US Supreme Court Closes “Actual Fraud” Loophole in Bankruptcy Code

A recent US Supreme Court ruling will likely have a major impact on some individuals who file for bankruptcy in the future.

The key issue that the Court had to determine in Husky International Electronics, Inc. v. Ritz was what exactly Congress meant when it referred to “actual fraud” in the Bankruptcy Code. In a 7-1 decision, the Supreme Court held that the term “actual fraud” in Section 523(a)(2)(A) of the Bankruptcy Code encompasses conveyance schemes, even when those schemes do not involve a false representation.

In other words: the case represented a major victory for creditors because it expanded the scope of what is meant by “actual fraud.” Creditors and lenders will now be able to more effectively go after someone who improperly transfers their assets during a bankruptcy filing.

What Husky v. Ritz Was About

Husky International sold electronic device boards to Chrysalis Manufacturing Corp. Over a period of four years, Chrysalis made many purchases and racked up a debt of $164,000. While Chrysalis was accumulating this debt, the company was also transferring money and other assets to other entities, essentially shielding those assets from future debt collection efforts. This became a major issue when Husky attempted to collect on the debt and Chrysalis subsequently filed for bankruptcy.

The problem was that Chrysalis no longer had any assets that Husky could collect on – because Chrysalis has conveyed those assets to other companies prior to filing for bankruptcy.

The bankruptcy trustees in Husky argued in front of the Supreme Court justices that the borrowers were exploiting a “dangerous loophole” in the Bankruptcy Code and “gaming the system” by accumulating massive debts, transferring or conveying their assets to another party, and then declaring bankruptcy. In its court filings, Husky said that debtors like Chrysalis were using the U.S. Bankruptcy Code as an “engine of fraud.”

Chrysalis countered by arguing that the Bankruptcy Code merely barred “actual fraud” that involved “a false representation to a creditor.” In this case, said the debtor, they had not made any false representations to the creditor.

Supreme Court Ruling: Expanding the Definition of “Actual Fraud”

Now the United States Supreme Court has weighed in on the matter. Justice Sonia Sotomayor wrote the opinion for the majority and said that the term “actual fraud” does, in fact, include various forms of fraud, including fraudulent transfers. Moreover, said Sotomayor, “actual fraud” is not limited to conduct or actions that involve a false representation.

While the Court’s ruling figures to have the greatest impact on individuals who attempt to skirt bankruptcy laws and avoid paying back creditors, the important ruling could also affect well-intentioned debtors who run small businesses and tend to transfer funds between their personal and business accounts.

To learn more about the Supreme Court ruling, read the SCOTUSblog.com case files.

 

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