When Does Fraud Not Require Intent?

By Chief Bankruptcy Judge Craig A. Gargotta - WDTX

Judge Craig A. Gargotta was appointed a bankruptcy judge to the Western District of Texas in 2007. He became chief judge in 2021. Judge Gargotta formerly served as editor-in-chief for The Federal Lawyer from 2002-2008 and was chair of the bankruptcy section from 2017-2019. Judge Gargotta is a fellow of the Federal Bar Foundation.

The United States Supreme Court decided that debts arising from another person’s fraud can be barred from discharge by imputing the fraud to the debtor, even when there is no act, omission, intent, or knowledge on the part of the debtor.1 The case was argued on December 6, 2022, and the Supreme Court rendered a 9-0 opinion (written by Justice Barrett) on February 22, 2023. The decision employed a textual analysis that found that the plain language of U.S. Bankruptcy Code § 523(a)(2)(A) does not require a specific actor, intent, or culpability in imputing fraud from one actor to another.2

The bankruptcy court in In re Bartenwerfer (Buckley v. Bartenwerfer) had to determine whether a judgment against the Bartenwerfers, who fraudulently withheld information concerning material defects in real property they sold Buckley, was nondischargeable under the code.3 The Bartenwerfers bought and remodeled a home and then sold it to Buckley.4 Buckley sued the Bartenwerfers in state court alleging that the Bartenwerfers failed to disclose material defects in the home.5 Buckley obtained a judgment, and the Bartenwerfers filed a Chapter 7 bankruptcy—seeking to discharge the state court judgment.6 Buckley filed an adversary proceeding against the Bartenwerfers alleging that the judgment was nondischargeable under 11 U.S.C. § 523(a)(2)(A). Section 523(a)(2) (A) provides in relevant part that “a discharge under section 727… does not discharge an individual debtor from any debt… obtained by false pretenses, a false representation, or actual fraud.”

The bankruptcy court applied collateral estoppel to the state court judgment, finding that three of the five requisite elements to apply collateral estoppel under California law had been met.7 The bankruptcy court determined that the falsity of the representations and the intent to deceive were not actually litigated in state court, so Buckley had to seek factual findings from the bankruptcy court on these elements.8 The bankruptcy court noted that Mr. Bartenwerfer’s bankruptcy court testimony conflicted with his testimony in state court, finding that Mr. Bartenwerfer attempted to shield Mrs. Bartenwerfer from any fraudulent findings assessed against her by testifying that Mr. Bartenwerfer alone was responsible for the material omissions in the Real Estate Transfer Disclosure Statement.9 Nonetheless, the bankruptcy court found that the testimony in the state court trial was that Mrs. Bartenwerfer authorized Mr. Bartenwerfer to fill out the disclosure statement on her behalf.10

The Bartenwerfers argued at trial that Mr. Bartenwerfer’s alleged fraudulent conduct could not be imputed to his wife based upon their marital relationship.11 The bankruptcy court agreed but found that an agency relationship existed between the Bartenwerfers based on their partnership regarding the remodel project.12 The Bartenwerfers moved for a directed verdict under Fed. R. Civ. P. 52(c), arguing that Buckley failed to prove by a preponderance of the evidence that Mrs. Bartenwerfer had the requisite knowledge of the misrepresentations and omissions regarding the material defects in the home or intent to defraud.13 The bankruptcy court denied the motion. The bankruptcy court also found that, because Mrs. Bartenwerfer signed the disclosure statement, and that she would benefit financially from the completion of the remodel of the home and subsequent sale, that was a sufficient basis for a finding of fraud against Mrs. Bartenwerfer.14 As such, the bankruptcy court found that Buckley’s judgment was nondischargeable as to both defendants.

