphasis in § 1328(a)(4) is on injury to an individual.”17 Judge Colton held that although the Adversary Complaint states cognizable claims in favor of Frank and Natasha Darras, the claims of DarrasLaw, a corporation, do not satisfy the requirements of § 1328(a)(4). The claims of The Darras Law Firm, Inc. dba DarrasLaw asserted under § 1328(a)
(4) failed to state a claim upon which relief may be
granted and were dismissed.

The Supreme Court’s ultimate decision interpreted “actual fraud” to encompass fraudulent conveyance schemes, even when those schemes do not involve a false representation. Debtors should be careful of any conveyance that could be deemed fraudulent and understand the implications Husky holds for fraudulent conveyances. Simultaneously, creditors should review the circumstances surrounding any conveyances of a debtor for determinations of dischargeability. By interpreting “actual fraud” to include fraudulent conveyance schemes, debtors may have a higher hill to climb to prove dischargeability of debts that carry even a whiff of fraud.