U.S. Supreme Court Bankruptcy Roundup

Exception from Discharge of Debts for Fraud Committed by Business Partner

On February 22, 2023, the U.S. Supreme Court handed down its ruling in Bartenwerfer v. Buckley, No. 21-908, 2023 WL 214441 (U.S. Feb. 22, 2023), where it resolved a circuit split in ruling that a debt based on fraud committed by, or a false representation made by, the debtor's partner or agent is nondischargeable in the debtor's bankruptcy case.

Under section 523(a)(2)(A) of the Bankruptcy Code, a discharge of debts under section 727 and parallel sections of other chapters of the Bankruptcy Code does not apply to "any debt … for money … obtained by … false pretenses, a false representation, or actual fraud." 

Although liability for fraud committed by a partner or agent can be imputed to other partners or a principal, the circuits and lower courts have long disagreed as to whether a debtor must have some degree of scienter (i.e., the debtor knew or should have known of its partner's or agent's fraud or false representation) before the debt based on that liability is deemed nondischargeable in the debtor's bankruptcy. See generally Collier on Bankruptcy ¶ 523.08[3] (16th ed. 2023) (discussing cases beginning with the Supreme Court's decision in Strang v. Bradner, 114 U.S. 555 (1885), under the since-repealed Bankruptcy Act of 1867).

The chapter 7 debtor in Bartenwerfer argued that she should not be held liable for the fraud committed by her husband because, even though she was her husband's business partner, she was not involved in or aware of the fraud, the fraud should not be imputed to her, and the debt should not be excepted from the scope of her chapter 7 discharge under section 523(a)(2)(A).

In a unanimous opinion authored by Justice Amy Coney Barrett, the Court disagreed, holding that section 523(a)(2)(A) turns on how the money that is subject to a creditor claim was obtained, rather than on who committed the fraud to obtain the money.

In so ruling, the Court agreed with the Ninth Circuit's 2021 decision below in In re Bartenwerfer, 860 F. App'x 544 (9th Cir. 2021), aff'd, No. 21-908, 2023 WL 214441 (U.S. Feb. 22, 2023).

Cases Pending Before Supreme Court

On January 13, 2023, the U.S. Supreme Court agreed to hear two cases involving or potentially impacting issues of bankruptcy law.

In Lac du Flambeau Band of Lake Superior Chippewa Indians v. Coughlin, No. 22-227 (U.S.), the Court granted certiorari to review a decision handed down by a divided panel of the U.S. Court of Appeals for the First Circuit holding that section 106(a) of the Bankruptcy Code abrogates sovereign immunity in bankruptcy cases for Native American tribes. See Coughlin v. Lac du Flambeau Band of Lake Superior Chippewa Indians (In re Coughlin), 33 F.4th 600 (1st Cir. May 6, 2022). In so ruling, the First Circuit sided with a 2004 decision from the Ninth Circuit, Krystal Energy Co. v. Navajo Nation, 357 F.3d 1055 (9th Cir. 2004), while disagreeing with the Sixth Circuit, which ruled in 2019 that there is no abrogation. See In re Greektown Holdings, LLC, 917 F.3d 451 (6th Cir. 2019), cert. dismissed sub nom. Buchwald Cap. Advisors LLC v. Sault Ste. Marie Tribe, 140 S. Ct. 2638 (2020). The central question in Coughlin is whether section 106(a)'s abrogation of sovereign immunity for any "governmental unit," which is defined in section 101(27) to include any "other … domestic government," unequivocally expressed Congress's intention to abrogate the sovereign immunity of Native American tribes.

In Tyler v. Hennepin County, No. 22-166 (U.S.), the Court agreed to review a decision by the U.S. Court of Appeals for the Eighth Circuit affirming a lower court's ruling that a real estate tax foreclosure proceeding in which a local taxing authority refused to pay to the homeowner the surplus realized from the sale does not violate the Takings Clause of the Fifth Amendment to the U.S. Constitution. See Tyler v. Hennepin County, 26 F.4th 789 (8th Cir. 2022). A circuit split arose after the Eighth Circuit's decision, when the Sixth Circuit reached the opposite conclusion later that year. See Hall v. Meisner, 51 F.4th 185 (6th Cir. 2022), reh'g en banc denied, 2023 WL 370649 (6th Cir. Jan. 4, 2023).

Although Tyler involves the Takings Clause, a ruling by the Court may shed light on a long-standing circuit split over whether a tax foreclosure can be challenged in bankruptcy as a fraudulent transfer. In BFP v. Resolution Trust, 511 U.S. 531 (1994), the Court held that a regularly conducted real estate mortgage foreclosure sale cannot be a fraudulent transfer, regardless of whether or not the foreclosure sale generated "fair market value." The Fifth, Ninth, and Tenth Circuits later expanded the reach of BFP by ruling that a real estate tax foreclosure cannot be deemed a fraudulent transfer. The Second, Third, Sixth, and Seventh Circuits have ruled to the contrary. If, however, the Supreme Court rules in Tyler that the Fifth Amendment prohibits a state from retaining the equity after a tax foreclosure, debtors will not need to resort to a fraudulent transfer action because they will have a direct Takings Clause Claim against the taxing authority.

Tyler and Coughlin are scheduled to be heard by the Court in April 2023, with decisions to be handed down before the end of the term in late June.