Buckley and the Bartenwerfers filed cross-appeals to the Bankruptcy Appellate Panel for the Ninth Circuit (BAP). A number of issues were raised on appeal, including the bankruptcy court’s determination that Mr. Bartenwerfer’s fraud could be imputed to Mrs. Bartenwerfer.15 The BAP agreed with the bankruptcy court that a marital relationship by itself is insufficient to impute the fraud of one spouse to another.16 The BAP further held that a business or agency relationship was necessary for Mr. Bartenwerfer’s fraud to be imputed to Mrs. Bartenwerfer.17 The BAP agreed with the bankruptcy court that a partnership/agency relationship was established between the Bartenwerfers because Mrs. Bartenwerfer had signed the seller’s disclosures and sales contract, and Mrs. Bartenwerfer would benefit financially from the sale of the home.18 The BAP disagreed with the bankruptcy court, however, regarding the bankruptcy court’s denial of the Bartenwerfers’ rule 52(c) motion, finding that for the bankruptcy court to have denied the rule 52(c) motion, the bankruptcy court needed to make a specific finding that Mrs. Bartenwerfer “‘knew or had reason to know’ of Mr. Bartenwerfer’s fraudulent omissions.”19 The BAP found that the bankruptcy court made no such finding, and concluded that the bankruptcy court appeared to have imposed judgment against Mrs. Bartenwerfer solely on the basis of an agency relationship.20 The BAP reversed the bankruptcy court, concluding that absent a finding that Mrs. Bartenwerfer knew or had reason to know about Mr. Bartenwerfer’s fraudulent omissions, the bankruptcy court could not make a legal determination of if the Buckley judgment was nondischargeable as to Mrs. Bartenwerfer.21

The BAP then remanded the case back to the bankruptcy court to make specific findings as to Mrs. Bartenwerfer’s knowledge of Mr. Bartenwerfer’s fraudulent omissions, specifically what Mrs. Bartenwerfer should have known about her husband’s fraudulent omissions regarding the material defects in the home. On remand, the bankruptcy court made extensive findings as to what Mrs. Bartenwerfer “should have known” about Mr. Bartenwerfer’s fraudulent omissions on the material defects.22 The bankruptcy court found that Mrs. Bartenwerfer was not involved in the day-to-day remodeling of the home, nor did she interact with the construction workers, architect, or consultants.23 Notably, the bankruptcy court explained that although Mrs. Bartenwerfer had signed the Real Estate Transfer Disclosure Statement, it was apparent that she had little, if any, personal knowledge regarding the defects in the home and did not confirm the accuracy of the representations on the disclosure statement.24 Moreover, the bankruptcy court found that Mrs. Bartenwerfer relied upon her husband’s false representations contained in the disclosure statement and in responses to discovery.25 The bankruptcy court concluded that Mrs. Bartenwerfer had no personal knowledge about the property’s defects and relied on her husband for any information concerning the condition of the property.26

The bankruptcy court then analyzed whether all the elements for determining if Mrs. Bartenwerfer was liable under § 523(a)(2) (A) were met. The Ninth Circuit (as do other circuit courts) requires that a creditor must prove by a preponderance of the evidence five elements:

(1) the debtor made a fraudulent misrepresentation or omission, or engaged in deceptive conduct; (2) the debtor knew of the falsity or deceptiveness of his or her statements or conduct; (3) the debtor made the representation with the intention and purpose of deceiving the creditor; (4) the creditor justifiably relied on the representation; and (5) the creditor suffered damage as a proximate result of the debtor’s fraudulent statements or conduct.27

The bankruptcy court determined that the only issue on remand was “whether Mrs. Bartenwerfer knew or should have known of her husband’s fraud, such that it can be imputed to her for purposes of section 523(a)(2)(A).”28 The bankruptcy court held that the seminal case for imputation of fraud in the Ninth Circuit is In re Huh. 29 The Huh Court held that imputation of an agent’s fraud to the agent’s principal requires proof of the agent’s culpability, which means that the principal knew or should have known of the agent’s fraud.30 The bankruptcy court observed that Huh “does not discuss what efforts, if any, a debtor must make to avoid a finding that he or she should have known of the agent’s fraud.”31 The bankruptcy court noted that there is no controlling authority in the Ninth Circuit regarding what a debtor “should have known,” and thoroughly examined case law from other circuit courts. The bankruptcy court found after surveying the relevant case law that the common thread in all the cases was that “the debtor knew of—but ignored—facts and circumstances that should have prompted him to investigate the truth of representations made by his agent.”32 In Bartenwerfer on remand, the bankruptcy court held that:

