United States: SCOTUS Holds Fraud-Discharge Exception Extends To All Debts Procured By Fraud Irrespective Of Debtor's Culpability

Key Takeaways:

• The Supreme Court of the United States held that the Bankruptcy Code's fraud-discharge exception covers debts obtained by fraud, regardless of who committed the fraud.
• Debtors who are liable for fraud on account of a special relationship with others cannot obtain a discharge for such debt in bankruptcy.

On February 22, 2023, the Supreme Court of the United States held that the discharge of prepetition liabilities for debts obtained by fraud of a chapter 7 debtor in bankruptcy, under Section 523(a)(2)(A) of the Bankruptcy Code, extends to all debts obtained by fraud, irrespective of whether it was the debtor who committed the fraud. The high court's decision in Bartenwerfer v. Buckley¹ has sweeping implications for debtors in special relationships in which the debtor could be held liable for someone else's fraud, such as partnerships, employer-employee, or principal-agent relationships.

The case concerned Kate Bartenwerfer's and David Bartenwerfer's sale of a home containing several defects to Kieran Buckley. After the Bartenwerfers represented that they had disclosed all material facts about the home to Buckley, Buckley brought suit and obtained a judgment against the Bartenwerfers for misrepresentation in California state court. The Bartenwerfers thereafter sought to discharge their debts, including the debt owed to Buckley, by filing voluntary petitions for protection under chapter 7 of the Bankruptcy Code. Buckley sued the Bartenwerfers in bankruptcy court, claiming that the debt owed to him was nondischargeable under the fraud-discharge exception. The bankruptcy court found that David knowingly concealed the home's defects from Buckley, and imputed David's fraudulent intent onto Kate by virtue of their business relationship as partners, thereby concluding that neither debt could be discharged. The Ninth Circuit's Bankruptcy Appellate Panel reversed, finding that the exception to the general rule that debts in bankruptcy are discharged giving the debtor a fresh start, the fraud-discharge exception under Section 532 (a)(2)(A), barred the discharge of Kate's debt only if Kate knew or had reason to know of David's fraud. After the bankruptcy court found that Kate did not know or had reason to know of David's fraud on remand, the Ninth Circuit reversed the Bankruptcy Appellate Panel's decision, holding that a debtor who is liable for her partner's fraud cannot discharge that debt in bankruptcy, regardless of the debtor's own culpability. The decision was affirmed by the Supreme Court.

Writing for the majority, Justice Barrett concluded that the plain language of the fraud-discharge exception was "agnostic" about who committed the fraud; all that mattered is that the debt had been procured by fraud. In doing so, the Court rejected Kate's arguments that the most natural way to read Section 523(a)(2)(A) was to bar the discharge of debtors for money obtained by the debtor's own fraud, finding that Congress' use of the passive voice in that section signaled Congress' intent to "focu[s] on an event that occurs without respect to a specific actor, and therefore without respect to any actor's intent or culpability." The Court likewise rebuffed Kate's contentions that the Bankruptcy Code must be read liberally to promote its "fresh start" policy. Justice Barrett wrote, "[b]ut the [Bankruptcy] Code, like all statutes balances multiple, other competing interests .... No statute pursues a single policy at all costs ...." The Court thus affirmed the Ninth Circuit's ruling and found that Kate's debt to Buckley was nondischargeable. Justice Sotomayor, joined by Justice Jackson, filed a concurrence.

The law has long recognized circumstances in which an individual who did not directly commit fraud could nonetheless be held liable for another's fraud where a special relationship exists between the two. For example, an unwitting individual might be held liable for fraud commissioned by his or her business partner, or a real estate company might be held liable for fraud commissioned by its agents if performed within the scope of their duties. As Justice Barrett noted in the Court's opinion, these individuals, "who were not themselves guilty of wrong, received and appropriated the fruits of the fraudulent conduct of their associate in business." Thus, according to the Court, Congress could have rendered (and did) such debts nondischargeable in bankruptcy. Similarly, various state laws protect parties from the fraud of others, including, for example, limited partnerships and victims of fraud.

Not only does this case provide insight into the new Justice's stance on plain meaning based upon grammatical construction, it serves as another decision of late limiting the use of bankruptcy as a shield for certain liabilities.²

Footnotes

1. Bartenwerfer v. Buckley,598 U.S. __, 2023 U.S. LEXIS 943 (Feb. 22, 2023).

2. LTL Mgmt., LLC v. Those Parties Listed on Appendix A to Complaint (In re LTL Mgmt., LLC), No. 22-2003, 2023 U.S. App. LEXIS 2323 (3d Cir. Jan. 20, 2023).

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