New Supreme Court Ruling: When Is a Bankruptcy Debtor on the Hook for Partner’s Fraud?

On February 22, the Supreme Court in Bartenwerfer v. Buckley, 2023 WL 2144417 (U.S. Feb. 22, 2023), held that a debt incurred by business partners and obtained by fraud may not be discharged in bankruptcy even when the debtor is an innocent partner who did not commit the fraud. One can expect bankruptcy creditors to try to extend the ruling to prevent consumer debtors from discharging debts incurred through fraud by their spouses or domestic partners. This is particularly the case because the debtors in Bartenwerfer were both business and marriage partners.

This article examines the decision and the critical distinctions between the business and personal partnerships, including implications for divorced or separated debtors and victims of economic abuse and coerced debt.  The article also discusses five potential ways for these consumer debtors to distinguish the Court’s holding and preserve their right to discharge debts that were fraudulently obtained by a co-obligor. 

Confusing Facts Lead to Confusing Legal Holding

In Bartenwerfer, David and Kate Bartenwerfer while still unmarried purchased a home they initially lived in, intending to renovate and sell it at a profit. David took complete control of the renovation project despite having no education or training in construction and no contractor license.  Upon the sale both Kate and David signed a disclosure statement about the property’s condition, but only David knew there were undisclosed defects.  Buckley, the home buyer, later brought a state court action alleging that he overpaid in reliance upon the disclosure statement and obtained a $234,000 judgment directly against both David and Kate. In that proceeding, Kate apparently did not offer evidence as to her innocence or the lack of a business partnership with David.

Unable to pay the judgment, the Bartenwerfers filed a joint chapter 7 bankruptcy. Buckley sought from the bankruptcy court a ruling under Bankruptcy Code § 523(a)(2)(A) that the judgment debt should not be discharged as to both David and Kate because it was obtained by fraud. For more on the dischargeability of debts incurred by fraud, see NCLC’sConsumer Bankruptcy Law and Practice § 15.4.3.2.  

After trial, the bankruptcy court held that the debt could not be discharged because David had knowingly concealed the defects and that this fraud could be imputed to Kate because “an agency relationship existed between Mr. and Mrs. Bartenwerfer based on their partnership with respect to the remodel project: she was on title to the Property, signed the disclosure statements relating to the Property, and would financially benefit from the successful completion of the project and sale of the Property.” In re Bartenwerfer, 549 B.R. 222, 225 (Bankr. N.D. Cal. 2016). However, the court did not make any findings as to the formation and terms of the Bartenwerfers’ partnership agreement.

On appeal, the Ninth Circuit’s Bankruptcy Appellate Panel affirmed the decision against David but held that the bankruptcy court had not made proper findings for imputing liability to Kate.  The case was remanded for the bankruptcy court to determine whether Kate “knew or had reason to know of Mr. Bartenwerfer's fraudulent omissions.” 

Following another bench trial in the bankruptcy court in which Kate was questioned at length about her knowledge of the defects, her involvement with the project, and her interactions with David, the bankruptcy court held that David’s fraud could not be imputed to her because she did not have actual knowledge of the fraud and did not know of any facts that suggest she “should have known.”  This decision was affirmed by the Bankruptcy Appellate Panel. 

Ninth Circuit Rules Against Unknowing Partner Based on 19^th Century Supreme Court Decision

On further appeal, the Ninth Circuit held that the lower courts had applied an incorrect legal standard (know or should have known) for imputed liability in a partnership relationship.  Instead, it held that Kate's debt was nondischargeable regardless of her knowledge of the fraud.  The court relied upon an 1885 Supreme Court decision that it found had applied basic partnership principles:

If, in the conduct of partnership business, ... one partner makes false or fraudulent misrepresentations of fact to the injury of innocent persons, ... his partners cannot escape pecuniary responsibility therefor upon the ground that such misrepresentations were made without their knowledge. This is especially so when ... the partners, who were not themselves guilty of wrong, received and appropriated the fruits of the fraudulent conduct of their associate in business.

In re Bartenwerfer, 860 F. App'x 544, 546 (9th Cir. 2021), quoting Strang v. Bradner, 114 U.S. 555, 561, 5 S. Ct. 1038, 29 L. Ed. 248 (1885).

The justification for the Ninth Circuit ruling thus is the business partnership relationship, not that there is a personal partnership relationship.

