Supreme Court to Consider Whether Imputed Fraud Can be the Basis for Nondischargeability in Bankruptcy

The U.S. Supreme Court and the Ninth Circuit Court of Appeals have two important and interesting cases pending before them. The U.S. Supreme Court granted cert on April 2, 2022 to hear an appeal of a Ninth Circuit decision finding a claim for fraud to be nondischargeable in Chapter 7 bankruptcy based on a judgement stemming from another person’s fraudulent act.

In Bartenwerfer, the debtor appealed after the Ninth Circuit determined that the debt was non-dischargeable despite the debtor’s contention that she “had no control or even knowledge” of her husband’s fraudulent conduct in the sale of their home. In Bartenwerfer, the purchaser of the Bartenwerfer’s house sued Bartenwerfer and her husband following the discovery of structural defects in the house located in California. The Bartenwerfers jointly declared bankruptcy after losing a jury verdict. Bartenwerfer contended that the Ninth Circuit Court of Appeals erred by imputing to Bartenwerfer, her husband’s liability for making false representations to the purchaser about the house. The Supreme Court granted cert to resolve a split among the circuits regarding the issue of imputed liability.

A similar issue is currently pending before the Ninth Circuit Court of Appeals in a case entitled In re Zuckerman. Zuckerman presents additional arguments that are not raised in Bartenwerfer, but which are equally important, including the overbreadth of California law and the disparate tests in various Ninth Circuit Bankruptcy Appellate Panel (“BAP”) decisions. In Zuckerman, the Plaintiffs made thirteen loans to eight entities secured by property in Malibu. Appellant Zuckerman was an officer of one entity. Appellant was tried in absentia after his trial attorney abandoned the courtroom without permission and resulting in an approximately $15,000,000 judgment. Liability was established by defaulted requests for admissions which were tantamount to admissions of law and not fact. One fact witness testified. The testimony established, among other things, that Appellant never met the Plaintiffs until after the loans were made and subsequent to foreclosure of the property. Nevertheless, the state court judgment held Appellant Zuckerman vicariously liable for 100% of the loans made by all entities because liability was established by the defaulted requests for admissions. Although Appellant’s counsel appealed the state court judgment, it also abandoned the state court appeal.

Consequently, Appellant filed for bankruptcy protection. The Plaintiff-Appellees filed separate adversary complaints for nondischargeability and then filed successive summary judgment motions seeking to establish nondischargeability on grounds that the existence of the state court judgment barred any litigation on the elements of fraud under federal law based on collateral estoppel. Plaintiff-Appellees relied on the existence of the judgment as being sufficient to establish preclusion and proffered no record from the state court action establishing that each of the factual elements of fraud under Section 523(a)(2)(A) of the Bankruptcy Code were actually litigated and decided. The bankruptcy court granted summary judgment for Plaintiff-Appellees on grounds that the state court judgment was categorically preclusive on its face and did not examine any aspect of the state court record proffered by Appellant in opposition. The BAP affirmed in In re Zuckerman, 613 B.R. 707 (9th Cir. B.A.P. 2020).

Appellant appealed both summary judgments to the Ninth Circuit Court of Appeals on several grounds. First, arguing that the bankruptcy court erred in finding the mere existence of the state court judgment categorically preclusive without examining the state court record to determine whether each factual element of fraud under Section 523(a)(2)(A) was actually litigated and necessarily decided. Second, even if such examination had occurred, summary judgment was unwarranted because the record demonstrated that several elements of Section 523(a)(2)(A) were unsatisfied. Third, exclusive reliance on defaulted discovery admissions to prove liability does not constitute actual litigation. Finally, Appellant, abandoned by counsel and tried in absentia, was not afforded a full and fair opportunity to litigate; thus, preclusion should not apply.

Similar to Bartenwerfer, Zuckerman argues that Section 523(a)(2)(A) requires a knowingly false misrepresentation made with specific intent to deceive. In Zuckerman, Appellant argues that the elements of fraud under California law and Section 523(a)(2)(A) are not identical as advanced by many courts. Specific intent to deceive is not an essential element of fraud in California. Section 523(a)(2)(A) requires that the debtor made representations he or she knew were false and made them with the intention and purpose of deceiving the creditor. Thus, while a statement made with reckless regard to its truth, made with the intent to induce reliance, can qualify as fraud in California, Appellant in Zuckerman argues that Section 523(a)(2)(A) requires a knowingly false statement made with the intent and purpose to deceive. Appellant further asserts that the state court complaint which gave rise to the judgment did not allege any knowingly false representation of Appellant made with the subjective intent and purpose to deceive. Instead, the state court complaint alleges that others made representations that were false and seeks to hold Appellant liable for those representations under an alter ego doctrine. While the judgment contained statements that Appellant fraudulently obtained loans, intentionally defrauded Plaintiffs, and oversaw a fraudulent scheme, the state court complaint contained no allegations that necessarily sustained such findings, nor a conclusion that such issues were submitted for decision. They were not submitted and could not be decided because they were never alleged or addressed at trial. The transcript shows Appellant personally made no knowingly false representation to any Plaintiff and that his liability was not even adjudicated.

Nevertheless, the bankruptcy court found that because the judgment contained express findings of fraud, preclusion was warranted under applicable law, and the BAP affirmed. The Appeal asserts that the judgment does not contain actual factual findings of liability establishing each element of Section 523(a)(2)(A), including that Appellant made a knowingly false representation to any Plaintiff with the intent to deceive that Plaintiff and that any Plaintiff relied on Appellant’s representation which was the proximate cause of loss. In addition, Appellant asserts that the judgment noted that liability was predicated solely on the defaulted admissions, which were not factual determinations but defaulted admissions to state law claims, which do not necessarily align with actual fraud under federal law, and do not constitute actual litigation. Finally, Appellate asserts that the court must examine the complaint’s allegations to determine what was alleged and submitted for decision before finding preclusion.

Leech Tishman’s Business Restructuring & Insolvency Practice Group regularly assist clients in Chapter 7 bankruptcy and general bankruptcy litigation matters.

If you have any questions about the two cases outlined above, or what they might mean for bankruptcy proceedings, please contact Sandford L. Frey.

Sandy is a Partner with Leech Tishman and Chair of the Business Restructuring & Insolvency Practice Group, where he co-leads the Bankruptcy Chapter 11 Debtor and Bankruptcy Chapter 11 Subchapter V Debtor Groups. Sandy is based in the Pasadena office and can be reached at 626.796.4000 or sfrey@leechtishman.com.

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Leech Tishman Fuscaldo & Lampl is a full-service law firm dedicated to assisting individuals, businesses, and institutions. Leech Tishman offers legal services in business restructuring & insolvency, corporate matters, employment & labor, estates & trusts, intellectual property, litigation & alternative dispute resolution, and real estate. In addition, the firm offers a wide range of legal services to clients in the aviation & aerospace, cannabis, construction, emerging cyber technologies, energy & natural resources, healthcare, and hospitality industries. Headquartered in Pittsburgh, PA, Leech Tishman also has offices in Chicago, Los Angeles, New York, Philadelphia, Sarasota, and Washington, D.C.