US Supreme Court Alert: Liability for a Partner’s Fraud Not Discharged in Bankruptcy

The US Supreme Court has issued a new ruling regarding the bankruptcy dischargeability of debts incurred through fraud.

Whenever the US Supreme Court rules on a consumer bankruptcy question, it is a noteworthy occasion. This is because it just doesn’t happen all that often.

However, before we discuss this new decision, revisiting the primary exception to the dischargeability of a debt in bankruptcy is necessary.

That exception is for debts incurred through fraud.

 

Debts Incurred through Fraud in Bankruptcy Generally

 

The default rule under the US Bankruptcy Code is that all debts are dischargeable unless the Bankruptcy Code itself provides an exception.

It is worth remembering, then, that bankruptcy in the US is a Federal legal process. The statutes and rules created under Michigan’s or another state’s laws, or the decisions issued by state courts, are not relevant in determining whether a debt is dischargeable in bankruptcy.

That question is entirely preempted (“overruled”) by Federal law. Federal law by way of the US Bankruptcy Code “occupies the field” when it comes to the question of what debts are or are not dischargeable in bankruptcy proceedings.

Indeed, one primary Section of the Bankruptcy Code (Section 523) does provide a list of exceptions to that default rule in favor of dischargeability.

Section 523, in particular, zeroes in on debts incurred through fraud as exceptions to the “discharge all of them!” rule.

Section 523(a)(2) states that debts incurred through “… false pretenses, a false representation, or actual fraud … or use of a statement in writing … that is materially false; respecting the debtor’s financial condition; on which the creditor … reasonably relied; and … that the debtor caused to be made or published with intent to deceive” are not dischargeable in bankruptcy.

Likewise, Section 523 defines fraud in other ways to specify certain debts which may also be non-dischargeable in bankruptcy.

Section 523(a)(4), for instance, makes debts incurred through “defalcation” non-dischargeable. Defalcation is the misuse of funds to which you’ve been entrusted as a fiduciary. That is, when someone gives you money for you to expend on their behalf and you use it for other purposes, that is defalcation.

In Michigan, defalcation appears most commonly in State and bankruptcy case-law where general contractors are paid money for a construction job by a property owner and they spend that money on their own expenses before using it to pay for the materials and subcontractors necessary to complete the job.

 

The Procedure of Excepting Fraudulent Debts from Discharge

 

When a creditor alleges that a debt originates in fraud and should not be discharged, the debt is not magically excepted.

The creditor must file an “adversary proceeding” lawsuit within your Chapter 7 or Chapter 13 bankruptcy case seeking a court order agreeing that the debt is not discharged due to fraud.

An adversary proceeding is a form of lawsuit that is adjudicated within your bankruptcy case. As with any other Federal civil litigation, it will include a pre-trial hearing, discovery, motion practice, and, eventually if not settled, a trial (usually a bench and not a jury trial).

A creditors has only 30 days from the date of your 341 Meeting of Creditors hearing to file such a lawsuit.

If it fails to do so, the debt will be discharged regardless of any allegation of fraud. However, if a Michigan state court has already, prior to the filing of the bankruptcy case, issued a decision stating that fraud has occurred, the creditor may continue to argue that it is not discharged even if an adversary proceeding is not filed.

 

Bartenwerfer v. Buckley: No Discharge for Fraud—Even if You Didn’t Commit the Fraud

 

This brings us to the new Bartenwerfer decision issued by the US Supreme Court.

In this case, a married couple in California, Kate and David Bartenwerfer, remodeled their home in order to sell it for a profit. David masterminded the project, with Kate’s name included in the underlying paperwork. The Bartenwerfers succeeded in selling the property to Buckley. However, the Bartenwerfers (or David, specifically) failed to disclose a number of material defects to Buckley in the purchase agreement. (Michigan law requires this as well.)

Buckley sued the Bartenwerfers in California state court and obtained a judgment of more than $200,000. In response, the Bartenwerfers filed for Chapter 7 bankruptcy.

Buckley filed a timely adversary proceeding for an order that the debt was nondischargeable due to fraud. The Bankruptcy Court agreed that David had indeed committed fraud. As to Kate, the Bankruptcy Court “imputed” David’s fraud to her as they had formed a legal partnership for the purpose of effecting the property sale.

The Bartenwerfers appealed to the 9^th Circuit Court of Appeals Bankruptcy Appellate Panel (“BAP”). The BAP disagreed that the fraud should be imputed to Kate. It held that fraud and resulting non-dischargeability could only arise from the specific intent to deceive noted above.

The BAP remanded the case back to the Bankruptcy Court in San Francisco to deal with the facts concerning Kate’s knowledge of the fraud. The Bankruptcy Court found her liability to be dischargeable under those facts (she didn’t know).

Buckley appealed again to the full 9^th Circuit Court of Appeals, which reverse as to that finding. And it was, then, finally, appealed again to the US Supreme Court.

The Supreme Court, in a unanimous opinion authored, by Justice Barrett, found that Kate was liable after all.

Why?

 

Kate Bartenwerfer’s Argument and Justice Barrett’s Decision

 

Kate Bartenwerfer argued that Section 523(a)(2), summarized above, relieved her of liability because the statute, although not specifying the fraud of any specific actor, implies that it is the debtor’s fraud that should bar dischargeability. The individual debtor’s fraud, that is. (In other words: David. Not Kate.)

Justice Barrett wasn’t convinced. She opined that Congress drafted the statute with passive voice language purposefully, to sweep in all fraud-based debts as excepted from discharge where there is liability for discharge, if not individual intent.

That is, because Kate formed the legal partnership with David for the purpose of the sale of the property, and because the property was sold under fraudulent circumstances, she is liable as a principal of that legal partnership. Even though she didn’t specifically know that this was happening.

Justice Barrett relied on and quoted precedent from an earlier case holding that one partner’s fraudulent activity could be imputed to a venture’s other partners.

The Bankruptcy Code, she stated, attempts to strike a balance between the “fresh start” needs of debtors and the creditors to whom debts are legally owed.

Here, although the Court expressed sympathy in its opinion for Kate Bartenwerfer, it declined to find an “innocent spouse exception” (as is found in tax law) to the underlying rule that a bankruptcy discharge is available only to “good faith” debtors.

 

Fraudulent Debt in Michigan Bankruptcy: The Bottom Line

 

The bottom line is that, now, unless the US Supreme Court overrules this decision with some later decision or the US Congress adds an “innocent spouse” exception to the exception into the Bankruptcy Code, it is applicable in Michigan bankruptcies.

One should not be distracted, by the marital relationship between Kate and David Bartenwerfer. This decision can and surely will be applied to business ventures, partnerships, corporations, and even law firms whenever a creditor can make a case for fraud.

If you are involved in a business venture through which a partner may have engaged in fraud, your liability may be difficult, now, to discharge in bankruptcy.

Thus, working with an experienced bankruptcy attorney in such complex circumstances is essential.

Attorney Walter Metzen is a Board Certified Bankruptcy Expert who has successfully assisted Metro Detroit Chapter 7 and Chapter 13 clients for over 30 years.

If you are considering filing for bankruptcy and aren’t sure whether a debt you owe is dischargeable or not, contact us now to schedule your free initial consultation.