The Fifth Circuit expanded Bartenwerfer by holding a debt to be nondischargeable when the debtor was neither a partner nor an agent nor the person who himself committed the fraud.
The October 16 opinion might not be a big deal because the debtor was found to be the alter ego of the corporation that committed the fraud. Perhaps alter ego rises to the same level as a partner or agent.
The Fifth Circuit’s decision brings into question whether the “understanding” in the Bartenwerfer concurring opinion will hold water. Justices Sonia Sotomayor and Ketanji Brown Jackson concurred, based on the belief that a debtor who did not commit fraud would be saddled with a nondischargeable debt under Section 523(a)(2)(A) only in cases of partnership and agency.
Misappropriated Construction Funds
A contractor who files bankruptcy after not paying subcontractors is begging to be sued for a declaration that the debt is nondischargeable. That’s what happened here.
To build his home, a homeowner hired the construction company owned by the debtor. When all was said and done, it turned out that the debtor’s construction company had taken down $761,000 in draws from the owner but had paid subcontractors only $193,000. The subcontractors filed liens for nonpayment. On giving draw requests to the owner, the debtor’s corporation’s bookkeeper had issued certificates saying that the subcontractors’ bills would be paid.
The owner sued the debtor and his corporation in state court for, among other things, breach of contract, fraud and violation of the Texas Construction Trust Fund Act, which says that construction payments are “trust funds” and that an “owner” who has control of trust funds “is a trustee of the funds.”
While the suit was pending, the debtor filed a chapter 7 petition. The debtor withdrew the state court suit to bankruptcy court.
The owner responded to the bankruptcy by filing an adversary proceeding to declare that the debt was nondischargeable under Section 523(a)(2)(A) and (a)(4). The former makes a debt nondischargeable for “any debt . . . for money, property [or] services . . . to the extent obtained by . . . false pretenses, a false representation, or actual fraud.”
Under Section 523(a)(4), a debt is nondischargeable for “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.”
The debtor invoked an arbitration clause and sent the removed state court suit to arbitration. After a four-day hearing with witnesses, the arbitrator awarded the owner about $370,000 in damages, plus $200,000 in attorneys’ fees.
The arbitrator found the corporation liable for fraudulent misrepresentations but found insufficient evidence to hold the owner liable for misrepresentations. Nonetheless, the arbitrator concluded that the owner was the corporation’s alter ego, making him personally liable for the misrepresentations.
The bankruptcy court confirmed the arbitration award. On cross motions for summary judgment, the bankruptcy court decided that the debt was dischargeable. The district court reversed, prompting the debtor’s appeal to the Fifth Circuit.
The Per Curiam Opinion
In a per curiam opinion, the Fifth Circuit panel said it was “greatly assisted by the Supreme Court’s recent decision in Bartenwerfer v. Buckley, 589 U.S. 69 (2023). There, the Court confirmed that § 523(a)(2)(A) can extend to liability for fraud that a debtor did not personally commit.”
The appeals court went on to note that the Supreme Court had focused “‘on how the money was obtained, not who committed fraud to obtain it.’ Bartenwerfer, 598 U.S. at 72.”
Similarly, the panel noted how Texas corporate law does not limit the liability of an owner who has used a corporation to perpetrate actual fraud for the direct, personal benefit of the owner. To that, the circuit court added the arbitrator’s finding that the owner should be held personally liable for the corporate misrepresentation on account of his alter ego status.
“[G]iven the arbitrator’s determination of [the owner’s] liability for [the corporation’s] misrepresentations,” the Fifth Circuit held that “Bartenwerfer supports § 523(a)(2)(A)’s application here” to render the debt nondischargeable under Section 523(a)(2)(A).
Nondischargeable Under Section 523(a)(4)
Focusing on defalcation as grounds for nondischargeability under Section 523(a)(4), the circuit court referred to Bullock v. BankChampaign, N.A., 569 U.S. 267, 273–74 (2013), where the Supreme Court held that defalcation requires “an intentional wrong.”
The appeals court referred to the arbitrator’s finding that the owner misapplied trust funds intentionally, knowingly and with intent to defraud and thus demonstrates “that [the owner] had the requisite scienter.”
The circuit court therefore also ruled that the debt was nondischargeable under Section 523(a)(4).
Observations
Justices Sotomayor and Jackson based their concurrence in Bartenwerfer on the “understanding” that fraud is imputed only to “agents” and “partners within the scope of the partnership.” Bartenwerfer, supra, 143 S. Ct. at 677.
Notably, the Fifth Circuit’s opinion did not mention the Bartenwerfer concurrence. Because the concurrence is not law, the appeals court had no obligation to deal with the concurrence.
The Fifth Circuit opinions gives rise to two questions: (1) Will other courts follow the Bartenwerfer concurrence; and (2) is an alter ego finding the equivalent of partnership or agency or an even more proper basis for finding nondischargeability?
The Fifth Circuit expanded Bartenwerfer by holding a debt to be nondischargeable when the debtor was neither a partner nor an agent nor the person who himself committed the fraud.
The October 16 opinion might not be a big deal because the debtor was found to be the alter ego of the corporation that committed the fraud. Perhaps alter ego rises to the same level as a partner or agent.
The Fifth Circuit’s decision brings into question whether the “understanding” in the Bartenwerfer concurring opinion will hold water. Justices Sonia Sotomayor and Ketanji Brown Jackson concurred, based on the belief that a debtor who did not commit fraud would be saddled with a nondischargeable debt under Section 523(a)(2)(A) only in cases of partnership and agency.