Wiping Away Debts From Others’ Fraud Weighed by Supreme Court (1)

A bankrupt California woman told the Supreme Court that she should be able to wipe out debts incurred in a home sale because she was unaware that her husband failed to disclose material defects about their house.

Subjecting Kate Bartenwerfer to liability for her husband’s fraud would amount to a “financial death sentence” for her and others in similar situations, Bartenwerfer attorney Sarah Harris of Williams & Connolly LLP told the justices Tuesday.

The buyer of the San Francisco house, Kieran Buckley—who sued the couple after discovering defects in 2007—argued that Kate and David Bartenwerfer were partners in the sale transaction who should have known the nature of the disclosures being made. Kate Bartenwerfer petitioned to the Supreme Court after the US Court of Appeals for the Ninth Circuit sided with Buckley.

The case tees up the question of whether an unwitting bankrupt debtor can wipe out a debt stemming from another party’s fraudulent act. The bankruptcy code doesn’t prevent debtors from wiping out debt in such situations, Harris said.

In pushing back on Harris’ argument, Justice Elena Kagan referred back to a US Bankruptcy Code provision that clearly bans bankrupt debtors from wiping out debts incurred through fraudulent conduct.

“The text, it seems to me, cuts against you,” Kagan said to Harris.

The bankruptcy code’s text suggests that the fraud could apply to Kate Bartenwerfer, Kagan said.

‘Should Have Known’

The Bartenwerfers in 2013 jointly declared Chapter 7 in the US Bankruptcy Court for the Northern District of California after losing a jury verdict in 2012 for failing to disclose material facts about the property’s defects.

In the California bankruptcy proceedings, Kate Bartenwerfer won a ruling to discharge what she owes to Buckley by showing she was unaware of her husband’s fraudulent concealment. The bankruptcy court’s debt discharge test examined whether she “knew or should have known” of the fraud.

The Ninth Circuit overturned the bankruptcy court’s decision in 2021, rejecting the lower court’s legal test. The couple were partners, a Ninth Circuit panel ruled, citing “basic partnership principles” rooted in Supreme Court precedent. “Mrs. Bartenwerfer’s debt is nondischargeable regardless of her knowledge of the fraud,” the panel said.

In her petition to the Supreme Court, Bartenwerfer argued that the Ninth Circuit’s decision conflicted with the US Court of Appeals for the Eighth Circuit’s standard.

The Ninth Circuit ruling would lead bankruptcy to become “a minefield of guilt-by-association,” she said in court filings.

If vicarious liability of wrongdoing in bankruptcy was allowed, that “would fall mostly on unsophisticated spouses who do not realize routine transactions in marriage, like selling homes, create business partnerships in the eyes of the law,” Harris said.

But Buckley’s attorney counterargued that the bankruptcy code is clear that “unwitting debtors” like Bartenwerfer can’t discharge debts from others’ fraud.

“Petitioner obtained my client’s money by means of an actual fraud, and she’s fully liable for the fraud,” said Buckley attorney Zachary Tripp of Weil, Gotshal & Manges LLP told the justices. “It is her fraud under bedrock principles of partnership law.”

Siding with Buckley, Erica Ross, an assistant US Solicitor General, told the justices that partnership rules in all 50 states, common law, and Supreme Court precedent show that debtors are liable for their partners’ frauds.

Justice Neil Gorsuch told Ross that he saw rational policy arguments from both Bartenwerfer and Buckley.

“The two policy judgments seem to me to be tugging at each other here,” Gorsuch said. “I could understand one or the other, but it’s very hard for me to understand a little bit of this and a little bit of that.”

The case is Bartenwerfer v. Buckley, U.S., No. 21-908, oral argument 12/6/22.