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).

In an April 11, 2014 decision the Second Circuit affirmed a ruling by the Southern District of New York, dismissing claims that certain Refco customers facilitated the wrongdoing of the now bankrupt financial services firm.

In Krys v. Pigott, 749 F.3d 117 (2d Cir. 2014), the plaintiffs were liquidators for a family of hedge funds that were customers of the financial services company Refco. The hedge funds had suffered significant losses in connection with Refco’s now infamous bankruptcy.

The liquidators filed suit against a group of customers of Refco alleging that the customers participated in a number of “round-trip” loan transactions with Refco and thereby aided and abetted Refco’s fraud and breach of fiduciary duty.

Under the “round trip” loan transactions, Refco would “loan” up to $720 million to some of its customers, including the defendants, who would then “loan” the same amount to RGHI, a Refco-related entity whose principal asset was shares of Refco. RGHI would then use the money it borrowed from the customers to pay down debt owed to Refco. By engaging in these circular loans at the end of every reporting and audit period, and then unwinding them by reversing the process after the start of each new reporting or audit period, Refco was able to conceal a large related-party receivable and the company’s overall insolvency.

In reviewing the claims against the customers, the Second Circuit agreed with the District Court ruling that under New York law, claims for aiding and abetting fraud and breach of fiduciary duty required the liquidators to establish that the alleged aider and abettor had actual knowledge of the underlying wrongful conduct.

The court emphasized that “constructive knowledge,” i.e. that the defendants should have known that they were aiding and abetting fraud or breach of fiduciary duty, was not enough to satisfy the scienter requirement for the allegations.

Although the liquidators alleged that the customers “knew and/or consciously avoided knowing” that the “round-trip” loans were created so that Refco could issue fraudulent financial statements and hide its insolvency, they failed to allege sufficient facts to “give rise to any reasonable inference that [the customers] knew or even suspected that Refco was insolvent” or that the loans were designed to hide that fact.

The court was not persuaded by arguments that the timing, specific amounts, or increasing size of the loans should have tipped the customers off about their fraudulent nature, and the court found it implausible that the customers knew about Refco’s insolvency because they continued to do business with the company, at times insisting on having the loans guaranteed by Refco.

In the absence of facts indicating that the customers had actual knowledge that Refco was engaged in fraud or breaching its fiduciary duties, the liquidators had failed to state a claim.

The Second Circuit decision demonstrates that future plaintiffs bringing similar claims will have to plead their cases with greater particularity, alleging facts sufficient to establish actual knowledge by those who they claim aided or abetted fraud or breach of fiduciary duty.

The recipient of funds that a trustee seeks to recover by means of a fraudulent transfer claim may avoid liability by establishing that it took “for value and in good faith,” under section 548(c) of the Bankruptcy Code.  The Bankruptcy Code does not define “good faith,” and case law does not provide a clear precedent of what constitutes good faith; rather courts generally consider whether the transferee knew or should have known of the debtor’s financial distress at the time of the transfer.  In its recent decision in In re Taneja (Gold v. First Tennessee Bank National Association), a divided Fourth Circuit Court of Appeals considered the meaning and proper application of the good faith defense in actions to avoid and recover fraudulent transfers under section 548. No. 13-1058, 743 F.3d 423 (4th Cir. Feb. 21, 2014).  The Fourth Circuit’s decision in Taneja does not provide a “bright line” legal precedent, but it does appear to lower the bar with respect to a transferee’s factual burden.  In Taneja, the court held that a transferee need not present evidence that its every action concerning the relevant transfers was objectively reasonable in light of industry standards.  Rather, the court’s inquiry regarding industry standards serves only to establish the correct context in which to consider what the transferee knew or should have known, and expert testimony is not necessarily required to establish that context.

In Taneja the debtor, Vijay K. Taneja, originated home mortgages through his company Financial Mortgage Inc. (“FMI”) and sold them to secondary purchasers who, in turn, aggregated and securitized the loans to create “mortgage-backed securities.”[1]  Taneja and FMI financed these loans by borrowing funds from warehouse mortgage lenders, including the defendant First Tennessee Bank National Association (the “Bank”).  Prior to filing for bankruptcy, Taneja and FMI transferred funds to the Bank in repayment of outstanding loans.  The bankruptcy trustee for Taneja and FMI brought an action to void and recover the repaid loan amounts as fraudulent transfers under section 548.  In response, the Bank asserted a good faith defense under section 548(c).  The Bankruptcy Court found that the Bank had accepted the transfers for value and in good faith, and the District Court affirmed.

On the trustee’s appeal, the Fourth Circuit considered the proper context in which to evaluate the reasonableness of a transferee in accepting funds later deemed to constitute a fraudulent conveyance.  Both lower courts had relied on the standard articulated in In re Nieves, 648 F.3d 232,237 (4th Cir. 2011), which bifurcated the good faith requirement into two components.  The first, a subjective component, relates to the transferee’s “honesty” and “state of mind,” while the second, objective, component relates to the transferee’s “observance of reasonable commercial standards.”  Notably, Nieves made clear that a transferee does not act in good faith if it “fails to abide by routine business practices.”

In Taneja, the Fourth Circuit affirmed the application of the binary standard of Nieves compelling the consideration of what the transferee “should have known . . . taking into consideration the ‘customary practices of the industry in which [it] operates’.”  However, the court held that a transferee relying on section 548(c) is not required to demonstrate that it abided by “routine business practices”, stating, “[w]e decline to adopt a bright-line rule requiring that a party asserting a good faith defense present evidence that his every action concerning the relevant transfers was objectively reasonable in light of industry standards.”  Instead, the court stated, “our inquiry regarding industry standards serves to establish the correct context in which to consider what the transferee knew or should have known.”  Relying on the bankruptcy court’s finding that the bank’s witnesses presented credible testimony concerning the bank’s practices “. . . and the mortgage warehouse industry,” the Fourth Circuit held that the district court did not clearly err in holding that the transferee Bank had carried its burden of showing that it received payments from FMI in good faith.[2]

Practical Implications

While the opinion does not go so far as to pronounce a clear legal standard by which to assess whether a fraudulent transfer is received in good faith, courts following the guidance of the Fourth Circuit’s precedent may apply relaxed standards of proving a good faith defense under section 548(c), particularly with respect to the objective component regarding the transferee’s observance of reasonable commercial standards.  Significantly, the panel unanimously agreed that the objective component of 548(c) could be satisfied through lay witness testimony from the transferee, and that expert testimony was not required.

[1].      Details of the fraud are provided in the court’s decision in In re Taneja (Gold v. First Tennessee Bank Nat’l Assoc.), No. 13-1058, 2014 WL 661065 (4th Cir. Feb. 21, 2014).  The Fourth Circuit reviewed the District Court decision for clear error, and as a result concluded it was not required to render any decision regarding whether the trustee was entitled to a ‘Ponzi scheme presumption’ with respect to the alleged fraudulent conveyances.

[2].      In re Taneja, 2014 WL 661065 at *12.  Although the objective good faith standard articulated by the Fourth Circuit in Taneja considers the “routine” or “customary” practices of the industry in which the transferee Bank operated, the Bank in Taneja presented scant, if any, evidence of customary industry practices, to the vexation of both the trustee and lone dissenting circuit judge James A. Wynn, Jr.  Instead, the case turned on evidence presented by the Bank of a downturn in the mortgage warehouse industry at the time it received the transfers.