Also anticipated before the July recess this year is the Court's decision in MOAC Mall Holdings LLC v. Transform Holdco LLC, 142 S. Ct. 2867 (2022). The question in MOAC is whether Bankruptcy Code section 363(m)—which prohibits an appeal of a sale order under section 363(b) or (c) from affecting the validity of the sale, unless the sale was stayed pending appeal—is jurisdictional such that it cannot be waived.

The Second Circuit had ruled that section 363(m) is jurisdictional, and dismissed an appeal by Mall of America ("MOA") challenging an assignment of Sears's lease in that facility through a sale order entered in Sears's chapter 11 case. MOA contends that section 363(m) is not jurisdictional, and that, even if it is, the Second Circuit gave an unduly broad reading to section 363(m) because the particular assignment it is challenging was not so integral to the sale order that invalidation of the assignment would undermine the sale. The Court heard argument in the case on December 5, 2022.

Status of Notable Petitions for Supreme Court Review

In addition to these cases, there are also four pending petitions seeking certiorari by the Supreme Court that relate to various issues of bankruptcy law.

On January 5 and January 16, 2023, respectively, Highland Capital Management, L.P. ("Highland") and NexPoint Advisors, L.P. ("NexPoint") filed petitions asking the Court to review an August 19, 2022, decision handed down by the U.S. Court of Appeals for the Fifth Circuit regarding Highland's confirmed chapter 11 plan. See Highland Capital Management, L.P., v. Nexpoint Advisors, L.P., No. 22-631 (U.S. Jan. 5, 2023); NexPoint Advisors, L.P. v. Highland Capital Management, L.P., No. 22-669 (U.S. Jan. 16, 2023). The Fifth Circuit held that because section 524(e) of the Bankruptcy Code—which, together with the other subsections of section 524, governs the scope of chapter 11 plan discharges—generally prohibits exculpating third parties from liability, a broad "All Related Parties" exculpation provision was invalid. But the Court upheld the exculpation of the debtor's independent directors for anything short of gross negligence on the ground that this tracked the common-law immunity of bankruptcy trustees, and it approved provisions exculpating both the debtor and other parties from ordinary business liabilities arising after confirmation.

In its petition, Highland argues that the Fifth Circuit's decision is wrong. According to Highland: 

Section 524(e) simply states that the discharge of a debtor's liability on a debt does not itself affect any other creditor's liability on that same debt. Section 524(e) uses no mandatory language at all; it does not tell the court or the parties what provisions a plan "shall" or "shall not" include. In other words, section 524(e) is simply a saving clause intended to clarify that a debtor's statutorily defined discharge is limited in scope to the debtor itself.

NexPoint's petition also challenges the Fifth Circuit's rulings, arguing that the court should have gone further to prohibit exculpation of any third parties, and that a plan cannot prospectively exculpate the debtors and others for post-bankruptcy business operations. 

In February 2023, petitions for certiorari were filed in two cases questioning the continued vitality of the pre-Bankruptcy Code "solvent-debtor exception" and the obligation under a chapter 11 plan to pay postpetition interest on unsecured claims in order to render the claims "unimpaired" by the plan (and therefore deemed to accept it). See Pacific Gas & Electric Co. v. Ad Hoc Committee of Holders of Trade Claims, No. 22-733 (U.S. Feb. 6, 2023); Ultra Petroleum Corp. v. Ad Hoc Comm. of OpCo Unsecured Creditors, 22-772 (U.S. Feb. 13, 2023). In PG&E, the petitioners seek review of an August 2022 decision by a divided Ninth Circuit panel holding that, pursuant to the solvent-debtor exception, unsecured creditors possess an equitable right to postpetition interest under section 1124(1) of the Bankruptcy Code when a debtor is solvent. See In re PG&E Corp., 46 F.4th 1047 (9th Cir. 2022). In Ultra Petroleum, the petition seeks review of an October 2022 ruling by a divided panel of the Fifth Circuit in which the majority concluded that "the solvent-debtor exception is alive and well" and ruled that a solvent chapter 11 debtor was obligated to pay a make-whole premium and postpetition interest to unimpaired noteholders "even though … it is indeed otherwise disallowed unmatured interest." See In re Ultra Petroleum Corp., 51 F.4th 138, 156 (5th Cir. 2022).

Finally, on March 20, 2023, the Court denied a petition to review the Second Circuit's decision in ESL Investments, Inc. v. Sears Holdings Corp. (In re Sears Holdings Corp.), 51 F.4th 53 (2d Cir. 2022), cert. denied sub nom. Cyrus Capital Partners, L.P. v. Sears Holdings Corp., No. 22-765 (U.S. Mar. 20, 2023). In Sears Holding, the Second Circuit affirmed a district court decision valuing at $0 the section 507(b) superpriority claims of certain second-lien lenders. According to the court of appeals, given the uncertainty surrounding the retail debtors' fate at the time they filed for bankruptcy, the bankruptcy court did not err in valuing inventory collateral securing second-lien debt at its "net orderly liquidation value," rather than book value, going-out-of-business sale value, or forced liquidation value. The Second Circuit also found no fault with the bankruptcy court's decision to value non-borrowing base inventory at zero and to ascribe full face value to undrawn letters of credit where, among other things, the junior lenders failed to meet their evidentiary burden of suggesting a reasonable alternative.

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