[none] of the other relevant caselaw requires a debtor to independently verify each and every representation made by his or her agent. If debtors were held to such a standard, it would render debtors liable for all misrepresentations made by their agents – a standard the BAP has rejected. Huh, 506 B.R. at 266. The Walker33 standard implicitly acknowledges that a principal must be able to trust and rely on his or her agent unless the principal knows or has reason to know of cause not to, and rightfully so. Otherwise, there would be little point to principal-agent relationships. It is only where a debtor learns of facts that require investigation into the agent’s conduct but fails to undertake such an inquiry that a court can find that the debtor “should have known” of the agent’s fraud and can impute such fraud to the debtor.34

The judgment creditor appealed to the BAP, inter alia, that the bankruptcy court incorrectly declined to impute to the debtor-wife the debtor-husband’s established fraud.35 The BAP affirmed the bankruptcy court’s construction of Huh and other case law, holding that:

Huh does not set forth efforts Mrs. Bartenwerfer must have taken to avoid a finding that she “should have known” of her agent’s fraud, the bankruptcy court appropriately consulted cases where courts imputed liability under the Huh and Walker “should have known” rule for guidance in determining if she “should have known” of Mr. Bartenwerfer’s fraud. It noted commonalities among these cases: “[i]n each of the foregoing cases, the debtor knew of—but ignored—facts and circumstances that should have prompted him to investigate the truth of representations made by his agent” and “the debtor’s willful refusal to pay minimal attention to the activities of their agents amounted to reckless indifference.” Id. at 685.36

The Ninth Circuit, in a short opinion, reversed the bankruptcy court and BAP, ruling that binding Supreme Court and Ninth Circuit precedent hold that a partner is responsible for the partner’s fraud when the fraud was performed “on behalf of the partnership and in the ordinary course of business of the partnership.”37 The Ninth Circuit determined that Mrs. Bartenwerfer’s debt is nondischargeable regardless of her knowledge of fraud and that using the “knew or should have known” standard was incorrect.38

The Supreme Court granted certiorari.39 By way of background, the Supreme Court generally only considers a few bankruptcy cases each term. More remarkable is the fact that both debtors’ and creditor’s counsel persisted through the appellate process multiple times before the Court granted certiorari. Rarely do consumer bankruptcy cases make it to the Supreme Court given that the cost and time of the appeal may exceed the amount of the claim at issue. That said, the petitioner argued that the Ninth Circuit’s reliance in the Bartenwerfer decision on Strang v. Bradner40 is misplaced and is contrary to

Hardie v. Swafford Bros. Dry Good Co.41, which declined to deny the discharge to an innocent debtor for fraud of another.

The petitioner argued in its Petition for Certiorari that: the issue potentially impacts every joint transaction or endeavor that may be construed as a partnership, including transactions involving married persons and couples, even the sale of a family home. Moreover, the aforesaid split of authorities among circuit courts makes the outcome depend upon geography and happenstance rather than the merits or substantive law.42

The Petition for Certiorari states the circuit courts are split on the imputation of fraud from one partner to the other, noting that the Fifth Circuit43 has denied a discharge without any level of scienter with the Eighth Circuit44 holding that the “knew or should have known” standard should apply. Moreover, the Petitioner argued that the Ninth Circuit’s determination further deepens the split of authorities because the Ninth Circuit does not require any scienter for an agent or partner of an individual found liable for fraud.45 Notably, the Petition for Certiorari argues that the Supreme Court has found that scienter is required for finding of fraud under § 523(a)(2)(A).46 Specifically, the Supreme Court held in Field v. Mans that Congress could have created a bar to discharge for unintentional conduct, but it did not.47

If Congress really had wished to bar discharge to a debtor who made unintentional and wholly immaterial misrepresentations having no effect on a creditor’s decision, it could have provided that. It would, however, take a very clear provision to convince anyone of anything so odd, and nothing so odd has ever been apparent to the courts that have previously construed this statute, routinely requiring intent, reliance, and materiality before applying § 523(a)(2)(A).48

