Can a Debtor’s Years-Old Fraudulent Transfer Preclude the Debtor from Obtaining a Discharge in Bankruptcy?

A 2016 Supreme Court case, Husky International v. Ritz, holds that if a debtor makes a fraudulent transfer, even if several years prior to filing the petition, any debt related to such fraudulent transfer will be nondischargeable. Section 523(a)(2)(A) of the Bankruptcy Code denies a debtor’s discharge of any debt obtained by false pretenses, false representations or actual fraud. There had been a split among the Circuits over whether “actual fraud” (e.g., a fraudulent transfer) required that a false representation be made to the creditor before a discharge would be denied. The Court in Husky concludes that as an exception to discharge, it is not necessary for the debtor to have incurred the debt based on a deception or fraud perpetrated on the creditor; instead, a fraudulent transfer involving no contact with the creditor is sufficient to give rise to the exception.

The facts in Husky illustrate the application of the decision. Daniel Ritz was a shareholder of Chrysalis. Chrysalis was indebted to Husky International based on purchases by Chrysalis of products manufactured by Husky International. Under Texas law Ritz, in his capacity as a shareholder, could be personally liable for the debt of Chrysalis to Husky if he engaged in fraud. Husky brought a suit against Ritz seeking a judgment against Ritz in his individual capacity based on this Texas law.

Several years prior to Husky International suing Ritz, Ritz caused Chrysalis to transfer assets to companies owned substantially by Ritz. These transfers were classic fraudulent transfers. Ritz subsequently filed a Chapter 7 bankruptcy seeking a discharge of his debts including his debt to Husky International. Husky International brought an adversarial proceeding in Ritz’ Chapter 7 case claiming that his debt to Husky International should not be discharged because Ritz had engaged in actual fraud, i.e., causing the fraudulent transfers from Chrysalis to Ritz’ controlled companies. Ritz objected claiming that while he made fraudulent transfers, he never committed an actual fraud on Husky International; indeed it was undisputed that he had little if any communication with Husky International and never in any context where it could be argued that Ritz fraudulently induced or deceived Husky International into extending credit to Chrysalis.

The Court thus faced the challenge of deciphering the meaning of the term “actual fraud” as an exception to discharge. The Court reviewed the history of fraudulent conveyance law back to the Statutes of Elizabeth and the decision in Twyne’s case. Based upon this jog through history the majority concluded that a fraudulent conveyance was most certainly an “actual fraud” and thus Section 523(a)(2)(A) of the Bankruptcy Code was satisfied on that point.

More difficult was how the Court was able to justify that the relevant debt for which discharge was being denied was obtained by actual fraud. In a convoluted explanation that the dissent admirably dissects, the Court forces a statutory construction that simply does not make sense. One must ask how Ritz’ fraudulent transfers to his related companies could be said to have led to Husky International obtaining the debt now due it from Ritz. Husky International obtained the debt by virtue of ordinary course of business sales to Chrysalis for which Ritz became liable under Texas law as a shareholder. Ritz’ fraudulent transfers had nothing to do with Husky International obtaining the debt. Only tortured analysis allowed the result the Court sought.

This case is particularly important in the asset protection planning world because the bankruptcy or asset protection planning attorney is frequently asked whether a fraudulent transfer will affect the debtor obtaining a discharge in bankruptcy. This discourse arises because a desperate debtor, despite the protestations of his legal representatives, might nonetheless make a fraudulent transfer believing that in some fashion this will provide additional negotiation or leverage in fighting his creditors. The debtor may be under the erroneous impression that there is little downside to the transfer…the worst being it is voidable and the transferee must return the ill-gotten gains. However, in some states there are significant penalties that can be imposed on both the transferor and transferee beyond just voiding the transfer. But importantly now, it is clearly a risk that a debtor engaging in a fraudulent transfer will lose the opportunity to discharge related debts in a bankruptcy proceeding.

For purposes of clarity and to avoid any confusion, we note that a separate section of the Bankruptcy Code, Section 727(a)(2), prevents a debtor from discharging all of his debts if, within the year prior to filing the petition, he “transferred, removed, destroyed, mutilated, or concealed” property “with intent to hinder, delay, or defraud a creditor or an officer of the estate charged with custody of the property.” But this section requires the improper act to have occurred with the 1 year period prior to filing. Section 523(a)(2)(A) has no such time requirement; hence it can be used to deny discharge even if made many years prior to the filing.