Supreme Court Tackles Fraud Among Business Partners, Not Spouses

The US Supreme Court opinion that a bankrupt California woman can’t wipe out debts incurred through her husband’s fraudulent conduct in a home sale is a big win for fraud victims, but the justices were careful not to extend the ruling to all married couples.

The 9-0 opinion issued Wednesday rejected Kate Bartenwerfer’s attempt to use bankruptcy to discharge the debt, even though she didn’t personally perpetrate the fraud. And though the couple is married, the substance of the ruling is largely aimed at their business partnership.

By focusing on the pair as business partners, the high court skirted the issue of whether married couples who are not in business with one another would be held to the same standard.

Had Bartenwerfer not been her husband’s business partner, the court may have allowed her to skirt the debt, said Lawrence D. Hirsch, a bankruptcy attorney with Parker Schwartz PLLC.

“I think it is an interesting decision but I think it will be cast as a case involving a husband and wife, when in fact it really deals with partnership issues,” Hirsch said.

Imputing Fraud

In upholding the US Court of Appeals for the Ninth Circuit opinion, the high court said that liability can be held against a partner of a wrongdoer. The justices said they wanted to clear up lower court “confusion” on the meaning of the bankruptcy code’s exception to discharging debts obtained by actual fraud.

Kieran Buckley—who bought the San Francisco house then sued the couple after discovering defects in 2007—argued that Kate and David Bartenwerfer were business partners in the sale transaction who should have known the nature of the disclosures being made.

After Buckley won a judgment of more than $200,000 jointly against the Bartenwerfers, they filed Chapter 7. Kate Bartenwerfer petitioned the Supreme Court after the Ninth Circuit sided with Buckley, saying she didn’t know about the defects at the time of the sale and that her husband was the only one who knowingly withheld information about the defects from the buyer.

But the bankruptcy code turns on how the money was obtained—not who committed the fraud—so the debt-discharge exception extends to Kate Bartenwerfer, the high court said.

The decision “shows the Bankruptcy Code cannot be used as a shield for those who profit from fraud,” Buckley attorney Zachary Tripp of Weil, Gotshal & Manges LLP said. He called the opinion an “important win for other victims of fraud.”

Elaine J. Goldenberg, a bankruptcy attorney with Munger, Tolles & Olson LLP, said the opinion is a straightforward interpretation of the bankruptcy code text. The court noted that it didn’t do anything to change understandings of what’s considered to be “fraud,” Goldenberg said. The bankruptcy code leaves that question to the states, she said.

“The opinion is consistent with the Justices’ ‘plain text’ approach to statutory language—it focuses on the ordinary meaning of the words Congress used and says that the Court shouldn’t be second-guessing Congress’s choices, even if those choices may sometimes result in hardship,” Goldenberg said.

Spouses v. Partners

The opinion eliminates any ambiguity as to whether one partner can bind another, said Randy Nussbaum, a bankruptcy attorney with Sacks Tierney P.A.

But the concurring opinion, written by Justice Sonia Sotomayor and joined by Justice Ketanji Brown Jackson, intentionally left open the question of whether “the sins of one spouse are visited upon the other” as a matter of law, Nussbaum said.

The opinion notes that the Bartenwerfers weren’t married when they jointly purchased the house in 2005 but acted as business partners to remodel the home and sell it for profit.

If the ruling were extended to all married couples, an “innocent” spouse could have their “entire financial future ruined” solely because the spouse engaged in wrongful conduct, Nussbaum argued. While the concurrence recognized the distinction between spouses and partners, debtors’ attorneys should be prepared for creditors’ counsels to still argue the opposite, Nussbaum said.

People who want to avoid vicarious liability related to fraud in real estate deals may want to form a limited liability company or similar entity to hold the real estate, said Peter Marchetti, an associate law professor at Texas Southern University who supported Bartenwerfer in an amicus brief.

“In most cases, such an ownership structure would prevent vicarious liability of the ‘innocent co-owners’ from arising in the first place,” Marchetti said.

Creditor Preference?

By ruling in favor of the fraud victim, the Supreme Court indicated that, in some cases, the rights of creditors are more important than debtors.

“One of the core functions of the Code is the correct balance between creditor and debtor relationships,” said David R. Kuney, a Georgetown University Law Center professor who supported Bartenwerfer in an amicus brief with other professors.

“Creditors already have ample tools to protect themselves,” he added. “The ability to impose vicarious liability on those who did no wrong was hardly necessary. How innocent spouses can protect themselves from misconduct by their spouses now seems highly troublesome.”

Nussbaum said the Supreme Court and Ninth Circuit have “sent an unequivocal message” that protecting creditors is their priority. The high court said the bankruptcy code generally allows debtors to wipe out pre-bankruptcy liabilities, but Congress has said creditors’ interest outweighs debtors’ when money is obtained by fraud.

“This decision provides a staggering amount of leverage to creditors as to ‘innocent’ parties when one party to an ‘agency’ relationship engages in objectionable conduct,” Nussbaum said.

The case is Bartenwerfer v. Buckley, U.S., No. 21-908, opinion 2/22/23.