In the case of Bartenwerfer v. Buckley, the U.S. Supreme Court recently held that a debtor who is liable for their business partner’s fraud cannot discharge that debt in bankruptcy, regardless of their own culpability. KingSpry’s Business Law Practice Group details what this recent decision means and how it may impact you.
Kate and David Bartenwerfer (the Bartenwerfers), unmarried at the time and acting as business partners, decided to remodel their jointly owned house in San Francisco, California to sell it for a profit. David took charge of the project, while Kate remained largely uninvolved. After a rocky road of renovation, the Bartenwerfers sold the house to Kieran Buckley (Buckley), attesting that they had disclosed all material facts relating to the property.
Shortly after the sale, Buckley discovered several defects that were not disclosed by the couple. Buckley claimed the Bartenwerfers failed to disclose a leaky roof, defective windows, a missing fire escape, and permit issues. Buckley sued them in California state court, alleging he overpaid in reliance on the Bartenwerfers’ misrepresentations.
The Litigation Process
In California state court, a jury found in Buckley’s favor. The Bartenwerfers were held jointly responsible for more than $200,000 in damages. As they were unable to pay this judgment and their other creditors, the Bartenwerfers filed for Chapter 7 Bankruptcy.
Why Did they File for Chapter 7 Bankruptcy?
Chapter 7 Bankruptcy allows debtors to get a “fresh start” by discharging their debts. The Bartenwerfers intended to reset their finances by discharging all prebankruptcy liabilities, including their liability to Buckley. Under Chapter 7 bankruptcy, however, not all debts are dischargeable. Specifically, Section 523(a)(2)(A) of the Bankruptcy Code bars the discharge of “any debt…for money…to the extent obtained by…false pretenses, a false representation, or actual fraud.”
Buckley asserted the money owed on the state-court judgment fell within this exception. After a bench trial, the Bankruptcy Court agreed and held that neither David nor Kate could discharge their debt to Buckley.
Wasn’t Kate Uninvolved?
Because the Bartenwerfers had a legal business partnership, the Bankruptcy Court imputed David’s fraudulent intent to Kate.
After an appeal to the Ninth Circuit’s Bankruptcy Appellate Panel, David’s fraudulent intent was confirmed but Kate’s was not. The panel reasoned that Kate could discharge the debt owed, because she had no reason to know of David’s fraud.
The Ninth Circuit later reversed that decision in part, because a debtor who is liable for their partner’s fraud cannot discharge that debt in bankruptcy, regardless of their own culpability. Kate remained liable for her debt to Buckley. The U.S. Supreme Court granted certiorari to resolve this confusion.
The Supreme Court Weighs In
The issue specifically addressed by the Supreme Court was whether the debt of an innocent debtor may be discharged under Section 523(a)(2)(A) of the Bankruptcy Code where such debt was result of the fraud of a business partner. On February 22, 2023, the Supreme Court unanimously held Kate’s debt was not dischargeable regardless of her own culpability
In coming to its conclusion, the Supreme Court relied on the express text of the Bankruptcy Code and states that while it is sensitive to the hardship faced by Kate, the passive investor, “Congress has ‘evidently concluded that the creditors’ interest in recovering full payment of debts’ obtained by fraud ‘outweigh[s] the debtors’ interest in a complete fresh start . . . and it is not our role to second guess that judgment.”
The Supreme Court goes on to emphasize that Section 523(a)(2)(A) of the Bankruptcy Code does “not define the scope of one person’s liability for another’s fraud – that is a function of the underlying law. . .” Meaning that if “[applicable state law] did not extend liability to honest partners, Section 523(a)(2)(A) would have no role to pay”.
This case reinforces the importance of proper legal planning as it relates to any business venture. Specifically, the importance of selecting and forming the right type of business entity. Here, Kate and David failed to organize their partnership as a limited liability entity. While forming a limited liability entity would not have protected David from liability on account of his fraud, it would have insulated Kate, a passive investor, from personal exposure to the debts of the business.
Proper legal planning at the onset of a business venture serves to limit the significant consequences of what can happen when a deal, or a relationship, goes bad. Most notably, it may limit your personal liability and protect your personal assets from the debts of the business.
At KingSpry, our experienced business law attorneys work with clients at all stages of development – from individuals and startups looking to establish their business, to experienced businesses looking to grow and/or plan for the next generation. If you are looking to start or grow your business, contact our office.