Fraud Claim Released in Settlement Agreement Preserved in Bankruptcy Proceedings

When the Warners failed to make the first payment on the promissory note, the Archers brought suit for the payment in state court. The Warners then filed for bankruptcy. The Bankruptcy Court ordered liquidation under Chapter 7 and the Archers sought a determination from the Bankruptcy Court that the $100,000 debt was nondischargeable because it was for 'money ' obtained by … fraud.'

The Bankruptcy Court held that the promissory note debt was dischargeable, and the District Court affirmed. The Fourth Circuit agreed, reasoning that the settlement agreement, releases and promissory note had worked a kind of novation. The Fourth Circuit concluded that the novation replaced an original potential debt for money obtained by fraud with a new debt that was not obtained by fraud. Rather, it was for money promised in a settlement contract and was, therefore, dischargeable in bankruptcy.

The Supreme Court reversed, holding that while the settlement agreement and releases may have worked a kind of novation, this fact does not prohibit 'the Archers from showing that the settlement debt arose out of 'false pretenses, a false representation, or actual fraud,' and consequently is nondischargeable.'

The Court based this ruling on its earlier decision in Brown v. Felsen, 442 U.S. 127 (1979), where a state court action alleging fraud resulted in a consent decree embodying a stipulation (which did not indicate the payment was for fraud). The stipulation was breached and the debtor filed for bankruptcy. The Court in Brown ruled that claim preclusion did not prevent the bankruptcy court from looking past the state court record and the documents that terminated the state court proceeding in order to decide whether the debt was a debt for money obtained by fraud. By analogy, the Court in the instant matter stated: 'Brown's holding means that the Fourth Circuit's novation theory cannot be right.' The Court reasoned that '[i]f the Fourth Circuit's view were correct ' if reducing a fraud claim to settlement definitively changed the nature of the debt for dischargeability purposes ' the nature of the debt in Brown would have changed similarly, thereby rendering the debt dischargeable.'

The only difference between the instant case and Brown, the Court observed, was that the relevant debt was embodied in a settlement, not a stipulation and consent judgment. The Court found this difference to be of no moment and stated: '[a] debt embodied in the settlement of a fraud case 'arises' no less 'out of' the underlying fraud than a debt embodied in a stipulation and consent decree. Policies that favor the settlement of disputes, like those that favor 'repose,' are neither any more nor any less at issue here than in Brown. ' In a word, we can find no significant difference between Brown and the case now before us.'

There is no doubt that a bankruptcy filing is bad news for a lessor. But, for a lessor looking to settle a legitimate fraud claim, this holding is significant as it preserves the underlying claim leading to a settlement agreement. Otherwise, how could a plaintiff with a fraud claim ever agree to settle a case for future consideration at the risk of jeopardizing this otherwise nondischargeable debt in a bankruptcy?

Adam J. Schlagman is editor-in-chief of this newsletter.

Suppose that a lessor has a legitimate fraud claim against its lessee. Also suppose that in an effort to save the costs of litigation, this lessor agrees to settle the matter. The lessee executes a promissory note in favor of the lessor in exchange for a release. Now assume that the lessee not only defaults on its obligation under the promissory note, but also files for bankruptcy. As counsel for the lessor you feel safe assuming that the underlying fraud claim is nondischargeable under Section 523(a)(2)(A) of the Bankruptcy Code, and therefore the lessor's position is fairly strong. Well, in the jurisdiction of the Fourth and Seventh Circuits this assumption was incorrect before a recent ruling by the U.S. Supreme Court finally resolved this issue.

In Archer v. Warner, No. 01-1418 (March 31, 2003), the Supreme Court resolved a circuit split by ruling that where a settlement agreement releases an underlying fraud claim in exchange for a promissory note, the note does not act as a novation that creates a new debt. Therefore, the underlying fraud claim may still be applied to the promissory note, thus rendering it a nondischargeable debt under '523(a)(2)(A).

In the instant matter, the Archers purchased a manufacturing company from the Warners for $610,000. A few months later the Archers sued the Warners in state court for (among other things) fraud connected with the sale. The lawsuit was settled pursuant to an agreement which specified that the Warners would pay the Archers $300,000 less legal and accounting expenses and that the Archers would release them from any and all claims arising out of the state court litigation, except as to amounts set forth in the settlement agreement. The Warners then paid the Archers $200,000 and executed a promissory note for the remaining $100,000. In exchange, the Archers' releases discharged the Warners ”from any and every right, claim, or demand' that the Archers 'now have or might otherwise hereafter have against' them, 'excepting only obligations under' the promissory note and related instruments.' The releases also stated that the parties were not admitting any liability or wrongdoing, and that the settlement was a compromise of disputed claims, and not an admission of liability. Following the execution of the releases, the Archers voluntarily dismissed the state court lawsuit with prejudice.

When the Warners failed to make the first payment on the promissory note, the Archers brought suit for the payment in state court. The Warners then filed for bankruptcy. The Bankruptcy Court ordered liquidation under Chapter 7 and the Archers sought a determination from the Bankruptcy Court that the $100,000 debt was nondischargeable because it was for 'money ' obtained by … fraud.'

The Bankruptcy Court held that the promissory note debt was dischargeable, and the District Court affirmed. The Fourth Circuit agreed, reasoning that the settlement agreement, releases and promissory note had worked a kind of novation. The Fourth Circuit concluded that the novation replaced an original potential debt for money obtained by fraud with a new debt that was not obtained by fraud. Rather, it was for money promised in a settlement contract and was, therefore, dischargeable in bankruptcy.

The Supreme Court reversed, holding that while the settlement agreement and releases may have worked a kind of novation, this fact does not prohibit 'the Archers from showing that the settlement debt arose out of 'false pretenses, a false representation, or actual fraud,' and consequently is nondischargeable.'

The Court based this ruling on its earlier decision in Brown v. Felsen , 442 U.S. 127 (1979), where a state court action alleging fraud resulted in a consent decree embodying a stipulation (which did not indicate the payment was for fraud). The stipulation was breached and the debtor filed for bankruptcy. The Court in Brown ruled that claim preclusion did not prevent the bankruptcy court from looking past the state court record and the documents that terminated the state court proceeding in order to decide whether the debt was a debt for money obtained by fraud. By analogy, the Court in the instant matter stated: 'Brown's holding means that the Fourth Circuit's novation theory cannot be right.' The Court reasoned that '[i]f the Fourth Circuit's view were correct ' if reducing a fraud claim to settlement definitively changed the nature of the debt for dischargeability purposes ' the nature of the debt in Brown would have changed similarly, thereby rendering the debt dischargeable.'

The only difference between the instant case and Brown, the Court observed, was that the relevant debt was embodied in a settlement, not a stipulation and consent judgment. The Court found this difference to be of no moment and stated: '[a] debt embodied in the settlement of a fraud case 'arises' no less 'out of' the underlying fraud than a debt embodied in a stipulation and consent decree. Policies that favor the settlement of disputes, like those that favor 'repose,' are neither any more nor any less at issue here than in Brown. ' In a word, we can find no significant difference between Brown and the case now before us.'

There is no doubt that a bankruptcy filing is bad news for a lessor. But, for a lessor looking to settle a legitimate fraud claim, this holding is significant as it preserves the underlying claim leading to a settlement agreement. Otherwise, how could a plaintiff with a fraud claim ever agree to settle a case for future consideration at the risk of jeopardizing this otherwise nondischargeable debt in a bankruptcy?

Adam J. Schlagman is editor-in-chief of this newsletter.