Supreme Court Sides with the Seventh Circuit on a Broader Scope of Debts for Which Corporate Credito Supreme Court Sides with the Seventh Circuit on a Broader Scope of Debts for Which Corporate Credito

Supreme Court Sides with the Seventh Circuit on a Broader Scope of Debts for Which Corporate Creditors Can Hold Principals Responsible in Bankruptcy

In a 7-1 decision issued on May 16, 2016, the U.S. Supreme Court had no problem, despite Justice Scalia’s untimely departure, in ruling that when a corporate creditor’s recovery efforts are fraudulently stymied, the creditor can seek to hold the orchestrating individual responsible in bankruptcy under certain circumstances. Husky International Electronics, Inc. v. Ritz, No. 15-145 (May 16, 2016). Justice Thomas was the lone dissenter.

One remedy available to a determined creditor is to pursue a non-dischargeability judgment in an individual’s bankruptcy. There are several common grounds to do so, but the Husky International decision concerned only one of these grounds, which is (a)(2)(A) of section 523 of the United States Bankruptcy Code. The Supreme Court’s decision resolves a split amongst the Seventh and Fifth Circuit Courts of Appeal and confirms that section 523(a)(2)(A) can apply to the not infrequent situation in which the principal of a company transfers assets out of that company to themselves or to other companies controlled by the principal, in order to avoid paying a corporate debt. As the petitioner argued, this could help to prevent debtors from using bankruptcy to shield this type of fraudulent activity. However, as also noted by the Court, there already may have been a somewhat overlapping ground to hold such a debt non-dischargeable under section 523(a)(6). Husky Int’l, slip op. at 7–8.

In the Husky International case, the Debtor, Mr. Ritz, prevented the creditor from recovering on an obligation by transferring assets to other companies in which he held an interest. This conduct, and its impact on the creditor, was not in dispute. What was in dispute is whether the debtor, even if held responsible under a Texas veil-piercing law, could still discharge the debt. The United States Court of Appeals for the Fifth Circuit had held that notwithstanding the debtor’s actions, the debt could be discharged. The Fifth Circuit reasoned that the wording of section 523(a)(2)(A) required the debtor to have made a fraudulent representation to the creditor in order to obtain the goods from the creditor. The Fifth Circuit’s decision stood in conflict with an earlier ruling by the United States Court of Appeals for the Seventh Circuit, McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000), the reasoning of which was subsequently adopted by the Bankruptcy Appellate Panel for the Sixth Circuit Court of Appeals, Mellon Bank, N.A. v. Vitanovich (In re Vitanovich), 259 B.R. 873 (B.A.P. 6th Cir. 2001). In McClellan the Seventh Circuit held that “section 523(a)(2)(A) is not limited to fraudulent misrepresentation’” 217 F.2d at 893 (cited in Vitanovich, 259 B.R. at 877).

Historically, some lower courts and bankruptcy treatises had presumed that the wording of section 523(a)(2)(A) required the debtor to make a fraudulent misrepresentation to the creditor. While this was one possible, but more restrictive reading—and is the reading promoted by Justice Thomas—the Supreme Court has adopted a broader reading. The opinion, however, does leave questions to be answered by the lower courts, as the ruling remanded the case for further proceedings. In any event, this ruling expands the use of section 523(a)(2)(A) as a means to hold certain debts non-dischargeable—to hold a principal responsible for what would otherwise be an uncollectable debt held against a corporate shell—in those jurisdictions that had not already adopted the Seventh Circuit’s reasoning in McClellan, but the extent of this expansion remains to be seen.

The Court noted that “from the beginning of English bankruptcy practice, courts and legislatures have used the term ‘fraud’ to describe a debtor’s transfer of assets that, like Ritz’s scheme, impairs a creditor’s ability to collect the debt.” Husky Int’l, slip op. at 4-5. In addition, “the common law also indicates that fraudulent conveyances, although a ‘fraud,’ do not require a misrepresentation from a debtor to a creditor.” Id. at 5. Because fraudulent conveyances are done in secret and “are not an inducement based fraud,” no false representation is necessary for a debt to be held non-dischargeable under section 523(a)(2)(A).

The point on which Justice Thomas dissented is his assertion that section 523(a)(2)(A) requires the debt to be for money, property or services “obtained by” actual fraud. He argued this fraud must occur “at the inception of a credit transaction.” Husky Int’l, slip op., dissent at 2. Thus, he believes that “actual fraud” does not cover fraudulent transfer schemes. Husky Int’l, slip op., dissent at 1. The majority, however, found that “[n]othing in the text of § 523(a)(2)(A) supports [this] additional requirement.” Id. at 10.

The Husky International opinion affirms that if the creditor can prove the corporate veil should be pierced to hold the debtor responsible and can show the debtor directed fraudulent transfers to attempt to render a company uncollectable, then the debt potentially can be held non-dischargeable. The case has been remanded to the United States Court of Appeals for the Fifth Circuit for further determination.

For further information on Husky International Electronics, Inc. v. Ritz or bankruptcy litigation, contact Tyson Crist or a member of our Bankruptcy and Financial Restructuring group.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstances.

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