The respondent, in its Brief for the Respondent in Opposition, argued that the plain text of § 523(a)(2)(A) does not require scienter or apply a standard of if the debtor “knew or should have known” of the fraud.49 Moreover, the respondent correctly notes that some of the provisions of § 523(a)(2) such as willful and malicious injury by the debtor to another under § 523(a)(6) require a state of mind, where others such as a debt for a “domestic support obligation” under § 523(a)(5) do not require a state of mind.50 Rather, the respondent points out that some of the exceptions to discharge under § 523(a) focus on the character of the debt—such as a domestic support obligation and the policy of not allowing those debts to be discharged. As such, respondent argues that had Congress wanted to include a state of mind component in § 523(a)(2)(A), Congress could have done so.51 Further, the plain text of the statute expressly provides “any debt” for “money… obtained by… actual fraud” cannot be discharged.52 Respondent further argues that § 523(a)(2)(A) does not contain a “knew or should have known” requirement.53

The Supreme Court affirmed the Ninth Circuit. The Court’s opinion in Bartenwerfer v. Buckley parses § 523(a)(2)(A) into three parts as it relates to Mrs. Bartenwerfer—(1) she is an “individual debtor”; (2) the judgment is a “debt”; and (3) the sale proceeds were obtained by David Bartenwerfer’s “fraudulent misrepresentations.”54 The Court noted that the § 523(a)(2)(A) is written in the passive voice; that is, § 523(a)(2)(A) does not specify a fraudulent actor.55 Further, the Court found that Congress framed § 523(a)(2)(A) on an event (the fraud) “that occurs without respect to a specific actor, and, therefore without respect to any actor’s intent or culpability.”56 The Court held that “[t]he debt must result from someone’s fraud, but Congress was ‘agnosti[c]’ about who committed it.”57 The Court further noted that common law fraud is not limited to the wrongdoer.58 The Court also found that its prior precedent—Strang v. Bradner—was still binding precedent and that Congress’s subsequent amendments to the exceptions to discharge for fraud (the precursors to § 523(a)(2)) did not evince a Congressional intent to override Strang, but rather embrace Strang’s holding that a principal of an actor who commits fraud can be liable for the fraud without any intent.59 Finally, the Court was unmoved by Bartenwerfer’s contention that its ruling would negatively impact the honest, but unfortunate debtor, and eviscerate the fresh discharge.60 Rather, the Court concluded that “a faultless individual is responsible for another’s debt only when the two have a special relationship, and even then, defenses to liability are available.”61 The Court further observed that when Congress balanced the equities of a debtor’s fresh start versus a creditor’s enforcement of a debt, Congress determined that in the context of this case that a creditor’s right to enforce his judgment overrides a debtor’s fresh start.62

As such, the Court determined that public policy (protection of the innocent but unfortunate debtor from the fraudulent acts of a partner or agent), must yield to the text of the statute (§ 523(a) (2)(A)), which does not include the “knew or should have known” standard. Bankruptcy lawyers will have to counsel their clients about the imputation consequences of a partner or agent being held liable for fraud to another agent or principal. Further, the benefits of one partner/spouse/principal’s discharge will be seriously diluted, if not eliminated, by the Supreme Court affirming the Ninth Circuit.

Endnotes

1Bartenwerfer v. Buckley, No. 21-908, slip op. Feb. 22, 2023, 598 U.S. _ (2023).

2Id. at 1.

3549 B.R. 222 (Bankr. N.D. Cal. 2016)

4Id. at 225.

5Id.

6Id.

7Id. at 227.

8Id.

9Id. at 228.

10Id

11Id. at 226 n.3.

12Id.

13Id

14Id.

15Bartenwerfer v. Buckley, Nos. 16-1277, 16-1299, 2017 WL 6553392 (9th Cir. B.A.P. Dec. 22, 2017) (unpublished).

162017 WL 6553392, at *9.

17Id.

18Id. at *10.

19Id.

20Id.

21Id

22In re Bartenwerfer (Buckley v. Bartenwerfer), 596 B.R. 675, 677-81 Spring