The Supreme Court Expands the Fraud Exception to Discharge — Maybe

The Supreme Court may have expanded the types of debts that are exempt from discharge under § 523 of the Code. In Bartenwerfer v. Buckley [1], the Court held that § 523 bars the discharge of a debt arising from fraud committed by the debtor’s business partner. While this result appears to be both straightforward and uncontroversial, the broad language used by the Court raises the possibility of expanded objections to dischargeability under § 523.

The facts of Bartenwerfer are simple. The debtor, Kate Bartenwerfer, and her then-boyfriend (now husband) [2] had formed a partnership to renovate and flip a house in San Francisco [3]. They sold the house to Buckley representing that the house had no undisclosed defects. In fact, the house had several significant defects, including a bad roof [4]. Buckley sued for fraud, recovering a $200,000 judgment against the debtor and her business partner [5]. The lower courts found, and the Supreme Court accepted, that the debtor was not personally involved in the fraud and had no knowledge that any of the representations made to Buckley were untrue [6]. Yet, while she may have been personally innocent of the fraud, the debtor was vicariously liable for her partner’s fraud.

Analyzing the issue, the Supreme Court started with the text of the statute. It noted that § 523(a)(2)(A) precludes an individual debtor from discharging a debt “for money ... obtained by ... false pretenses, a false representation, or actual fraud.” To the Court, § 523(a)(2)(A) was written in the passive voice and does not specify that an actor was decisive. In the Court’s words, “Passive voice pulls the actor off the stage. ” [7] Congress framed the statute to “focu[s] on an event that occurs without respect to a specific actor, and therefore without respect to any actor's intent or culpability.” [8] The Court concluded that the “debt must result from someone's fraud, but Congress was ‘agnosti[c]’ about who committed it.” [9]

To support its textual analysis, the Court then turned to its 1885 opinion in Strang v. Bradner. [10] At the time that Strang was decided, the bankruptcy statute precluded the discharge of debt “created by the fraud or embezzlement of the bankrupt.” [11] As in Bartenwerfer, the Strang debtor was vicariously liable for his partners’ fraud, even though the misrepresentations were made without his authorization or knowledge [12]. Despite the statute’s requirement that the debt be created by the bankrupt’s fraud, the Supreme Court in Strang held that the debt could not be discharged because the “fraud of one partner, we explained, is the fraud of all because ‘[e]ach partner was the agent and representative of the firm with reference to all business within the scope of the partnership.’” [13]

After Strang, Congress enacted a new bankruptcy statute (the Bankruptcy Act of 1898) that deleted “of the bankrupt” from the discharge exception for fraud [14]. The “unmistakable implication” of the 1898 Act was that “Congress embraced Strang’s holding,” which supports the Court’s textual analysis. [15]

Finally, the Court made short work of the debtor’s “innocence,” reasoning that her true complaint was not with the Code but with the California law that made her vicariously liable for her partner’s debt. It noted that she could have avoided this problem by forming a limited liability company or limited partnership instead of a general partnership [16].

What is the impact of Bartenwerfer? Is it, as Justice Sotomayor’s concurrence argues [17], limited to situations involving fraud committed by partners or agents? Or is it somewhat broader? Justice Sotomayor is certainly correct that the facts of Bartenwerfer involve a formal partnership. But the majority’s language is much broader: In § 523(a)(2)(A), the person committing the fraud is “off the stage,” and Congress was “agnostic” as to who committed the fraud. The majority’s language suggests that anytime a debtor has incurred a debt arising from someone’s fraud, the debt cannot be discharged.

This occurs quite frequently in cases involving Ponzi schemes. In these situations, payments to investors of fake profits are deemed to be intentionally fraudulent transfers and subject to recovery by bankruptcy trustees and receivers [18]. The investors are innocent, but their debts resulted from someone’s fraud.

If, as the majority’s reasoning suggests, Congress was truly agnostic as to who committed the fraud, these investors cannot discharge those debts. This is, no doubt, far afield of the facts of Bartenwerfer, but as Justice Sotomayor warned, it may well be within its reasoning.