U.S. Supreme Court: Debts Due to Business Partner’s Fraud Non-Dischargeable

April 26, 2023 | Stuart I. Gordon | Matthew V. Spero | Alexandria E. (Tomanelli) Vath | Bankruptcy | Corporate

Earlier this year, the Supreme Court issued a decision that all business owners should be aware of. The Supreme Court resolved a Circuit split over whether a debtor can discharge a debt incurred by a fraud committed by the debtor’s business partner or agent. In a unanimous decision, the Court held that such a debt is not dischargeable in bankruptcy, despite the debtor’s lack of culpability for the fraud.

This decision settled the controversy over the interpretation of Bankruptcy Code §523(a)(2)(A), which allows debtors to discharge their pre-bankruptcy debts, except for those obtained by “false pretenses, a false representation, or actual fraud.” 11 U.S.C. §523(a)(2)(A).

This decision means that when individuals enter into a partnership or agency relationship, they can be held responsible for their partner’s fraud, even if they had no knowledge of it.

In Bartenwerfer v. Buckley, Kate Bartenwerfer and David Bartenwerfer (the “Debtors”) remodeled a house they jointly owned. Kate’s boyfriend, David, who later became her husband, was responsible for overseeing the home’s renovations, and she remained uninvolved. The couple then sold the house to Kieran Buckley.

Before the sale, the Debtors signed disclosure statements to Buckley, the buyer, regarding the property’s condition. The Debtors represented that they had disclosed all the material facts and defects to Buckley concerning the property’s condition.

After the sale, Buckley discovered several defects within the home, such as a leaky roof, defective windows, a missing fire escape, and permit problems. As a result, Buckley sued the Debtors in state court.

Buckley alleged that the Debtors failed to disclose material facts regarding the home’s condition. The jury found the Debtors liable for failing to make material disclosures and awarded Buckley over $200,000 in damages.

Since the Debtors could not pay the judgment, they sought protection under Chapter 7 of the Bankruptcy Code to obtain a “fresh start” and discharge their debts, including the debt to Buckley.

After the Debtors filed their Chapter 7 petition, Buckley filed an adversary complaint against them, alleging that his judgment was not dischargeable in their bankruptcy because the Bankruptcy Code excludes from discharge “any debt . . . for money . . .to the extent obtained by . . . false pretenses, a false representation, or actual fraud.” 11 U.S.C. §523(a)(2)(A).

The Bankruptcy Court decided that neither Debtor could discharge the debt owed to Buckley. Even though David, and not Kate, had knowingly concealed the defects, the fraud was imputed to Kate because the two were in a legal partnership to renovate and sell the property.

The decision was appealed, and the Ninth Circuit’s Bankruptcy Appellate Panel agreed that David had fraudulent intent but disagreed that David’s intent could prevent Kate’s debt from being discharged. The Court found that §523(a)(2)(A) would only prevent the discharge of Kate’s debt if Kate knew or had reason to know of David’s fraud, and it remanded the case back to the Bankruptcy Court. The Bankruptcy Court, applying this standard, concluded that Kate lacked the knowledge required to impute David’s fraud to her. The Bankruptcy Appellate Panel subsequently affirmed.

However, the Ninth Circuit Court of Appeals reversed in part, holding that Kate, despite her lack of knowledge, could not discharge the debt incurred from David’s fraud, and the Supreme Court ultimately granted certiorari to resolve the confusion over the interpretation of §523(a)(2)(A).

The question presented to the Supreme Court was whether a debt incurred by the fraud of one partner may be discharged by the second partner’s bankruptcy, or whether 11 U.S.C. §523(a)(2)(A) barred the discharge of the debt by imputation and without any act, omission, intent, or knowledge of the second partner.

The Supreme Court unanimously affirmed the lower court’s ruling. In doing so, it held that §523(a)(2)(A) of the Bankruptcy Code does not allow even an “innocent debtor” who lacked culpability, like Kate Bartenwerfer, to discharge a debt incurred by her partner’s fraud.

It is important for individuals to know that when a partnership relationship is created, an innocent party can be held liable for their partner’s fraud, and any debt incurred because of such fraud will be considered non-dischargeable, even for the “innocent partner.”

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  • Stuart I. Gordon
  • Matthew V. Spero
  • Alexandria E. (Tomanelli) Vath

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