On May 16, 2016, the United States Supreme Court issued a slip opinion in the case of Husky International Electronics, Inc. v. Ritz, 578 U.S. __, Case No. 15-145 (2016). Sifting through the history of fraudulent transfer law, the Supreme Court concluded that the term “actual fraud” – for purposes of denying a discharge in bankruptcy – includes “fraudulent conveyance schemes,” even when those schemes do not involve the making of any false representations. Unfortunately, a majority of the Supreme Court justices repeat the same mistake made by a number of state court judges, erroneously equating a fraudulent transfer with “fraud” at common law. Despite the efforts of the Uniform Law Committee to dispel this notion – by renaming the “Uniform Fraudulent Transfer Act” the “Uniform Voidable Transactions Act” – this ruling adds fuel to the raging fire of judicial confusion and is likely to lead to more adverse rulings in the context of asset protection planning.
Facts
The creditor in the case, Husky International Electronics, Inc., was a supplier of electrical components to Chrysalis Manufacturing Corp. between 2003 and 2007. By the end of 2007, Chrysalis had racked up a debt of $163,999.38 on orders with Husky. The defendant in the case, Daniel Lee Ritz, Jr., was a director and 30% shareholder of Chrysalis.
Between 2006 and 2007, Ritz caused Chrysalis to transfer large sums of cash to other entities owned and controlled in whole or in part by Ritz. (One of the companies appears to have been a captive insurer.) Husky responded in 2009 by filing suit against Ritz personally, alleging that the transfers constituted “actual fraud” under a Texas law making shareholders liable for the unpaid debts of a corporation. That same year, Ritz filed a petition in bankruptcy, seeking to discharge Husky’s claim against him. Husky intervened in the bankruptcy proceeding to try and hold Ritz personally liable for Chrysalis’ unpaid debt. Husky also argued that Ritz could not discharge the debt in bankruptcy, contending that the fraudulent transfers from Chrysalis to Ritz’s three other companies constituted “actual fraud” under 11 U. S. C. §523(a)(2)(A)’s exemption to discharge.
Procedural History
The district court reviewing the bankruptcy proceeding concluded that Husky could not exempt its claim from discharge. Likewise, the Fifth Circuit affirmed, reasoning that a necessary element of “actual fraud” in bankruptcy is a misrepresentation from the debtor to the creditor. The Fifth Circuit cited, as an example, a person who applies for credit by falsifying income or employment information. In re Ritz, 787 F. 3d 312, 316 (2015).
The Supreme Court Ruling
Defining “Actual Fraud”
The Supreme Court reversed the Fifth Circuit. Seven of the eight justices joined in the opinion, with only Justice Thomas dissenting. Writing for the majority, Justice Sotomayor first analyzed the language of the statute, noting that the term “actual fraud” was added in 1978 to supplement existing grounds for denying discharge based on obtaining money, property, or credit by “false pretenses” or “false representation.” Thus, the Court felt that the term “actual fraud” should mean something more than just a restatement of the term “false representation.”
The Court then analyzed the term “actual fraud” more precisely, noting the distinction between the two words “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.” Neal v. Clark, 95 U. S. 704, 709 (1878). “Actual” fraud stands in contrast to “implied” fraud or fraud “in law,” which describe acts of deception that “may exist without the imputation of bad faith or immorality.” Ibid. Thus, anything that counts as “fraud” and is done with wrongful intent is “actual fraud.”
Slip Op. at 4.
Fraudulent Transfers as “Fraud”
Justice Sotomayor then rather summarily stated that the term “fraud” in the context of bankruptcy has always included transfers meant to hinder a creditor:
There is no need to adopt a definition for all times and all circumstances here because, 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’ scheme, impairs a creditor’s ability to collect the debt.
Slip Op. at 4- 5. Following this summary, Justice Sotomayor went into the history of fraudulent transfer law, first turning to the Statutes of 13 Elizabeth (1571) and its public policy of criminalizing fraudulent transfers. Noting its ubiquitous application in the civil context in modern law, Justice Sotomayor concluded that “[t]he degree to which this statute remains embedded in laws related to fraud today clarifies that the common-law term ‘actual fraud’ is broad enough to incorporate a fraudulent conveyance.” Slip Op. at 5.
The opinion then went on to state that, of equal importance, fraudulent transfer law does not require the presence of a misrepresentation. This is an accurate statement of the law on fraudulent transfers. Its presence in the opinion suggests that misrepresentation is a completely unnecessarily element of a fraud based on a fraudulent transfer.
Justice Sotomayor followed this with a discussion of Twyne’s Case, 76 Eng. Rep. 809 (1601), an old English ruling in which the recipient of a gift from a debtor was held liable in fraudulent transfer:
Relatedly, under the Statute of 13 Elizabeth and the laws that followed, both the debtor and the recipient of the conveyed assets were liable for fraud even though the recipient of a fraudulent conveyance of course made no representation, true or false, to the debtor’s creditor. The famous Twyne’s Case, which this Court relied upon in BFP, illustrates this point. See Twyne’s Case, 76 Eng. Rep., at 823 (convicting Twyne of fraud under the Statute of 13 Elizabeth, even though he was the recipient of a debtor’s conveyance). 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.” Glenn, Law of Fraudulent Conveyances §233, at 312. That principle also underscores the point that a false representation has never been a required element of “actual fraud,” and we decline to adopt it as one today.
