Last November, the HHR Bankruptcy Report reported on the Supreme Court’s grant of the petition for certiorari in Husky International Electronics, Inc. v. Ritz, a case in which the Fifth Circuit had held that “actual fraud” under section 523(a)(2)(A) of the Bankruptcy Code (which limits the breadth and effect of a debtor’s discharge) required proof of a false representation.  Earlier today, in a 7-1 decision, the Supreme Court issued its opinion, reversing the Fifth Circuit’s holding and ruling that actual fraud encompasses “fraudulent conveyance schemes, even when those schemes do not involve a false representation.”

In holding that actual fraud “encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation,” the Supreme Court looked to congressional intent and the historical meaning of actual fraud. As to congressional intent, the Court explained that before 1978, the Bankruptcy Code prohibited debtors from discharging a debt obtained by “false pretenses or false representations.”  In the Bankruptcy Reform Act of 1978, Congress changed the statute such that a debtor cannot discharge a debt obtained by “false pretense, a false representation, or actual fraud.”  As Justice Sotomayor explained, it can be presumed “that Congress did not intend ‘actual fraud’ to mean the same thing as a ‘false representation,’ as the Fifth Circuit’s holding suggests.”

Turning to the historical meaning of actual fraud, the Court began its analysis by quoting the original Elizabethan language of the one of the first bankruptcy statutes, the Statute of 13 Elizabeth, also known as Fraudulent Conveyances Act of 1571, which “identified as fraud ‘feigned convenous and fraudulent Feoffmentes Gyftes Grauntes Alientations [and] Conveyaunces’ made with “Intent to delaye hynder or defraude Creditors.’” The Court noted that the principles behind the 1571 Act, which make it fraudulent to hide assets from creditors by giving them to one’s family or friends, are still used and “embedded in laws related to fraud today.”  This, the Court explained, “clarifies that the common-law term ‘actual fraud’ is broad enough to incorporate a fraudulent conveyance.”  Further, the fact that, under the 1571 Act and laws that followed, both the debtor and recipient of the assets are liable for fraud, underscores the notion that a “false representation has never been a required element of ‘actual fraud.’”

The Court also rejected the debtor’s argument that the Court’s interpretation would create a redundancy with section 727(a)(2), which prevents a debtor from discharging all debts if, within the year preceding the filing of the petition, the debtor transferred or concealed its assets for the purposes of hindering, delaying, or defrauding a creditor. The Court noted that the two sections may overlap, but that section 727(a)(2) is broader in scope because it prevents an offending debtor from discharging all debt in bankruptcy, and is narrower in timing as it applies only if the debtor fraudulently conveys assets within a year preceding the filing of the petition. Therefore, unlike section 727(a)(2), section 523(a)(2)(A) is tailored as a remedy for behavior connected only to specific debts.

In dissent, Justice Thomas opined that “actual fraud” in section 523(a)(2)(A) “does not apply so expansively” to include fraudulent transfer schemes effectuated without any false representation. Although he agreed with the majority that the common law definition of “actual fraud” included fraudulent transfers, he explained that the general rule that a common law term of art should be given its established common law meaning must give way where the meaning does not fit.  Here, according to Justice Thomas, “context dictates” that actual fraud does not include fraudulent transfers because that meaning fails to fit with the rest of section 523(a)(2).

Earlier this month the Supreme Court granted certiorari to hear the Fifth Circuit case Husky International Electronics, Inc. v. Ritz, which originated in the United States Bankruptcy Court for the Southern District of Texas. The Fifth Circuit’s decision interprets “actual fraud” in the context of an exception to a debtor’s discharge that would require a creditor to prove that the debtor made a false representation. As the decision stands, this interpretation would make it more difficult for creditors to prove actual fraud when debtors transfer assets with the intent of hindering payments to creditors, making it easier for debtors to place assets out of creditors’ reach.

The question presented to the Supreme Court focuses on the “actual fraud” exception to discharge under § 532(a)(2)(A) of the bankruptcy code, and whether this exception applies only when the debtor has made a false representation, or whether the “actual fraud” exception also applies if the debtor deliberately obtained money through a fraudulent transfer scheme that was actually intended to cheat a creditor.

In Husky, Husky International Electronics, Inc. (“Husky”) sold and delivered goods to Chrysalis Manufacturing Corp. (“Chrysalis”), which the debtor, Daniel Lee Ritz, Jr. controlled.[1] Chrysalis failed to pay for the goods purchased from Husky, leaving $163,999.38 as the total amount of Chrysalis’ unpaid debt to Husky.[2] Between November 2006 and May 2007, Ritz transferred millions of dollars from Chrysalis to seven other entities he controlled and owned.[3] Husky sought to hold Ritz personally liable and sued him for the debt of Chrysalis in May 2009.[4] Seven months later, Ritz filed a chapter 7 petition in the United States Bankruptcy Court for the Southern District of Texas.[5] Husky then initiated an adversary proceeding and objected to the discharge of Ritz’s alleged debt.[6] The bankruptcy court held a trial on the matter and found that the transfers Ritz made “were not made for reasonably equivalent value” and that Husky suffered damages in the amount of the debt owed by Ritz.[7] However, the court found that the “actual fraud” exception to discharge did not apply because Husky failed to show that Ritz made a false representation to Husky and therefore Ritz could not have perpetuated an “actual fraud.”[8] On appeal, the district court affirmed the bankruptcy court’s decision, holding that “actual fraud under 11 U.S.C. § 523(a)(2)(A) . . . requires a misrepresentation.”[9]

