Fraudulent Transfers and the Fresh Start in Bankruptcy.

• Author: Norberg, Scott F.

1. INTRODUCTION

   As is often stated, the fresh start in bankruptcy is reserved for the honest but unfortunate debtor. (1) The Bankruptcy Code distinguishes the honest from dishonest debtor primarily through the grounds for denial of the discharge of any debts in [section] 727(a) (2) and several of the exceptions to the discharge for particular debts in [section] 523(a). (3) Section 727(a) focuses on debtor misconduct that relates to the bankruptcy process and impacts creditors in general, while [section] 523(a) includes exceptions to the discharge of certain individual debts that arise from culpable misconduct by the debtor. (4) Questions about the scope of an exception to the discharge often raise fundamental questions about the balance between Code policies favoring the discharge and fresh start for the debtor, on the one hand, and the need to sanction dishonesty and misconduct, on the other. (5) The more broadly an exception to discharge is construed, the more limited is the debtors fresh start.

   In 2016, the Supreme Court once again tackled a question concerning the scope of one of the exceptions to the discharge, (6) found in [section] 523(a)(2)(A), which covers debts "for money, property, services, or ... credit, to the extent obtained by false pretenses, a false representation, or actual fraud." (7) In Husky International, Inc. v. Ritz, the Court held that "actual fraud" in section 523(a)(2)(A) is broad enough to encompass debts arising from a debtor's participation as a transferee in an intentionally fraudulent transfer. (8) The Court read "actual fraud" according to its long established common law meaning, (9) but gave a strained interpretation to the words "obtained by," (10) which most naturally mean, "obtained from the creditor." The transferee of a fraudulent transfer does not, of course, obtain anything from the transferors creditors.

   Whereas the typical case concerning an exception to discharge under [section] 523(a) involves a single creditor and claim, under Husky, a debtor's receipt of an intentionally fraudulent transfer may give rise to debts owed to the entire class of creditors with unsecured claims against the debtor/transferor at the time of the transfer. Thus, the decision in Husky allows [section] 523(a)(2)(A) to operate more like a ground for denial of discharge in toto under [section] 727(a), and potentially narrows the scope of the fresh start to an unusual degree.

   Lower courts have also held that the exception to discharge for debts "for willful and malicious injury" in [section] 523(a)(6) applies to debts arising from a debtors knowing receipt of an intentionally fraudulent transfer; (11) and that the exception for debts "for fraud or defalcation while acting in a fiduciary capacity" in [section] 523(a)(4) may cover debts incurred by a debtor who fraudulently transferred property of an insolvent corporation of which he was an insider. (12) These cases likewise hold the potential to significantly diminish the scope of the fresh start by excepting from discharge the entire class of debts owed to creditors with claims against the transferor at the time of the transfer. The basic fact pattern is the same in almost all of the cases in which a creditor objects to the dischargeability of a fraudulent transfer debt under [section] [section] 523(a)(2), (4), or (6). As in Husky, the debtor was an insider (the controlling officer and director) of the transferor (a corporation), and received or was the beneficiary of a transfer made by the transferor with intent to defraud a creditor.

   This article offers three primary contributions. First, it argues that the exceptions to discharge in [section] 523(a) must be interpreted within the context of related Code provisions. In Husky, the Court did not fully consider the similar provisions in [section] [section] 727(a) and 523(a)(2)(A) as applied to fraudulent transfers. If it had, it would have found a sound basis for the more natural interpretation of "obtained by" in 523(a)(2)(A) to mean "obtained from the creditor." Second, this article reviews and summarizes court decisions applying [section] [section] 523(a)(2), (4), and (6) to intentionally fraudulent transfers. The lower courts consistently hold that [section] 523(a)(6) may operate to except a fraudulent transfer debt from discharge where the debtor is the transferee, but not where the debtor was the transferor. The decisions applying [section] 523(a)(4) to fraudulent transfer debts are divided, and the reasoning in many of the cases is muddled and unclear. Finally, accepting that Husky now requires courts to apply [section] 523(a)(2)(A) to actually fraudulent transfers, this author explores a basis for limiting the damage awards in such cases to the loss suffered as a result of the transfer. Where other creditors hold the same nondischargeability claim, their collective loss is the value of the assets transferred, and their individual losses would be a pro rata allocation based on the ratio of the total of their claims to the value of the assets transferred.