Slip. Op. at 6.
Unfortunately for those of us who follow fraudulent transfer case law closely, Ritz did not put up much of a defense. His counterargument was that, while a fraudulent transfer is an “actual fraud,” the use of the term “actual fraud” in 11 U.S.C. § 523 serves a different purpose. This points up the fallacy of so much fraudulent transfer cases, where the debtor fails to put up a proper defense and thus lends credence to the arguments of the creditors’ bar.
Analysis
Confusing “Fraudulent Transfers” with “Fraud”
For years, members of our firm have criticized the manner in which many state court judges have confused the term “fraudulent transfer” under debtor-creditor law with common law notions of “fraud.” Whereas a fraudulent transfer is a term used to describe a transaction that can be devoid of intent in certain instances, common law fraud requires a finding of intent. However, when the highest court in the land makes the same mistake, the mistake becomes the law… And so the consequences must be tallied.
Justice Thomas, in his lone dissent, came close to the mark. The dissent pointed out the distinction between “actual intent” fraudulent transfers, in which badges of fraud evince an ill intent on the part of the transferor, and “constructive intent” fraudulent transfers, which are often devoid of any intent but are deemed to be fraudulent transfers out of public policy considerations (e.g., operating a business with insufficient capital). Unfortunately, even Justice Thomas does not carry this argument to its logical conclusion, but instead wrestles over the meaning of the term “actual fraud” in the context of the bankruptcy statute at issue in the case.
The logical fallacy of equating “fraudulent transfers” with “fraud,” as Justice Thomas began to deduce, is that there are types of fraudulent transfers in which intent is irrelevant. At the time of the Statutes of 13 Elizabeth, constructive fraudulent transfers did not yet exist quite like in their modern form. Those fraudulent transfers that were written about, such as Twyne’s Case, featured classic badges of fraud indicative of intent. Modern fraudulent transfer law, however, often ignores intent altogether and is often only discernible in hindsight.
Fraudulent Transfers in Bankruptcy
Should the Supreme Court’s opinion be read to say that all fraudulent transfers constitute “actual fraud” under 11. U.S.C. § 523, or only “actual intent” fraudulent transfers? There is no clear guidance offered in the ruling, and we are left with two possible competing interpretations, either of which could be supported by these facts:
- “Actual Fraud” Includes Only “Actual Intent” Fraudulent Transfers: Remember that Justice Sotomayor emphasized the separate and independent meaning of the word “actual” before the word “fraud.” She explained that “actual” in this sense entails behavior of moral turpitude or intentional wrongdoing. While a misrepresentation is not an explicit requirement of this test, nevertheless the creditor must prove an “actual intent” fraudulent transfer under this interpretation.
- “Actual Fraud” Includes All Forms of Fraudulent Transfers: This interpretation is supported by the Court’s conclusion that any fraudulent transfer is a “fraud.” To then find an “actual” fraud requires only some evidence that the fraudulent transfer was done intentionally, and not with regard to any moral culpability. In other words, so long as a transfer is made willingly and not by accident, the fraud is “actual.”
Implications Outside of Bankruptcy
We tend to think the implications of Husky in the bankruptcy setting are nominal, given that bankruptcy courts normally excise wide latitude over potentially fraudulent transfers. Our larger concern is with Justice Sotomayor’s equating “fraudulent transfers” with “fraud” at common law. It must be remembered that fraudulent transfers were treated as a form of fraud in the era of debtors’ prisons in old England, when large banking interests ruled the roost in England’s Parliament. While this abhorrent tradition was imported to the American colonies, this despicable practice was eventually banished from Western countries. Thus, to broadly accept the idea that any “fraudulent transfer” constitutes a “fraud” in this day and age raises the prospect of further injustice.
Today’s Uniform Fraudulent Transfer Act is thought to confine creditors to civil remedies. Yet, a relic of old English fraudulent transfer law persists to sow confusion among jurists who are tempted to bootstrap a civil matter to a more egregious case of intentional wrongdoing in the nature of a conspiracy or civil RICO matter. See, e.g. Mack v. Newton, 737 F.2d 1343 (5th Cir. 1984). For example, in 2004, the Florida Supreme Court in Freeman v. First Union Nat. Bank, 865 So.2d 1272, 1277 (Fla. 2004), was asked to equate a “fraudulent transfer” with a “fraud” for purposes of holding a non-transferee liable for aiding and abetting on a fraudulent transfer; fortunately, the Florida Supreme Court found the requested remedy incompatible with the UFTA’s ostensible purposes. However, in California, a lawyer may yet be held liable under such a theory. See, e.g., Durant Software v. Herman, 255 Cal. Rptr. 250, 256 (Cal. Ct. App. 1989), reh’g granted, opinion not citeable (Feb. 24, 1989), vacated, 257 Cal. Rptr. 200 (Cal Ct. App. 1989), review granted and opinion superseded, 775 P.2d 1034 (Cal. 1989).
The immediate impact of Husky will be to incite more judges to support new angles of attack against asset protection planning, equating “fraudulent transfers” with “fraud” for purposes of civil conspiracy, aiding and abetting, and RICO claims. Asset protection planning lawyers should take heed of Husky and be prepared to argue that Justice Sotomayor’s expansive declarations on “fraud” should be confined as much as possible to instances of “actual intent” fraudulent transfers.