A recent U.S. Supreme Court decision affirmed that debtors cannot discharge debts obtained through fraudulent actions in bankruptcy, even if they did not personally commit the fraud.

The ruling is a win for both fraud victims and creditors, as it shows that bankruptcy cannot be used to shield someone who profited from fraudulent acts.

However, the ruling also serves as a critical reminder to investors and would-be business partners to protect themselves through a limited liability entity before entering into a business partnership.

One investor’s fraud (and liability thereof) can be imputed to their business partner through no fault of their own.

Background
Before they were married, Kate Bartenwerfer and her then-boyfriend David Bartenwerfer bought a home in San Francisco and jointly decided to renovate the house for sale.

Mr. Bartenwerfer did all the work, managing contractors and signing contracts, while Ms. Bartenwerfer served as a passive investor.

The couple completed a Real Estate Transfer Disclosure Statement and did not disclose any defects.

The buyer, Kieran Buckley, later discovered several defects, including a leaking roof, defective windows, a missing fire escape, and permit issues.

He sued and was awarded damages of more than $200,000.

Nondischargeability

Subsequently, the couple filed for bankruptcy, seeking to discharge their debts.

Regarding the judgment owed to Buckley, the U.S. Bankruptcy Court found that the debt was nondischargeable because it was incurred due to fraud. Liability for the fraud was imputed to Ms. Bartenwerfer as a business partner in the renovation and sale.

Ms. Bartenwerfer appealed to the Bankruptcy Appellate Panel (BAP), which found that she did not know of the fraud and therefore the debt could be discharged. Buckley then appealed to the U.S. Court of Appeals for the 9th Circuit, which reversed the BAP decision. Ms. Bartenwerfer appealed again, and the Supreme Court agreed to hear the case.

In Bartenwerfer v. Buckley, the Supreme Court addressed the federal circuit split over the scope and application of nondischargeability provisions related to fraudulent conduct.

The High Court determined that the Bankruptcy Code turns on how the money was obtained, not who committed the fraud. Ultimately, in a unanimous decision, they found that a debtor cannot discharge a debt obtained through fraud, even if the debtor was not the fraudulent actor.

Takeaways
When you engage in a business deal with someone, even something as innocuous as a house flip, you take on “agency liability” for business activities. So if someone involved in that deal commits fraud, you become liable for that fraud by extension.

One way for an investor to protect themselves is by organizing a limited liability entity, such as an LLC (limited liability company) or LLP (limited liability partnership). These entities allow investors to participate in business deals without risking liability beyond their investment.

If the Bartenwerfers had formed a corporation with limited liability protections – and managed their business accordingly – Ms. Bartenwerfer would have been shielded from liability. Essentially, while a member of such an entity that commits fraud still be liable due to their actions, any other members of an LLC or LLP would be shielded from personal liability.

Meanwhile, the victory is a solid win for creditors and fraud victims. It means that someone who profits from fraud, even if they weren’t aware of it, cannot discharge their liability in Bankruptcy Court. While we have sympathy for innocent business partners, the judgment was necessary. Thankfully the court decided the way it did, rather than opening a dangerous loophole for fraudsters and their partners to profit with impunity.

ABOUT THE AUTHOR: Lewis J. Cohn is the Managing Partner of Cohn & Dussi.  Mr. Cohn’s practice focuses on representing lenders in all phases of the commercial loan process, with a special expertise in the collection, workout and liquidation of troubled debt. He is a long-time member of the Equipment Leasing and Finance Association (ELFA), where he serves on the Credit and Collections Committee. A recipient of the Top Lawyers Award from Boston Magazine, Mr. Cohn holds a LL.M. in Taxation from Boston University School of Law and a J.D. from Suffolk University School of Law. Mr. Cohn can be reached at 781-494-0209 or [email protected].