CASE ALERT: U.S. Supreme Court Issues Unanimous Decision Holding that Certain Debts Incurred Through Fraud Cannot be Discharged in Bankruptcy, Even if the Debtor Was Not a Knowing Participant in the Fraud

On February 22, 2023, the Supreme Court of the United States issued a decision holding that debtors whose debts were incurred through fraud may not have such debts discharged, even if the debtor did not participate in, or even have knowledge of, the fraud. In Bartenwerfer v. Buckley, 598 U.S.       (2023), Mr. and Ms. Bartenwerfer (who were not yet married at the time) sold a remodeled home to Mr. Buckley. Mr. Bartenwerfer was in charge of remodeling the home, and Ms. Bartenwerfer generally was uninvolved. In order to sell the home, the Bartenwerfers attested that they had disclosed all material facts regarding the condition of the home to Mr. Buckley, however, Mr. Buckley subsequently discovered that the Bartenwerfers failed to disclose significant defects. Mr. Buckley sued the Bartenwerkers in California state court alleging claims for breach of contract, negligence, and nondisclosure of material facts. Following trial, a jury found in favor of Mr. Buckley and awarded $200,000.

The Bartenwerfers filed for Chapter 7 bankruptcy. Mr. Buckley filed an adversary complaint alleging that the debt was nondischargeable under 11 U.S.C. § 523(a)(2)(A), and the Bankruptcy Court agreed. Specifically, the Bankruptcy Court found that Mr. Bartenwerfer knowingly concealed the home’s defects and his fraudulent intent could be imputed to Ms. Bartenwerfer because they had a partnership to remodel and sell the house. On appeal, the Ninth Circuit’s Bankruptcy Appellate Panel reversed the decision, holding that Ms. Bartenwerfer was entitled to a discharge unless she knew or had reason to know of Mr. Bartenwerfer’s fraudulent conduct. The Ninth Circuit then reversed the Appellate Panel’s ruling holding that Ms. Bartenwerfer’s debt was nondischargeable, regardless of her lack of knowledge.

The Supreme Court unanimously affirmed the Ninth Circuit, holding that Ms. Bartenwerfer’s debt was nondischargeable under Section 523(a)(2)(A) which exempts as dischargeable those debts “obtained by . . . false pretenses, a false representation, or actual fraud.” Writing for the Court, Justice Barrett reasoned that the “passive voice” used in Section 523(a)(2)(A) removes the fraudulent actor from consideration, such that Section 523(a)(2)(A) applies to all debts that arise from fraud, regardless of the debtor’s state of mind. Therefore, a partner or agent of a fraudster may not obtain bankruptcy protections against creditors who were the victims of such fraud, even if the debtor did not participate in the fraud or was unaware of the fraud.  Importantly, Justice Barrett pointed out that the potential discharge of a debt will depend upon whether the underlying state law imputes liability to an unknowing beneficiary for another’s fraud. In Ms. Bartenwerfer’s case, as the partner of Mr. Bartenwerfer, California state law imputed liability onto to her for Mr. Bartenwerfer’s fraudulent conduct. 

Implications for creditors:

Consistent with its recent decisions to provide more protections for businesses, Justice Barrett emphasized that although the Bankruptcy Code embraces a “fresh start” policy to release debtors from their obligations to creditors, the Code also balances the interests of creditors. This decision suggests that the Court may continue to be more creditor-friendly at the expense of debtors.  In addition, Judge Barrett strictly construed the language contained in the Bankruptcy Code provision consistent with other recent strict-construction decisions.    

Implications for fraud victims and fidelity insurers:

Bartenwerfer provides significant leverage to creditors when debts arise from fraudulent or deceptive conduct. Victims of fraud and insurers that have paid fidelity claims now have stronger claims against those who may have benefited from another’s fraud scheme, even unknowingly. Whereas, prior to Bartenwerfer, such beneficiaries may have been able to obtain a discharge for such debts, claiming that they did not participate in the fraud, after Bartenwerfer Section 523(a)(2)(A) should render such debts nondischargeable, as long as the underlying state law imputes liability onto the debtor.  A common scenario is where a person does not participate in a fraud, but unknowingly benefits from it, and later seeks a discharge of a creditor’s claim for conversion, money had and received or unjust enrichment. Pursuant to Bartenwerfer, as long as the state law permits a claim against the ignorant beneficiary, such claim likely will not be discharged.    

Implications for sureties:

Surety indemnity agreements typically contain a trust fund provision stating that contract funds received are trust funds. Courts have held that violations of this trust may bar discharge of an indemnitor’s debts in bankruptcy. Courts have held under 523(a)(4) that violations of a contractual trust funds provision may constitute a defalcation that leads to a declaration of non-dischargeability of the indemnitor’s liability to the bonding company as an indemnitor.  Bartenwerfer was decided under 523(a)(2)(A). Under Bartenwerfer, sureties are reminded to consider that partners or agents of a fraudster may not obtain bankruptcy protections, and to consider whether sureties may be able to assert claims for non-dischargeability against those who benefited from another’s fraud that may have caused damage to the surety. 

Conclusion:

While Bartenwerfer offers additional protections for creditors who were the victims of fraud, its application depends heavily on the relevant state’s laws. We will continue to monitor this developing area in creditors’ rights. Please do not hesitate to contact us if you have any questions regarding these recent developments.

If you have any questions about the applicability of this new law or wish to discuss any of these changes, please do not hesitate to contact us.