Partners – Beware what your Partner Represents to Others!

By: Julie Koenig

Pursuant to 11 U.S.C. §523(a), certain categories of debts may be held non-dischargeable in bankruptcy.   One category is debts for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor’s or an insider’s financial condition.  §523(a)(2)(A).

            To prevail in a §523(a)(2)(A) action, a creditor must prove five elements by a preponderance of the evidence:  (1) a misrepresentation, fraudulent omission or deceptive conduct by the debtor[1]; (2) knowledge of the falsity or deceptiveness of his statement or conduct; (3) the debtor[2] made the representation with the intention and purpose of deceiving the creditor; (4) the creditor justifiably relied on the representation; and (5) the creditor sustained damage as the proximate result of the representation.   Turtle Rock Meadows Homeowners Ass’n v. Slyman (In re Slyman), 234 F.3d 1081, 1085 ((th Cir. 2000).

            Seems pretty simple doesn’t it?  The potentially non-dischargeable debt is particular to the debtor – wrong!    A creditor just spent the last nine years obtaining a Supreme Court ruling that both a husband and wife, as partners, were liable on a non-dischargeable debt because the husband failed to disclose pertinent information on a real estate disclosure form.  Pay attention to what your partners represents to third parties!

Background

            In 2005, Kate Bartenwerfer and her then boyfriend, David Bartenwerfer, jointly purchased a house in San Francisco.   They decided to form a partnership to renovate the house and resell it for a profit.  From 2005 until 2008, David Bartenwerfer remodeled the house - hiring an architect, structural engineer, designer, and general contractor to perform the repairs.  During this time Kate Bartenwerfer worked a full time job and had little involvement in the renovations.  At some point during this process the two were married.

            In 2007, they placed the property on the market and ultimately entered into a sales contract with Kieran Buckley, to sell him the house.   As part of the sales contract, David executed a disclosure statement and a supplemental disclosure statement but failed to disclose information regarding water leaks, window conditions, permits and a missing fire escape.  Although the buyer was himself a general contractor, the omissions and attendant defects were not discovered until after the closing on the sale.

The Road to the Supreme Court

Mr. Buckley sued the Bartenwerfers in San Francisco County Superior Court for breach of contract, negligent misrepresentation, intentional misrepresentation, and seller’s failure to disclose information regarding the sale.  After a 19 day jury trial, the jury returned a verdict in favor of Mr. Buckley and against both David and Kate Bartenwerfer for, among other things, non-disclosure of material facts.

            Unable to satisfy the judgment and pay other debts, the Bartenwerfers filed for Chapter 7 bankruptcy relief.   Mr. Buckley filed an adversary proceeding to have his debt as to both parties ruled non-dischargeable under §523(a)(2)(A).   The bankruptcy court found in favor of Mr. Buckley and held the judgment debt to be non-dischargeable as to both David and Kate Bartenwerfer.

            The Bartenwerfers appealed to the Ninth Circuit Bankruptcy Appellate Panel which agreed as to David’s fraudulent intent but not as to Kate’s.  The case was remanded to the bankruptcy court who, after a second trial, determined that Kate lacked the requisite knowledge of David’s fraud and could therefore discharge the judgment debt.  The Bankruptcy Appellate Panel affirmed that judgment.

            On appeal to the full Ninth Circuit, the appellate court reversed in relevant part holding that a debtor who is liable for her partner’s fraud cannot discharge that debt in bankruptcy, regardless of her own culpability.  The Ninth Circuit, in reaching its decision, relied upon  an 1885  Supreme Court decision - Strang v. Bradner, 114 U.S. 555 (1885).

The Supreme Court

            The case was then appealed to the Supreme Court which granted certiorari to resolve confusion in the lower courts on the meaning of §523(a)(2)(A).

            The Supreme Court determined that the passive voice in §523(a)(2)(A) does not hide the relevant actor in plain sight – it removes the actor altogether.  “Congress framed §523(a)(2)(A) to ‘focus on an event that occurs without respect to a specific actor, and therefore without respect to any actor’s intent or culpability.”’[3]  The Court upheld its 1885 determination that “the fraud of one partner should be imputed to the other partners, who ‘received and appropriated the fruits of the fraudulent conduct.’” [4]  Therefore the Supreme Court affirmed the Ninth Circuit’s judgment that Kate Bartenwerfer’s debt is not dischargeable in bankruptcy.

            This Supreme Court ruling applies to partnership debts only.  If the Bartenwerfer’s had formed a limited liability entity, Kate would have been insulated from personal exposure to the business’s debts.  Unfortunately, most partners never think to form a separate limited liability company in flipping houses or other small businesses.