In a case decided Wednesday, February 23, 2023, the U.S. Supreme Court held that a Chapter 7 bankruptcy debtor is precluded from discharging in bankruptcy a debt obtained by fraud, regardless of the debtor’s own personal knowledge of or culpability in the fraud, at least where the fraud was committed by an agent or partner within the scope of the partnership. The case – Bartenwerfer v. Buckley – resolved a split in the lower federal courts about whether the debtor was required to have knowledge or culpability for the debt to remain nondischargeable under the Bankruptcy Code.
The case involved a couple who decided to flip a jointly owned home for profit in San Francisco. The husband took charge of the project, while the wife remained largely uninvolved. They eventually sold the house to a buyer.
After the purchase, the buyer discovered several defects that the sellers had failed to disclose. The buyer sued in California state court and won, leaving the sellers jointly responsible for more than $200,000 in damages.
When the sellers were unable to pay that judgment or their other creditors, they filed for Chapter 7 bankruptcy. The buyer filed an adversary complaint in the bankruptcy proceeding, alleging that the debt owed him on the state-court judgment was nondischargeable under the Bankruptcy Code’s exception to discharge of “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 found that the husband had committed fraud and imputed his fraudulent intent to the wife because the two had formed a legal partnership to renovate and sell the property.
On initial appeal, the Bankruptcy Appellate Panel for the Ninth Circuit disagreed as to the wife’s culpability, holding that the statute barred her from discharging the debt only if she knew or had reason to know of her husband’s fraud.
On further appeal, the Ninth Circuit the Bankruptcy Appellate Panel, holding that a debtor who is liable for her partner’s fraud cannot discharge that debt in bankruptcy, regardless of her own culpability. The wife appealed to the U.S. Supreme Court.
Supreme Court Decision
In a unanimous decision, the Supreme Court held that Section 523(a)(2)(A) agreed with the Ninth Circuit, holding that a debtor could not discharge a debt obtained by fraud, regardless of the debtor’s own culpability.
The Supreme Court first looked at a straightforward reading of the statute:
(a) A discharge . . . does not discharge an individual debtor from any debt–
(2) for money . . . to the extent obtained by–
(A) false pretenses, a false representation, or actual fraud . . . .
The wife argued that an ordinary English speaker would understand “money obtained by fraud” to mean money obtained by the individual debtor’s fraud. The Court noted, however, that the statute focused on an event that occurred (i.e. the fraud) without respect to a specific actor committing the event, and therefore the statute was “agnostic” as to any actor’s individual intent, knowledge, or culpability. In essence: the focus was on the fraudulently-obtained debt, not the fraudster.
The wife further argued that all of the other paragraphs surrounding 523(a)(2)(A) in the statute pertained to “the debtor” and not merely “the debt,” suggesting that Congress had made a sloppy error in drafting the statute. The Court flipped this argument on its head, noting that this argument actually suggested that this paragraph specifically excluded consideration of the debtor’s culpability, given that the surrounding paragraphs expressly hinged on it. This reflected the Court’s hesitance to overstep its constitutional authority and rewrite statutes duly enacted by Congress.
As further evidence of Congress’s intent, the Court looked back to a case from 1885, Strang v. Bradner, in which the Court had held that the fraud of one partner should be imputed to the other partners who received the benefit of the fraud. This was despite the fact that the Bankruptcy Code at the time only barred discharge of fraudulent debts “created by the fraud or embezzlement of the bankrupt.” In response, when Congress overhauled the Bankruptcy Code, it removed the phrase “of the bankrupt,” suggesting that it agreed with the Strang decision.
Lastly, the wife argued that a decision against her would result in innocent people being held liable for fraud they did not commit. In response, the Court first noted that a faultless individual is ordinarily responsible for another’s debt only when the two have a special relationship, such as an agency or partnership relationship, and even then, defenses to liability are sometimes available. However, that being said, the Court held that innocent people are sometimes held liable for fraud they did not personally commit, and that, under Congress’s duly enacted Bankruptcy Code, if they declare bankruptcy, §523(a)(2)(A) bars discharge of that debt.
While the Supreme Court considered the fact that the husband and wife were “partners” as supporting evidence of its decision, the statute still does not explicitly require a partnership or agency relationship for the “innocent” debtor to be barred from discharging fraudulently-obtained debt. In fact, in oral arguments, the buyer’s attorney argued that a non-agent or non-partner would still be out of luck if he or she somehow obtained fraudulent debt. However, the Court declined to rule on this issue, and two justices filed a concurring opinion expressly stating that this opinion was limited to “agents” or “partners within the scope of the partnership.”
Perhaps more interesting for bankers and lawyers in Minnesota and other Eighth Circuit states is the fact that this opinion effectively overrules prior Eighth Circuit precedent which held that “Proof that a debtor’s agent obtains money by fraud does not justify the denial of a discharge to the debtor, unless it is accompanied by proof which demonstrates or justifies an inference that the debtor knew or should have known of the fraud.” Matter of Walker, 726 F.2d 452, 454 (8th Cir. 1984) (emphasis added). As such, Eighth Circuit bankruptcy parties should be aware that the knowledge or culpability of the debtor is now irrelevant in the determination of dischargeability in cases of fraud under Section 523(a)(2)(A).
Case citation: Bartenwerfer v. Buckley, 21-908, 2023 WL 2144417 (U.S. Feb. 22, 2023)