Supreme Court’s Confusing Ruling  

In a unanimous decision, the Supreme Court affirmed the Ninth Circuit ruling.  The ruling is based on a plain reading of Bankruptcy Code § 523(a)(2)(A), which refers to money, property or services “obtained by ... false pretenses, a false representation, or actual fraud.”  Because the provision omits the phrase “of the debtor” with respect to the fraud and is drafted in the passive voice, the Court held that “§ 523(a)(2)(A) turns on how the money was obtained, not who committed fraud to obtain it.” 2023 WL 2144417, at *4.  Thus, section 523(a)(2)(A) can prevent a debtor from discharging a debt obtained by fraud that is committed solely by another. This broad interpretation and emphasis on the passive voice creates some confusion about how the provision should be applied.

But the opinion qualifies this conclusion in several respects.  The Court stated:

It also bears emphasis—because the thread is easily lost in Bartenwerfer's argument—that § 523(a)(2)(A) does not define the scope of one person’s liability for another’s fraud. That is the function of the underlying law—here, the law of California. Section 523(a)(2)(A) takes the debt as it finds it, so if California did not extend liability to honest partners, § 523(a)(2)(A) would have no role to play.

2023 WL 2144417, at *8. 

That is, a debt may be nondischargeable as to an innocent debtor only if under state law the debtor would be liable for another’s fraud involved in incurring that debt.

In addition, the Court, as did the Ninth Circuit, viewed Congress in enacting the current section 523(a)(2)(A) nondischargeable provision, as adopting the holding in Strang v. Bradner.  “The unmistakable implication is that Congress embraced Strang’s holding—so we do too.” 2023 WL 2144417, at *7.   The ruling in Strang is that one business partner cannot escape responsibility for a fraudulent business partner.

In a concurring opinion, Justice Sotomayor (joined by Justice Jackson) also explicitly confined the scope of the Court’s opinion by noting that it is limited to fraudulent debts obtained by agents and partners within the scope of the partnership, applying common-law agency and partnership principles.  Justice Sotomayor noted that Kate had not disputed that she and her husband had “an agency relationship and obtained the debt at issue after they formed a partnership,” and that the Court’s opinion would not apply to “a situation involving fraud by a person bearing no agency or partnership relationship to the debtor.”  2023 WL 2144417, at *8–9. 

Rule # 1 in Limiting Bartenwerfer:  Business Partners Are Different than Personal Partners

The Bartenwerfer and earlier Strang decisions speak to business partners and not personal partners.  For example, the Court notes that the Bartenwerfers were “[a]cting as business partners” and that “the pair decided to remodel the house and sell it at a profit.” The Bartenwerfers are also described in the opinion as having a “legal partnership.” 

Despite this and because the facts of the case also show a personal relationship between the Bartenwerfers, bankruptcy creditors may argue that jointly acquiring property with a profit motive by itself should be sufficient to establish a business partnership.  If the fraud exception is being asserted against an innocent debtor, attorneys should become familiar with state law on partnerships and be prepared to present evidence showing that no agency or legal partnership existed between the co-obligors.

Rule # 2 in Limiting Bartenwerfer:  Lack of Debtor’s Fraud Liability Under State Law

The Supreme Court stated explicitly that: “§ 523(a)(2)(A) does not define the scope of one person’s liability for another’s fraud. That is the function of the underlying law—here, the law of California.” 2023 WL 2144417, at *8.   Thus it is important to avoid any prior finding in a state court proceeding that the innocent debtor is liable for the partner’s fraud.  Absent such a finding, the issue must be determined in a bankruptcy dischargeability proceeding where the debtor may offer evidence and argument establishing that under state law the debtor is not liable for the partner’s fraud.  

Rule #3 in Limiting Bartenwerfer: Special Consideration for Victims of Economic Abuse and Coerced Debt

Issues may arise in some consumer bankruptcy cases as to the dischargeability of debts incurred by an abusive partner through coercion and fraud.  As discussed in another NCLC Digital Library article, Advising Clients When an Abusive Partner Coerces Debt, financial abuse in the form of coerced debt occurs when an abusive partner utilizes the threat of physical, emotional, psychological, or financial harm to the victimized partner to manipulate, intimidate, or force the victimized partner to incur debt or provide access to assets, such as a credit card, bank account, or other assets. Abusers can also coerce victims into taking out new credit or other financial obligations in the victimized partner’s name for the abuser’s sole use and benefit.  Many of the recommendations for clients discussed in that article, if adopted, help to establish an evidentiary basis for distinguishing the Bartenwerfer holding.

