By: Franklin Barbosa, Jr., Esq.

On February 22, 2023, the United States Supreme Court ruled that Section 523(a)(2)(A) of the Bankruptcy Code renders any debt procured through fraud non-dischargeable even if the debtor was not personally involved in or had no knowledge of the alleged fraudulent scheme. Bartenwerfer v. Buckley, No. 21-908 (Feb. 22, 2023).

In other words, a debtor can be burdened with non-dischargeable debt arising from the fraud of a business partner even if the debtor is entirely innocent.

Non-Dischargeable Debts

The Bankruptcy Code renders certain debts non-dischargeable, meaning that the debtor remains responsible for a specific debt despite the entry of a discharge order at the conclusion of the debtor’s bankruptcy case.

Section 523(a) sets forth a list of debts that cannot be discharged in a bankruptcy case.  For our purposes, debts procured by fraud are not discharged:

(a) A discharge under section 727, 1141, 1192, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt—

(2) for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by—

(A) false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor’s or an insider’s financial condition;

11 U.S.C. 523(a)(2)(A).

It is well-accepted that Section 523(a)(2)(A) precludes a discharge for a debtor incurring a debt through a fraudulent scheme that they designed and implemented.  However, until the Court’s decision, there was uncertainty as to whether a co-debtor, who was not involved in fraud committed by a business partner, would receive the benefit of a discharge as to the debt/claim resulting from the fraud.  Stated differently, can one debtor’s fraud be imputed to an “innocent” co-debtor?

The Alleged Fraud

Bartenwerfer concerns two debtors’ alleged failure to disclose defects in a residential property they sold.  In short, the debtors, a husband and wife, formed a partnership for the purposes of purchasing a home, renovating it and then selling the home.  The husband was directly involved in the renovation, but the wife was not.  The home was eventually sold to a buyer.  After the purchase, the buyer discovered certain defects in the home.  The buyer subsequently sued the debtors in state court on various claims, including intentional misrepresentation for failing to disclose the defects in the home.  The buyer obtained a judgment in state court, and the debtors then filed for Chapter 7 bankruptcy.

In response, the buyer filed a non-dischargeability action in the debtors’ pending bankruptcy case seeking a determination that the debtors were not entitled to a discharge of the judgment under Section 523(a)(2)(A).  The wife argued that the judgment must be discharged as to her because she was not involved in the home renovation and was not aware of any fraud perpetrated by her husband.  The bankruptcy court rejected the debtors’ arguments and held that the judgment was non-dischargeable as to both of them.

On appeal, the Bankruptcy Appellate Panel for the Ninth Circuit (“BAP”) reversed as to the wife, finding that she could only be barred from a discharge if she knew or had reason to know of her husband’s fraudulent intent.  The BAP remanded the case to the bankruptcy court for application of that standard.  After a second bench trial, the bankruptcy court concluded that the wife lacked the requisite knowledge of her husband’s fraud and, therefore, she was entitled to a discharge.  The BAP affirmed that judgment.  The Ninth Circuit reversed the BAP, reasoning that a debtor’s individual culpability does not factor into whether a debt procured by fraud should be discharged. 

The wife subsequently filed a petition for certiorari to the Supreme Court, which was granted.

The Supreme Court Interprets Section 523 Broadly

The issue before the Court was whether a debtor’s scienter – i.e., intent or knowledge – with respect to the fraud is required in order for a debt to be deemed non-dischargeable.  The Supreme Court sought to resolve a circuit split on the issue.  The Fifth, Sixth, Ninth and Eleventh Circuits took the approach that Section 523(a)(2)(A) does not require proof of scienter for the debt to be discharged, and the Second, Fourth, Seventh and Eighth Circuits took the opposite approach.

The Court firmly sided with the circuit courts using the non-scienter approach.  Justice Amy Coney Barrett, writing for the majority, reached her decision primarily based upon the plain language of the statute and the common law liability principles applicable to the principal-agent relationship.  Judge Barrett reasoned that the plain language of Section 523(a)(2), which does not address the issue of scienter, suggests that “Congress was ‘agnosti[c]’ about who committed [the fraud].’”  Moreover, Justice Barrett noted that a prior version of the statute required the fraud “of the bankrupt” for a non-dischargeability finding, but Congress later “overhauled bankruptcy law” and deleted the phrase “of the bankrupt” from the statutory discharge exception.  Judge Barrett interpreted that revision to mean that Congress did not want scienter to factor into the fraud exception analysis.

Justice Barrett also noted that “the common law of fraud – has long maintained that fraud liability is not limited to the wrongdoer” and this is consistent with the “traditionally held” notion that principals are “liable for the frauds of their agents.”

Keep an Eye on Business Partners

Bankruptcy is not a viable option for shedding debts arising from frauds committed by a business partner.  The only way to avoid being saddled with your partner’s fraud-based liabilities is to proactively monitor your business dealings and stop the fraud before it occurs.  Be selective in your choice of business partner.  Exercise your right to view the books and records of your partnership.  Where possible and feasible, hire independent professionals, such as accountants and attorneys, to review financials and proposed transactions.  Attorneys can also assist you in interpreting your rights under an applicable operating agreement or statutory scheme.

For more information, contact Franklin Barbosa, Jr. at FB@spsk.com or 973-539-1013.

DISCLAIMER: This Alert is designed to keep you aware of recent developments in the law. It is not intended to be legal advice, which can only be given after the attorney understands the facts of a particular matter and the goals of the client.