February 9, 2023

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The Legal System

A bungled house sale, a bankrupt couple, and a statutory puzzle involving debts incurred through fraud

CASE PREVIEW

The court will hear its second bankruptcy case of the week next Tuesday, with Bartenwerfer v. Buckley following close on the heels of the Monday argument in MOAC Mall Holdings LLC v. Transform Holdco LLC. The cases could hardly be more different. MOAC Mall Holdings involves the assignment of a shopping-center lease in a large corporate reorganization. Bartenwerfer presents a single impecunious debtor attempting to discharge a debt incurred through the fraud of her husband.

The case involves the sale of a house in San Francisco from David and Kate Bartenwerfer to Kieran Buckley. Dissatisfied with the purchase, Buckley eventually obtained a judgment in a California state court based on the failure of the Bartenwerfers to disclose information about the house on the standard-form Transfer Disclosure Statement. Under California law (which is not the least bit unusual on this point), both of the spouses are jointly responsible for that judgment, even though David was much more directly involved than Kate in the repairs and renovations related to the deficient disclosures.

Later, the Bartenwerfers filed for bankruptcy relief. The Bankruptcy Code offers debtors a broad discharge of obligations that they incurred before filing for bankruptcy, but an exception (Section 523(a)(2)(A)) protects – and thus preserves – any claim for “money … obtained by … actual fraud.” Reasoning that Buckley’s claim falls under that exception, the bankruptcy court held that David could not discharge it.

The bankruptcy court thought Kate’s situation should be different, because she lacked any “actual knowledge” of the deficiencies in the disclosure statement. Because Buckley’s claim did not involve money obtained by her fraud, the bankruptcy court ruled that Kate could discharge that claim. The court of appeals, by contrast, concluded that the discharge exception protects any claim for money obtained by fraud; it does not matter if the debtor committed the fraud. The question before the Supreme Court, then, is whether Section 523 turns on the state of mind of the debtor (is this an honest or fraudulent debtor?) or the state of the claim (was this debt incurred legitimately or fraudulently?). The arguments on the two sides are crisp and logical.

Bartenwerfer points first to the court’s articulation of a clear-statement rule, under which the exceptions to discharge are narrowly limited to those that are “plainly expressed” in the statute. Because the statute bars the discharge of “an individual debtor from any debt … for money … obtained by … fraud,” it is natural, Bartenwerfer argues, to read the text as describing the fraud of the individual debtor rather than the fraud of a third party that the statute does not mention.

Turning from the literal text to the broader statutory context, Bartenwerfer emphasizes the next subparagraph of the statute. Section 523(a)(2) as a whole provides a discharge exception for “money, property, services, or an extension, renewal, or refinancing of credit,” but only “to the extent obtained by” one of three forms of misconduct – described in subparagraphs (A) (at issue in Bartenwerfer), (B) and (C). Within the provision, where subparagraph (A) deals generally with “false pretenses, a false representation, or actual fraud,” subparagraph (B) deals with financial statements (“a statement respecting the debtor’s or an insider’s financial condition”). In subparagraph (B), the exception to discharge applies only if “the debtor caused [the statement] to be made or published with intent to deceive.” Thus, Bartenwerfer emphasizes, liability under subparagraph (B) plainly is limited to the debtor’s own conduct. It would be “bizarre,” she contends, for the liability under subparagraph (A) to leave a debtor unable to discharge a debt incurred through the fraud of another when the parallel provision for fraudulent financial statements clearly is limited to the debtor’s own malfeasance.

More broadly, as a policy matter, Bartenwerfer emphasizes how burdensome it would be to limit the discharge in cases like this: Under Buckley’s reading of the statute, a spouse who learns of fraudulent behavior of her husband and responds by immediately divorcing her husband and distancing herself from his financial affairs would remain forever unable to discharge her responsibility for the debt.

Buckley, by contrast, argues that the plain and literal meaning of the statute compels the protection the claim from discharge. The statute refers to the discharge of “any” debt obtained by “fraud.” Not a word of subparagraph (a)(2)(A) suggests that the identity of the fraudster is relevant. If state law holds a party responsible to compensate the victim of the fraud, Buckley reasons, the Bankruptcy Code must protect the claim from discharge.

Buckley also emphasizes a Supreme Court decision from 1885 (not a typo), Strang v. Bradner. Strang rejected the discharge of a debt in strikingly similar circumstances: Debtors were obligated to victims for fraud perpetrated by the debtors’ partner on behalf of a partnership. Even though the statute of the time (the Bankruptcy Act of 1867) required actual fraud “of the bankrupt” to protect a claim from discharge, the Supreme Court held that such a debt was “created by [the debtors’] fraud [because the fraud of one partner is] imputed … to all.” Strang brings into play Buckley’s interpretive canon – under which the Supreme Court reads the Bankruptcy Code as incorporating jurisprudence under older bankruptcy statutes unless the Bankruptcy Code directly rejects it. (For what it’s worth, I’m pretty sure the Supreme Court has never considered application of that principle to its cases under the ancient Bankruptcy Act of 1867!) In this case, if anything the language of Section 523 is broader than the language at issue in Strang, because it omits the limitation of the exception to fraud by the individual debtor. Accordingly, Buckley reasons, the court should read Section 523 as carrying forward the rule of Strang that the discharge exception turns on the fraudulent basis for the claim rather than the conduct of the individual debtor.

The preceding discussion pitches the case as a debate between a clear-statement rule calling for narrow interpretation of discharge exceptions and a clear-statement rule calling for preservation of pre-Code practice. I should throw one more idea in the mix: the trope of the “honest but unfortunate debtor,” a phrase from the Depression-era Supreme Court decision in Local Loan Co. v. Hunt. Hunt’s conception of the Bankruptcy Code as designed to protect the “honest but unfortunate debtor” has been an almost ubiquitous feature of the court’s opinions in bankruptcy cases involving individual debtors; the court has referred to Hunt in more than two dozen of its later cases. Justices wedded to that conception well might come down in favor of a discharge here for Kate.

Competing interpretive canons. A fact pattern worthy of a law-school classroom. And, while I’m at it, a pair of experienced advocates familiar to the justices (Lisa Blatt and Zachary Tripp). What’s not to love. It is fair to expect that the justices will have a good time with this one on Tuesday.