   Part II provides an overview of the scheme of the Bankruptcy Code provisions that affect the fresh start where the debtor has participated in an intentionally fraudulent transfer. Part III discusses the decision in Husky and its impact on nondischargeability determinations under [section] 523(a)(2)(A). It also reviews case law applying [section][section] 523(a)(4) and 523(a)(6) to fraudulent transfer debts. Part IV critically analyzes the reasoning in these cases that apply [section][section] 523(a)(2), (4), and (6) to fraudulent transfer debts. Part V concludes with the author's argument that applying [section][section] 523(a)(2), (4), and (6) to fraudulent transfer debts may overly diminish the scope of the discharge, but that an appropriate balance between the policies favoring the fresh start and sanctioning debtor misconduct may be found in a clear rule limiting damages to the creditor's pro rata loss.

2. THE STATUTORY CONTEXT: OVERVIEW OF THE CODE PROVISIONS LIMITING THE FRESH START WHERE THE DEBTOR PARTICIPATED IN AN ACTUALLY FRAUDULENT TRANSFER

   As the Supreme Court recognized in Husky, the statutory limits on the discharge should be construed within the larger scheme of related Code provisions. (13) Thus, exceptions to discharge and a denial of discharge should be interpreted in part based on the extent to which they duplicate each other. The following chart summarizes the several Code provisions that may limit the fresh start of a debtor who participated in an intentionally fraudulent transfer. Each provision is more fully discussed below.

   This Part now briefly reviews the grounds for denial of the discharge under [section][section] 727(a)(2) and (a)(7) as a predicate to a close examination of the application of [section][section] 523(a)(2), (4), and (6) to debts arising from a debtor's participation in an intentionally fraudulent transfer. In examining the scope of the latter provisions, it will be necessary to understand how they complement and overlap with the former. The final section of this Part briefly explains [section][section] 522(g) and (o), which mandate for the loss of exemptions in some cases where the debtor has participated in an actually fraudulent transfer.

   1. Fraudulent Transfers and Denial of Discharge under Sections 727(a)(2) and (a)(7)

   Sections 727(a)(2) and (a)(7), which are applicable to chapter 7 and chapter 11 debtors, (14) but not to chapter 13 debtors, (15) bar the discharge of all debts where the debtor has participated in certain intentionally fraudulent transfers. Section 727(a)(2)(A) applies where "the debtor, with intent to hinder, delay, or defraud a creditor ... has transferred ... property of the debtor, within one year before" bankruptcy. (16) It also applies where the debtor converted non-exempt to exempt assets with the intent to defraud creditors within the year before filing. (17) In such cases, the debtor is considered both the transferor and the transferee of the asset. Section 727(a)(2) applies by virtue of the debtor's role as a transferor. It does not apply where the debtor, acting as an insider of a corporation, caused the corporation to transfer assets with intent to defraud creditors. (18)

   Section 727(a)(7) precludes the discharge where the debtor has transferred property with intent to hinder, delay, or defraud a creditor "on or within one year before the date of the filing of the petition, or during the case, in connection with another [bankruptcy] case ... concerning an insider." (19) Most importantly, it covers the situation where the debtor, acting as the officer or director of a corporation that has also filed for bankruptcy, caused the corporation to transfer property with intent to defraud creditors within one year before the debtors bankruptcy. (20)

   Groman v. Watman (In re Watman21) illustrates the application of both [section][section] 727(a)(2) and (a)(7). In Watman, the plaintiff sold the debtor stock in a dental practice (Childrens Dental) on credit. When the debtor failed to pay, the plaintiff obtained a state court judgment against him. One week later, the debtor transferred the corporation's assets to himself for no consideration and then shortly afterwards he transferred them again for no consideration to a new corporation. The debtor continued to operate the dental practice with the same patients, employees, and assets of Childrens Dental. When the debtor later filed for chapter 7 relief and Childrens Dental filed under chapter 11, the plaintiff objected to the debtor's discharge under [section][section] 727(a)(2) and (a)(7). (22)

   Applying [section] 727(a)(2), the bankruptcy court observed that the statute requires a transfer of property of the debtor. Since the transfer in question was the transfer of the entity's assets, the plaintiff had not stated a cause of action. Under [section] 727(a)(7), the court held that the debtor's conduct in...