U.S. Supreme Court confirms debts from a partner’s fraud are non-dischargeable

Business partners may be jointly liable for damages caused by their partners' fraudulent activities

At the beginning of a business partnership, the focus is generally on developing a business plan in consideration of each partner’s strengths, knowledge and financial contributions. The expectation should be that each partner will honestly perform their assigned responsibilities.

However, that is not always the case. As a result, years later innocent business partners may find themselves jointly liable damages caused by the acts of their partners as result.  Even worse, the U.S. Supreme Court confirmed earlier this year, in Bartenwerfer v. Buckley, that an innocent business partner cannot discharge a debt arising from a state court judgment based on imputed liability for fraud committed by a partner.

This decision should serve as an important reminder about one of the downsides of operating as a partnership, as well as a warning to be careful when choosing business partners.

Kate Bartenwerfer’s journey to the Supreme Court started in 2005 when she and her then boyfriend, David Bartenwerfer, jointly purchased a home in San Francisco. For several years, David Bartenwerfer worked on remodeling the house, including hiring professionals to perform the repairs. Mrs. Bartenwerfer had little involvement in the renovations.

The home was ultimately sold Kieran Buckley. Post-closing, Buckley discovered several defects, including water leaks, issues with the windows, permitting problems and a missing fire escape.  Buckley sued the Bartenwerfers for negligent misrepresentation, intentional misrepresentations and failure to disclose. The jury returned a verdict in favor of Buckley and awarded him $200,000 in damages.

The Bartenwerfers filed a chapter 7 bankruptcy and Buckley filed an adversary proceeding to obtain a judgment that the debt was non-dischargeable under a provision of the code (11 U.S.C. § 523(a)(2)(A))  that excludes “any debt…for money…to the extent obtained by…false pretenses, a false representation, or actual fraud” from the debtor’s discharge.

The bankruptcy court ruled that Mr. Bartenwerfer concealed the home’s defects and, even though Mrs. Bartenwerfer did not act with fraudulent intent, the court imputed Mr. Bartenwerfer’s fraudulent intent to her. As a result, both Bartenwerfers could not discharge the debt owed to Buckley.

On appeal to the Ninth Circuit Bankruptcy Appellate Panel, the denial of the discharge as to Mr. Bartenwerfer was affirmed, however, the appellate panel remanded the case as to Mrs. Bartenwerfer. A second trial determined that Mrs. Bartenwerfer lacked the requisite knowledge of Mr. Bartenwerfer’s fraud and, therefore, the debt was discharged as to her.  The judgment was affirmed by the appellate panel.

Buckley then appealed the case to the Ninth Circuit Court of Appeals. The Ninth Circuit reversed the bankruptcy court based on a U.S. Supreme Court decision from 1885 that held that an innocent partner cannot discharge a debt due to a partner’s fraud.  With the lower courts clearly in conflict, the U.S. Supreme Court reviewed the decision.

The Supreme Court reversed holding under a plain reading of the statute, Mrs. Bartenwerfer could not escape liability for the debt.  Noting the use of the passive voice, the Supreme Court held §523(a)(2)(A) turns on “how the money was obtained, not who committed fraud to obtain it.”   In contrast, subsections (B) and (C) of § 523(a)(2) “expressly require some culpable act on the part of the debtor.”

Referencing the analysis in Bradner, the Bartenwerfer the court noted that in a partnership, fraud on the part of one partner is imputed to all partners because the partners are agents and representatives of the company.

The justification for this potentially harsh rule is that even though the partners did not participate in the wrongdoing, they benefited from the fruits of the deception. Finally, to the extent a denial of the discharge may be inconsistent with bankruptcy law’s “fresh start” policy, those concerns said the court “seem better directed toward the state law that imposed the obligation on her in the first-place.”

While clear that liability imputed to partners is nondischargeable in a bankruptcy case, the Bartenwerfer decision left unanswered the question of whether innocent spouses and non-partners are entitled to a discharge when someone connected to them commits fraud.

In their concurring opinion, Justices Sotomayor and Jackson emphasized that the court’s ruling was limited to cases involving an agency relationship where the debt was incurred after the partnership was formed.  “The Court here does not confront a situation involving fraud by a person bearing no agency or partnership relationship to the debtor.”

In the few months since Bartenwerfer was issued, a few cases have tested its limits. Creditors and trustees will likely continue to try to frame arguments to take advantage of Bartenwerfer’s favorable holding.

Therefore, individuals seeking to minimize their liability exposure should consider seeking legal advice at the outset of a business venture to discuss forming a limited liability company or other business entity.

Joe Foster is a director and chair of McLane Middleton’s Bankruptcy Practice Group. He can be reached at joe.foster@mclane.com. Sabrina Beavens is a member of the Corporate Department and Real Estate Practice Group at McLane Middleton. She can be reached at sabrina.beavens@mclane.com.