Exceptions to discharge in bankruptcy

Here at Shenwick & Associates, the magic word for our debtor bankruptcy clients (we represent creditors, too) is "discharge." When a debt is discharged in bankruptcy, the debtor no longer has any personal liability for the debt and the creditor can no longer communicate with or take legal action against the debtor for the debt. This is the primary reason why debtors file for bankruptcy.

However, not all debts are dischargeable in bankruptcy. Section 523 of the Bankruptcy Code specifically lists many exceptions to discharge, including debts "obtained by–false pretenses, a false representation or actual fraud . . ." (§ 523(a)(2)(A)) and any debt "for willful and malicious injury by the debtor . . ." (§ 523(a)(6)).

This section of the Bankruptcy Code dates back to the Bankruptcy Reform Act of 1978, and since then, the federal courts have had to interpret the statute. For example, in Kawaauhau v. Geiger, the Supreme Court held that to be excepted from discharge under § 523(a)(6), an injury had to be deliberate or intentional.

In Husky Int'l Elec. v. Ritz, the Supreme Court will resolve a circuit split and determine whether the "actual fraud" bar to discharge under § 523(a)(2)(A) applies only when the debtor has made a false representation, or whether the bar also applies when the debtor has deliberately obtained money through a fraudulent transfer scheme that was actually intended to cheat a creditor.

In this case, appellant Husky sold and delivered electronic devices to Chrysalis Manufacturing Corp., an entity that was controlled by appellee Daniel Ritz. Chrysalis failed to pay Husky for any of the goods delivered, and incurred a debt of approximately $164,000. During this time, Ritz transferred much of Chrysalis' funds to various other entities that he also controlled. Husky sued Ritz in an attempt to hold him personally liable for Chrysalis' debt.

Ritz filed for personal bankruptcy, and Husky filed an adversary proceeding (bankruptcy litigation) seeking to except his debt to Husky from discharge, based on §§ 523(a)(2)(a) and 523(a)(6), as well as § 523(a)(4) (which excepts debts arising from fraud or defalcation in a fiduciary capacity, larceny and embezzlement). The bankruptcy court denied all of Husky's requested relief, and held that Husky had not established that Ritz had perpetuated an "actual fraud" on Husky, because Husky failed to show that Ritz made a false representation (one of the elements of an "actual fraud" under Texas law, which may be made by written or spoken words or by conduct) to Husky. The district court affirmed, and Husky appealed to the Fifth Circuit Court of Appeals.

The Court of Appeals reviewed the case law, including McClellan v. Cantrell, a Seventh Circuit Court of Appeals case that held that actual fraud under § 523(a)(2) is not limited to misrepresentations and misleading omissions. However, the Fifth Circuit relied on its own precedents (which held that representations were a required element of fraud and that exceptions to discharge were to be construed narrowly) to affirm the district court.

However, this past July in In re Lawson, the First Circuit Court of Appeals cited McClellan in holding that "actual fraud" also includes debts incurred as a result of knowingly accepting a fraudulent conveyance that the transferee knew was intended to hinder the transferor's creditors.

Although these issues seem esoteric, they demonstrate the complex and fact intensive nature of bankruptcy law. In a recent case, we had to analyze wage claim actions against a food vendor as a possible exception to discharge. For your toughest bankruptcy questions, please contact Jim Shenwick.