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Fraudulent Transfer Scheme Prevents Discharge of Debtor’s Obligation

Restructuring, Bankruptcy & Creditors' Rights Alert Craig L. Friedrichs, Christopher Combest

An individual files a bankruptcy case to have his debts forgiven, or “discharged.” Where that individual is a principal shareholder or officer of a corporate borrower who has guaranteed payment of his company’s loans, those debts can be substantial. An individual guarantor in that dire situation may try to hide assets – his own or those of his company – and then file a bankruptcy case, in an effort to defeat a lender’s right to be repaid.

In response, a lender can prevent the discharge of debts owed for money or property obtained by an individual debtor’s “actual fraud.” However, some courts have held that “actual fraud” can exist only in cases where a debtor makes misrepresentations directly to its creditor – and schemes involving the manipulation or hiding of assets may not involve any direct contact between the individual debtor and the creditor at all.

Now, in a victory for creditors that provides them with a stronger weapon against individuals’ fraud, the United States Supreme Court has rejected that narrow view, finding that a wider range of conduct intended to defraud a creditor – like participation in a fraudulent transfer scheme – can also justify prohibiting the discharge of a debt, even without any direct misrepresentations.

In Husky International Electronics, Inc. v. Ritz, Daniel Ritz controlled a company that owed a debt to Husky. Ritz caused that company to fraudulently transfer over $1 million – money the company could have used to pay that debt – to other companies that Ritz also controlled. However, Ritz managed to avoid making any false statements directly to Husky.

After Husky sued Ritz personally for the company’s debt, Ritz filed a bankruptcy case. Husky argued that Ritz’s shuffling of assets among his companies constituted “actual fraud.” But, since Ritz never made false statements directly to Husky, the lower courts found that his debt could be discharged.

The Supreme Court disagreed, concluding that the term "actual fraud" applies to a range of schemes designed to prevent a creditor from collecting a debt, and not solely to schemes involving false statements.

Husky represents a victory for creditors dealing with evasive debtors who resist collection efforts through the transfer of funds or by other fraudulent schemes. Today, individuals can engineer sophisticated frauds involving multiple layers of companies that can insulate the fraudster from his victims. After this decision, it may be more difficult for an individual to escape fraud-related debt in bankruptcy.

Experienced counsel can help creditors determine whether to challenge the discharge of their debts and, if successful, can help them take steps to recover these debts from their debtors.

If you have any questions, please contact Craig L. Friedrichs at (602) 229-5642/, Christopher Combest at (312) 715-5091/, or your local Quarles & Brady attorney.