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Fraud Claim Released in Settlement Agreement Preserved in Bankruptcy Proceedings
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.
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