U.S. Supreme Court and 4th Circuit Each Rules for Creditors in Recent Notable Opinions

Posted on by Neil E. McCullagh in Creditors' Rights, Bankruptcy and Insolvency

This month we report on two very recent court decisions that are noteworthy for creditors. In the first decision, the U.S. Supreme Court defined "actual fraud" in a way that allows a creditor's claim against the recipient of a fraudulent transfer to be declared nondischargeable in bankruptcy. In the second decision, the federal Fourth Circuit Court of Appeals clarified that a Chapter 13 debtor's right to "cure" his mortgage default doesn't mean that he gets to reinstate a pre-default interest rate.

U.S. Supreme Court: "Actual Fraud" Does Not Require a False Representation, so Claim Against Fraudulent-Conveyance Recipient may be Nondischargeable

On May 16, 2016, the U.S. Supreme Court ruled that the phrase "actual fraud" in Bankruptcy Code § 523 - which defines the scope of debts that can be excepted from a bankruptcy discharge - "encompasses forms of fraud, like fraudulent transfer schemes, that can be effected without a false representation." The case is Husky Int'l Elecs., Inc. v. Ritz, 2016 U.S. LEXIS 3048 (U.S. May 16, 2016).

The Husky case involved a corporation that sold approximately $164,000 of goods on credit to another corporation, of which a Mr. Ritz was a director and 30% owner. Mr. Ritz drained the buyer corporation's funds by transferring them to other entities he controlled. The seller corporation sued Mr. Ritz, arguing that due to his transfer scheme, he was liable under a Texas statute that imposes personal liability on a shareholder who uses a corporation to perpetrate an actual fraud primarily for his own benefit. Ritz then filed Chapter 7 bankruptcy, and the seller corporation filed a nondischargeability lawsuit against him, arguing that his transfer scheme constituted "actual fraud" not only under the Texas statute but also under Bankruptcy Code § 523. Mr. Ritz prevailed in the lower courts by arguing that for a debt to be nondischargeable based on "actual fraud," the debtor must have made a false representation to the creditor - for example, in the Supreme Court's words, "as when a person applying for credit adds an extra zero to her income or falsifies her employment history" - which he had not done.

The Supreme Court, however, found that neither the language of section 523 nor the historical usage of "actual fraud" supports the notion that that phrase encompasses only the debtor making a false representation to the creditor. Further, the Court found that even though section 523 requires that the debt at issue be based on money, property, services, or credit "obtained by" actual fraud, "fraudulent conveyances are not wholly incompatible with the 'obtained by' requirement." In this regard, the Court noted that while it is true that one who fraudulently transfers assets (i.e., the original debtor) does not obtain a debt in the process, (a) "the recipient of the transfer - who, with the requisite intent, also commits fraud - can 'obtain' assets 'by' his or her participation in the fraud," and (b) that "any debts 'traceable to' the fraudulent conveyance" will therefore be nondischargeable. The Supreme Court then sent the case back to the lower court to decide whether Mr. Ritz's debt to the creditor was "obtained by" fraud.

In sum, a creditor may have a nondischargeable claim against a bankruptcy debtor even if there was no fraud on the front end of the transaction - e.g., no fraudulent credit application. So long as the debtor received assets through a fraudulent conveyance, with fraudulent intent, and the debtor owes a debt to the creditor "traceable to" the fraudulent conveyance, the creditor has a claim that can be declared nondischargeable in a timely filed lawsuit in the bankruptcy case.