The Fifth Circuit agreed with the bankruptcy court and district court and held “that a representation is a necessary prerequisite for a showing of ‘actual fraud’” and because there was no evidence of a representation, § 523(a)(2)(A) does not bar the discharge of the debt.[10] The court rejected the Seventh Circuit’s interpretation of § 523(a)(2)(A) in McClellan v. Cantrell,[11] which explained that because § 523(a)(2)(A) covers both actual fraud and false representations, the statute makes clear that the former is broader than the latter, and therefore a misrepresentation is not necessary for § 523(a)(2)(A) to bar the discharge of a debt. The Fifth Circuit explained that this interpretation is in tension with Supreme Court precedent and is inconsistent with previous decisions of the Fifth Circuit.[12] The court explained that both prior to and subsequent to McClellan, the Fifth Circuit has stated that “to prove nondischargeability under an ‘actual fraud’ theory, the objecting creditor must prove” that [] the debtor made misrepresentations.[13]

Husky presents a circuit split for the Supreme Court to review. After the Fifth Circuit issued its decision, the First Circuit issued its decision in Sauer, Inc. v. Lawson.[14] In Sauer, the First Circuit joined the Seventh Circuit in finding that § 523(a)(2)(A) “extends beyond debts incurred through fraudulent misrepresentations to also include debts incurred as a result of accepting a fraudulent conveyance that the transferee knew was intended to hinder the transferor’s creditors.”[15] In its petition for certiorari, Husky argued that the Fifth Circuit’s decision “creates a roadmap for dishonest debtors to cheat creditors through deliberate fraudulent-transfer schemes, and then to escape liability through discharge in bankruptcy.”[16] In opposition to appellant’s petition for certiorari, Ritz argued that the decision does not warrant the Supreme Court’s review at this time, and that even if the Court resolved the question in Husky’s favor, Husky would not get the relief it seeks because under Texas law, “actual fraud” requires a misrepresentation.[17] Oral arguments are expected to be heard during the first half of 2016. Visit HHR’s Bankruptcy Report for future updates on this case.

[1].      Husky International Electronics, Inc. v. Ritz, 787 F.3d 213, 314.

[2].      Id.

[3].      Id.

[4].      Id.

[5].      Id. at 315.

[6].      Id.

[7].      Id. at 315.

[8].      Id.

[9].      Id.

[10].    Id. at 316.

[11].    McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000).

[12].    787 F.3d at 317, 319.

[13].    Id. at 319.

[14].    No. 14-2058, 2015 WL 3982395.

[15].    Id. at *1.

[16].    Petition for Certiorari, Husky International Electronics, Inc. v. Ritz, 15-145 (U.S. July 2015).

[17].    Respondent’s Brief in Opposition to Petition for Certiorari, Husky International Electronics, Inc. v. Ritz, 15-145 (U.S. Sept. 30, 2015).

The Fifth Circuit recently held that a debtor-in-possession (DIP) lender did not qualify as a “good faith” lender, overturning orders of the United States District Court and Bankruptcy Court for the Southern District of Texas, including a final order approving DIP financing.  In re TMT Procurement Corp., 764 F.3d 512 (5th Cir. 2014).   Notably, the court held that because the DIP lender knew that collateral securing its loan was subject to adverse claims by a third-party in an unrelated proceeding, the DIP lender was not a “good faith” lender.  As a result, challenges to the lower courts’ orders were not moot under sections 363(m) and 364(e) of the Bankruptcy Code (as the lender and debtor had asserted), and the court proceeded to hear the merits of the appeal and ultimately vacated the lower courts’ orders. The decision underscores the importance of the “good faith” requirement, particularly for DIP lenders relying on collateral that is not property of the estate.

Background

Vantage Drilling Company (“Vantage”), an offshore drilling company, entered agreements with companies owned by Hsin-Chi Su (“Su”) for the acquisition of offshore drilling rigs and ships.  As part of the arrangement, Vantage issued 100 million shares of its stock to F3 Capital, an entity solely owned and controlled by Su.  After business disputes arose, in 2012, Vantage sued Su in Texas on several theories, fraud, negligent misrepresentation and unjust enrichment (the “Vantage Litigation”).  Vantage sought a constructive trust on all profits or benefits obtained by Su — including the Vantage stock issued to F3 Capital.