The Court’s opinion also lends support for employing general concepts of agency and partnership law as a defense by a victim of coerced debt.  The Court stated:

For instance, though an employer is generally accountable for the wrongdoing of an employee, he usually can escape liability if he proves that the employee’s action was committed outside the scope of employment. Restatement (Third) of Agency §7.07 (2006); D. Dobbs, P. Hayden, & E. Bublick, Law of Torts §425 (2022). Similarly, if one partner takes a wrongful act without authority or outside the ordinary course of business, then the partnership—and by extension, the innocent partners—are generally not on the hook. Uniform Partnership Act §305 (2013).

2023 WL 2144417, at *8. 

Thus, a victim who signed a false disclosure statement or loan documents under duress and threat of harm, even if they were aware of misrepresentations, may argue based on general agency law that the abuser’s fraud was done without their authority or was outside the ordinary course of the business relationship.  The victim signed the statement not because they were giving authority to the fraudster to make the misrepresentations on their behalf, but because they were under duress.

Rule #4 in Limiting Bartenwerfer: Using the Creditor’s Burden to Initiate a Timely Adversary Proceeding to the Debtor’s Advantage

Unlike some debts that are automatically excepted from the debtor’s discharge, a nondischargeability finding based on fraud requires the creditor to seek a determination from the bankruptcy court by filing an adversary complaint within a strict time limit (sixty days after the first date set for the meeting of creditors) and proving that the debt should not be discharged.  11 U.S.C. § 523(c); Bankruptcy Rule 4007(c).  If a timely action is not brought by the creditor, the debt is discharged and the debtor need not worry about potential imputed liability stemming from a partnership.  See NCLC’sConsumer Bankruptcy Law and Practice § 15.4.2.

Some creditors will threaten to bring nondischargeability proceedings based on fraud even when debtors (or their partners) have done nothing wrong.  Their goal is often to pressure debtors into agreeing to reaffirm a portion of the debt, knowing that the litigation costs for the debtor may exceed the settlement offer.  Most experienced debtor attorneys will advise their clients not to reaffirm a debt in this situation and that such creditors almost always do not file a nondischargeability complaint. 

Moreover, if the creditor loses a nondischargeability action alleging that a debt was obtained by fraud and the court finds that the creditor’s position was not substantially justified, the court shall grant the debtor an award of reasonable attorney fees and costs. 11 U.S.C. § 523(d).  This is discussed more fully in NCLC’s Consumer Bankruptcy Law and Practice § 15.4.3.2.4.  

Rule #5 in Limiting Bartenwerfer: Challenge the Collateral Estoppel Effect of a State Court Fraud Decision

If fraud liability has been reduced to judgment in a state court action before bankruptcy is filed, the question arises as to whether the debtor will be precluded from litigating issues related to the fraud or the partnership relationship in the bankruptcy adversary proceeding.  In general, collateral estoppel can be applied to prevent re-litigation of factual issues related to the fraud that were actually litigated and decided in a prior case.  This is discussed in NCLC’s Consumer Bankruptcy Law and Practice § 15.4.4. 

A creditor seeking collateral estoppel has the burden of making an evidentiary record sufficient to establish that the issue was actually litigated and decided.  If the jury or court did not make findings as to the agency or partnership relationship between the co-obligors, the debtor should not be precluded from litigating that matter as a defense in the bankruptcy court.  

Although a state court judgment was entered against the Bartenwerfers, the bankruptcy court did not find that there were jury findings with respect to the business partnership or any imputed liability, and so those issues could be litigated in the bankruptcy court. Moreover, even if findings were made, the Ninth Circuit pointed out in Bartenwerfer that collateral estoppel may not apply if the state court findings are conflicting or ambiguous. In re Bartenwerfer, 860 F. App'x 544, 546 (9th Cir. 2021), citing In re Kelly, 182 B.R. 255, 258 (B.A.P. 9th Cir. 1995) (“Any reasonable doubt as to what was decided by a prior judgment should be resolved against allowing the collateral estoppel effect”), aff'd, 100 F.3d 110 (9th Cir. 1996).

Low-income debtors often lack the resources to mount a defense in state court if a fraud action is brought against them.  Victims of coerced debt may not appear in state court out of fear of harm by an abuser.  If a default judgment is entered against a debtor and issues related to the debtor’s innocence or lack of agency or partnership relationship were therefore not actually litigated, collateral estoppel should not prevent the debtor from litigating these issues in the bankruptcy court.  However, bankruptcy courts generally look to state law on the preclusive effect of a default judgment. This is discussed in NCLC’s Consumer Bankruptcy Law and Practice § 15.4.4.