Under Virginia law, it is possible to hold the transferee of a fraudulent transfer personally liable if the creditor does not otherwise have an adequate remedy - e.g., if the asset that was transferred has been disposed of and therefore cannot be recovered for the benefit of the creditor. Price v. Hawkins, 247 Va. 32, 37, 439 S.E.2d 382, 1994 Va. LEXIS 17 (1994) ("Here, an in personam judgment against these transferees in the full amount of the fraudulent conveyances is appropriate under the circumstances."). Further, prior to the Husky case, the U.S. Bankruptcy Court for the Eastern District of Virginia held that a false representation by the debtor to the creditor was a prerequisite to a nondischargeability claim based on actual fraud. KMK Factoring, L.L.C. v. McKnew (In re McKnew), 270 B.R. 593, 618 n.40, 2001 Bankr. LEXIS 1628 (Bankr. E.D. Va. 2001). Therefore, the Husky case offers a new and valuable tool to creditors in Virginia whose efforts to collect their claims are stymied by their debtor's fraudulent conveyance of his assets.

Fourth Circuit: Chapter 13 Debtor's Right to Cure Mortgage Default Does Not Include Reinstating Non-Default Interest Rate

On April 27, 2016, the federal Fourth Circuit Court of Appeals, which covers Virginia among some other states, ruled that a Chapter 13 debtor's right to cure or waive mortgage defaults through his Chapter 13 plan does not include the right to reinstate a non-default interest rate that was lost prior to the bankruptcy case. The case is Anderson v. Hancock (In re Anderson), 2016 U.S. App. LEXIS 7634 (4th Cir. April 27, 2016).

In the Anderson case, the borrowers purchased a home financed by a 30-year mortgage with a fixed 5% interest rate that would increase to 7% upon default. Prior to filing Chapter 13 bankruptcy, the borrowers failed to make their regular monthly payment, and the secured creditor accordingly imposed the 7% default rate. The secured creditor subsequently initiated foreclosure proceedings, to which the borrowers responded by filing their Chapter 13 case.

The debtors' Chapter 13 plan proposed to cure their prepetition payment arrears at an interest rate of 5% and to reinstate the 5% interest rate on post-petition payments. The secured creditor objected, requesting application of the 7% default interest rate for both the prepetition arrearage and the post-petition payments. The bankruptcy court ruled for the secured creditor based on Bankruptcy Code section 1322(b)(2), which prohibits modification of a claim secured only by a debtor's principal residence. After appealing to the district court, and losing, the debtors appealed to the Fourth Circuit.

The Fourth Circuit framed the question as "whether the plan's proposed change to the debtors' rate of interest is part of a 'cure' permissible under § 1322(b)(3) and (5), or alternatively, is a 'modification' forbidden by" section 1322(b)(2). In this regard, the court noted that subsection (b)(3) allows a Chapter 13 plan to "provide for the curing or waiving of any default" and that subsection (b)(5) creates an explicit exception to subsection (b)(2) in which a plan can "provide for the curing of any default within a reasonable time and maintenance of payments while the case is pending" on long-term debts.

The Fourth Circuit examined the language of section 1322(b) and concluded that the meaning of "cure" "focuses on the ability of a debtor to decelerate and continue paying a loan, thereby avoiding foreclosure," as opposed to modification of loan terms. The court also found support for this interpretation in the legislative history of section 1322(b), which the court said showed that Congress's intent was to allow debtors a second chance to pay their mortgages but not a chance to modify loan terms. The court said that maintaining this "deliberative balance" reached by Congress was not, as the borrowers argued, contrary to the principal purpose of bankruptcy - granting a fresh start to the honest but unfortunate debtor - because allowing debtors to negate default interest rates might (a) increase mortgage rates generally, (b) motivate lenders to pursue foreclosure sooner, or (c) make mortgage loans less accessible generally. In other words, the "spirit of bankruptcy" (as the court called it) should not be interpreted so broadly as to potentially harm future mortgage debtors.

About the Author

Neil E. McCullagh is an attorney who works with banks on a wide variety of issues, including lending, insolvency, workouts, creditors' rights, bankruptcy, and collections.

Spotts Fain publications are provided as an educational service and are not meant to be and should not be construed as legal advice. Readers with particular needs on specific issues should retain the services of competent counsel.