Meanwhile, in 2013, 23 foreign marine shipping companies Su owned (the “Debtors”) filed for chapter 11 bankruptcy in the United States Bankruptcy Court for the Southern District of Texas.  The Bankruptcy Court granted several creditors’ motion to dismiss as to two of the companies, and denied the motions as to the remaining 21, but required those companies to pledge certain non-estate “Good Faith” property to ensure compliance with court orders, pay sanctions, serve as collateral for capital loans and satisfy any amounts arising under section 507 of the Bankruptcy Code.  Ultimately, the Debtors agreed to an escrow agreement pursuant to which it would pledge more than 25 million shares of F3’s Vantage stock (the “Vantage Shares”) to the Bankruptcy Court to be held in custodia legis for the benefit of the debtors.  In doing so, both F3 Capital and Su represented and warranted that they could deliver the collateral “without violating any requirements of, or injunctive relief in, the [Vantage Litigation].”  Id. at 517.

Vantage was not so confident and sought a preliminary injunction in the Vantage Litigation. The district court determined that Su could not otherwise sell, transfer, pledge or encumber his Vantage stock without court permission, but directed Vantage to raise in the bankruptcy court its complaints about encumbrances on the Vantage stock to the bankruptcy court that issued the order.

In the bankruptcy court, Vantage challenged the escrow agreement as a “party in interest.”  The bankruptcy court rejected Vantage’s challenge and upheld the escrow agreement, noting that F3 Capital was not a party in the Vantage Litigation and had received the Vantage Shares prior to the commencement of that lawsuit.  Vantage filed an interlocutory appeal with the district court.

At the same time, the Debtors filed an emergency motion in the district court to borrow up to $20 million in DIP financing.  The district court approved a DIP lending facility that gave the DIP Lender a first priority lien and security interest in the deposited shares of Vantage stock (the “DIP Order”).  The DIP Order provided that the DIP Lender’s interest in the shares could not be modified by any subsequent order of the bankruptcy court or district court.  The DIP Order also found that the DIP Lender had extended financing to the Debtors in good faith and was entitled to the full protections of sections 363(m) and 364(e) of the Bankruptcy Code, shielding the DIP Lender from subsequent reversals that might discourage DIP lending.  Accordingly, unless the DIP Order were to be stayed pending appeal a reversal or modified, the debts incurred or liens granted would be valid.

Fifth Circuit Ruling

Vantage appealed the DIP Order and several related decisions of the district court and bankruptcy court to the Fifth Circuit.  In response, the Debtors asserted that Vantage’s appeal was moot under sections 363(m) and 364(e).  Vantage’s assertion was based on the settled legal principle that a failure to obtain a stay of an authorization under sections 363 and 364 moots an appeal when the transaction was conducted in good faith, and Vantage had not sought or obtained a stay of any orders.  Vantage countered by arguing that the DIP Lender did not act in “good faith.”  The Debtors in turn argued that Vantage had waived its “lack of good faith” argument by raising it for the first time on appeal.

First, the Fifth Circuit concluded that Vantage had sufficiently raised the issue of good faith below.  Vantage had asserted both that F3 Capital had fraudulently obtained the Vantage Shares and that Vantage’s constructive trust over the shares would survive any attempt to pledge the shares to another party who was on notice of Vantage’s adverse claim, including the DIP Lender.

Next, the Fifth Circuit addressed the good faith question directly.  In the context of section 363(m), the court had previously defined “good faith” in several ways, including instances where a purchaser acts without notice of adverse claims.  The Fifth Circuit distinguished between (i) knowledge of an objection to a transaction — as would be the case whenever a creditor objections to a transaction and seeks to have it reversed on appeal — from (ii) knowledge of an adverse claim with respect to the property being purchased or pledged.  Only the latter precluded a finding of good faith.  Here, the DIP Lender knew and had adequate notice that Vantage, a third-party entirely unrelated to the bankruptcy proceedings, had an adverse claim on the Vantage Shares.  On this basis, the Fifth Circuit concluded that the DIP Lender did not come within the meaning of “good faith” as envisioned by sections 363(m) and 364(e), and therefore, Vantage’s appeal of the lower courts’ orders were not moot.

The Fifth Circuit next addressed Vantage’s arguments that the lower courts lacked subject matter jurisdiction over the Vantage Shares and the Vantage Litigation.  First, Vantage had argued that the Vantage Shares were never “property of the estate,” and did not become so pursuant to section 541(a)(7) of the Bankruptcy Code simply by virtue of being pledged to the Bankruptcy Court in custodia legis.  The Fifth Circuit agreed, noting that the Vantage Shares “were not created with or by property of the estate, they were not acquired in the estate’s normal course of business, and they were not traceable to or arise out of any prepetition interest included in the bankruptcy estate.”  Id. at 525.  The Fifth Circuit also held that the lower courts lacked jurisdiction to adjudicate matters subject to the Vantage Litigation because that litigation was not “related to” the bankruptcy proceeding.  That F3 Capital and the Debtors had a common owner — Su — was immaterial for the purpose of establishing “related to” jurisdiction; the outcome of the Vantage Litigation would have no conceivable effect on the Debtors’ estate.  For this reason, the lower courts lacked subject matter jurisdiction.

In sum, after determining that the appeals were not moot, that the Vantage Shares were not “property of the estate” and that the Vantage Litigation was not “related to” the bankruptcy proceedings, the Fifth Circuit concluded that the lower courts lacked the authority to encumber the Vantage Shares.  The Fifth Circuit vacated the orders and remanded the case to the bankruptcy court.