Supreme Court Ruling In Bankruptcy Case Could Pose Risk For Informal Partnerships

A Supreme Court ruling earlier this month prevents fraudulent credit from being claimed in bankruptcy proceedings for business partnerships, even when one partner was innocent of the fraud.

Bankruptcy usually allows debtors relief from debts incurred before filing, but there are exceptions, according to the U.S. Bankruptcy Code, including a creditor’s claim for “money … obtained by false pretenses, a false representation, or actual fraud.”

In Bartenwerfer v. Buckley, the high court affirmed that exception, even for those who did not themselves participate in the fraud that their business associates perpetrated.

The decision does not, however, pose much of a new threat to business partners, including those in real estate, according to legal experts, even though a real estate transaction was at the heart of the matter in Bartenwerfer.

“The case doesn't really change anything for business partnerships,” Columbia University Professor of Law Ronald Mann said. “In the great majority of cases, there will be limited liability entities between any individual and an operating business that could be accused of fraud.

“So except in the most small and informal cases like this one, which had not even an oral agreement of partnership, much less a document reviewed by an attorney, any fraud at the partnership level wouldn't expose any individuals except the ones directly responsible for the fraud,” Mann said.

In Bartenwerfer, the high court found unanimously that Kate Bartenwerfer couldn't use Chapter 7 bankruptcy to discharge a debt, namely a judgment won by Kieran Buckley, whom Kate's husband, David Bartenwerfer, had defrauded in a residential real estate sale. The bankruptcy court found that Kate, David's informal business partner, had not herself known about the fraud.

The Bartenwerfers jointly owned a house in San Francisco that they decided to renovate and sell for a profit. Court documents note that David took charge of the project, while Kate was mostly not involved. Both, however, attested to Buckley before he bought the house that they had disclosed all material facts about the property, as they were legally required to do.

David had, in fact, neglected to disclose a number of major defects in the property. Buckley sued and won $200K in damages. The Bartenwerfers filed for bankruptcy, asserting that they couldn't pay that debt and others. Buckley filed a complaint in the bankruptcy proceeding, alleging that debt owed to him was nondischargeable.

Ultimately, writing the high court's decision in ruling for Buckley, Associate Justice Amy Coney Barrett rejected Kate Bartenwerfer's assertion that she should have bankruptcy relief for the fraud that someone else, her informal partner David, had committed.

“The legal context ... has long maintained that fraud liability is not limited to the wrongdoer,” Barrett wrote, also dismissing  arguments made by Kate Bartenwerfer's attorney about the wording of the bankruptcy law.

Barrett noted that the law's only concern isn't debtors, and that certain conditions need to be met before someone is stuck with fraudulent debt for which they are not responsible. 

“Bartenwerfer insists that the preclusion of faultless debtors from discharging liabilities run up by their associates is inconsistent with bankruptcy law’s 'fresh start' policy. But the Bankruptcy Code is not focused on the unadulterated pursuit of the debtor’s interest, and instead seeks to balance multiple, often competing interests.

“While Bartenwerfer paints a picture of liability being imposed on hapless bystanders, fraud liability generally requires a special relationship to the wrongdoer and, even then, defenses to liability are available,” Barrett wrote.

“The Court here does not confront a situation involving fraud by a person bearing no agency or partnership relationship to the debtor,” Associate Justice Sonia Sotomayor wrote separately, concurring with the opinion. “Instead, '[t]he relevant legal context' concerns fraud only by 'agents' and 'partners within the scope of the partnership.'”

“This marks a complete victory for our client, Kieran Buckley, who has been fighting to recover his losses since he was defrauded nearly 15 years ago,” Weil, Gotshal & Manges partner Zachary Tripp said in a statement emailed to Bisnow.

“And it marks an important win for other victims of fraud, as the court’s decision shows the bankruptcy code cannot be used as a shield for those who profit from fraud,” Tripp said.

The law firm representing Kate Bartenwerfer didn't respond to Bisnow's queries for a comment.

While partners in most professionally structured real estate deals have little to worry about when it comes to this decision, many informal real estate partnerships do exist, especially for residential sales, and consumer advocates stress the need for caution in such instances.

“This case... carries consequences for cohabitating couples, spouses and people in informal business partnerships with regard to their potential vulnerability to non-dischargeable debt,” AARP Foundation Senior Attorney Elizabeth Aniskevich wrote before the case was decided, noting that people over 55 make up a majority of home sellers, with most of them selling with a spouse or as part of an unmarried couple.

"If the Supreme Court [rules for Buckley], it will be especially important for older adults to be cautious when pursuing business ventures with a partner and protect themselves by limiting their liability when possible,” Aniskevich wrote.