Thursday, May 28, 2015

Fifth Circuit Narrows Fraud Dischargeability Claims

Rejecting a Seventh Circuit precedent, the Fifth Circuit has ruled that a non-dischargeability claim under section 523(a)(2)(A) must be based upon a false representation.    While bad conduct that does not involve a misrepresentation may be actionable under other sections of the Code, it will not constitute actual fraud under Sec. 523(a)(2)(A).   Husky International Electronics, Incorporated v. Ritz (Matter of Ritz), No. 14-20526 (5th Cir. 5/22/15).  

What Happened

Over the course of four years, Husky sold electronic components to Chrysalis Manufacturing Corp.     Chrysalis failed to pay for $163,999.38 in product.    Ritz controlled the finances of Chrysalis and was a director and 30% shareholder.  At the same time that Chrysalis was failing to pay Husky, it paid out over a million dollars to entities controlled by Ritz.   These transfers were made without reasonably equivalent consideration while Chrysalis was insolvent.

Although Ritz had not guaranteed the debt, Husky sued him in an attempt to pierce the corporate veil.  Ritz filed bankruptcy before the case could go to trial.  Husky brought a dischargeability complaint under sections 523(a)(2) and (a)(6) based on the fraudulent transfers.     

When the case went to trial, the Bankruptcy Court found that Ritz was not a credible witness.   Nevertheless, it found that Husky had failed to prove that Ritz had perpetrated an actual fraud in order to pierce the corporate veil.  It also found that because Ritz had not made a false representation to Husky that there was not a valid claim under section 523(a)(2) and that Husky had failed to prove up its claim for willful and malicious injury under section 523(a)(6).

On appeal, the District Court found that Husky had proven actual fraud under the Texas Business Organizations Code so that Husky had a claim against Ritz, but that it had not established either ground for non-dischargeability.    

In an opinion written by Judge Carolyn King, the Fifth Circuit ruled that lack of a representation doomed the fraud claim and that proving fraudulent transfers without more did not satisfy the requirements for a willful and malicious injury.

The Ruling

Most of the opinion was devoted to whether "actual fraud" under section 523(a)(2)(A) required a representation.    McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000) had held that actual fraud was broader than false representations and encompassed the full spectrum of conduct by which men may take advantage of one another.    The Court rejected this reasoning on multiple grounds.   

Judge King relied heavily on the reasoning of Field v. Mans, 516 U.S. 59 (1995).    Field was based on how the term actual fraud was interpreted under the common law in effect when the term was added to the Code in 1978.  It cited  the Restatement (Second) of Torts and Prosser on Torts to establish that justifiable reliance was the appropriate standard of intent to establish actual fraud.    The same authorities defined actual fraud as based on a misrepresentation.    The Supreme Court also "appeared to assume" that a false representation was part of the cause of action.    While nondischargeable fraud claims are based on the common law, the law of fraudulent transfer is a creature of statute.   

Multiple Fifth Circuit decisions have defined fraud under section 523(a)(2) as involving a a false representation,  e.g., Matter of Acosta, 406 F.3d 367 (5th Cir. 2005).   No Fifth Circuit case had expanded section 523(a)(2) beyond a representation and no other circuit had followed McClellan.

The Court rejected application of the canon of statutory construction that every word in a statute should be given effect.    The Court noted that canons of construction are used to help determine Congressional intent, "not to lead courts to interpret the law contrary to that intent."    The Court cited a treatise by Justice Scalia and Bryan Garner which pointed out that the canon against surplusage cannot always be dispositive because it is not invariably true.   In other words, sometimes words in a statute really are duplicative of each other.    In this case, the Court found that the term "actual fraud" was intended to reflect the common law and referred to "actual or positive fraud rather than fraud implied by law."     

As an additional ground, the Court found that transfers made with intent to hinder, delay or defraud a creditor were actionable under section 727(a)(2)(A).  Judge King stated that ""(i)t would appear odd at the very least for Congress to have intended that the 'actual fraud' provision cover fraudulent transfers when there is another provision directly addressing such transfers."

As the final brick in her statutory construction, Judge King relied upon the rule that exceptions to discharge be construed in favor of debtors.

Thus, fraudulent transfers unaccompanied by false representations cannot constitute actual fraud under section 523(a)(2)(A).

The Court also affirmed denial of the claim under section 523(a)(6).    The Court based its ruling on the Supreme Court holding in Kawaahua v. Geiger, 523 U.S. 57 (1998) that willful and malicious injury requires more than an intentional action which results in harm.   There must be either subjective intent to harm or a substantial objective certainty of harm.   Because the creditor apparently did not prove anything beyond the fact of the fraudulent transfers, it did not meet its burden of proof.

What It Means

This is an important decision because it limits what can be alleged under section 523(a)(2)(A).   Claims which do not allege a false representation can be disposed of under Rule 12(b)(6) without the need for a trial.     Bad acts which do not rely upon a representation must be grounded elsewhere in the Code.   Larceny and embezzlement are nondischargeable under section 523(a)(4).   Conversion is actionable under section 523(a)(6).   Most importantly for this case, transfers of property made with intent to hinder, delay or defraud a creditor may result in denial of discharge under section 727(a)(2)(A).    

Had the creditor sought to deny discharge rather than to determine dischargeablility, it would have been a closer case.   However, in order to have standing to pursue the claim, it would have needed to establish that it was a creditor.   This would have required piercing the corporate veil. The District Court found that Husky could have pierced the corporate veil while the Fifth Circuit declined to reach this question.    

A secondary lesson is that claims under sections 523 and 727 are narrow technical claims.  It is not enough to prove that the debtor did bad things and was not a credible witness.   Proving that the debtor was evasive and slippery is not a substitute for proving up the statutory elements.    

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