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Bankruptcy is a powerful tool that can allow honest, hardworking individuals to eliminate debt through liquidation or a repayment plan. The power of bankruptcy can permit businesses and individuals to get a fresh start so that they can pursue their goals free from overly burdensome debt. However, the power of bankruptcy is checked in a number of ways. One is the “actual fraud” provisions of the bankruptcy code. Under this provision, a bankruptcy filer who has committed “actual fraud” is not eligible to obtain relief through bankruptcy.  

Significant controversy and questions exist over what exactly constitutes fraud under the bankruptcy code. On one hand, it is well-established that the bankruptcy code prevents an individual who has obtained credit on the basis of false representations or pretenses from obtaining relief. What is not clear is what constitutes “actual fraud.” While some courts have held that actual fraud is any scheme that defrauds creditors, other courts have held that a misrepresentation or lie to a creditor is required.

What Happens when a Creditor Is Defrauded Without a Misrepresentation?

In Husky International Electronics, Inc. v. Ritz, Husky International was a Colorado-based distributor that sold electronics to Chrysalis Manufacturing Corp. Over a period of time, Chrysalis had incurred a debt of $164,000 to Husky International. After running up this debt, Ritz, a 30-percent owner in Chrysalis, began transferring at least $1 million in money and assets from Chrysalis to other entities under his control. In time, the debts owed by Chrysalis remained unpaid. Husky filed a lawsuit against Ritz personally seeking the repayment of the debts, since Chrysalis had been stripped of most of its valuable assets.

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Prior to a court being able to rule on whether Ritz was personally liable to Husky, Ritz filed for Chapter 7 bankruptcy protections. Ritz sought to discharge his potential liability to Husky for the goods. However, Husky sued Ritz in bankruptcy court alleging that Ritz was personally liable for the debts because he had committed fraud by moving the assets out of Chrysalis and beyond the reach of Husky. Lower courts ruled that Ritz was not liable for the debts because he had not committed actual fraud because his actions did not include misrepresentations or lies to Husky regarding the debt.

Supreme Court Reverse and Broadens the Scope of “Actual Fraud”

Writing for a 7-1 majority, Supreme Court Justice Sonia Sotomayor found that Section 523(a)(2)(A), the actual fraud provision, involved forms of fraud that do not include a false representation. The court noted that Congress had explicitly changed the language in the code from forbidding the discharge of debts obtained solely by  “false pretenses” or “false representations” to also include “actual fraud.” This change suggests that Congress intended for the actual fraud language to reach beyond fraud by misrepresentation or false pretenses.

While the decision seems to be a fair and just one, it may nevertheless have a number of unintended consequences. In particular, it remains to be seen how the court’s expansion of the actual fraud provision will affect self-employed filers or small business owners. In these scenarios the line between personal and business assets blur and assets can be transferred from personal accounts to business accounts, and vice-versa without fraudulent intent. Regardless, the effect of the transfer may be to bring assets beyond the reach of creditors. It will be interesting to see how bankruptcy courts will handle this type of scenario and whether small business owners will be affected by the Supreme Court’s decision to expand the bankruptcy code. Small business owners considering bankruptcy should proceed carefully and cautiously with their transactions prior to filing. More than ever, it’s become necessary to work with bankruptcy attorneys in Sacramento who can assess both the company finances but also the likelihood for relief under the bankruptcy code.

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Small Business Owners Can Work with California Bankruptcy Lawyers

If you are a small business owner who has fallen behind on debts and other obligations, bankruptcy may offer a solution to your company’s problems. A Sacramento bankruptcy attorney of The Bankruptcy Group can help. To schedule a free and confidential consultation, call our law firm at 1-800-920-5351 today or contact us online.