In the recent case of Archer v. Warner, 123 S.Ct. 1462, 155 L.Ed2d 454 (2003), the Supreme Court reversed the Fourth Circuit Court of Appeals and found that a claim based on payments due under an agreement resulting from the settlement of fraud claims can retain its status as a nondischargeable debt. The fact that the debt was reduced to a payment under a settlement agreement did not change the character of the debt for nondischargeability purposes.
A debt is not dischargeable in bankruptcy to the extent it is for money obtained by fraud. 11 U.S.C. §523(a)(2)(A). In the Archer case, the Archers sued the Warners for fraud connected with the purchase of the Warners' company. The parties settled and released all claims with the exception of payments to be made under a $100,000 promissory note.1 The Warners failed to make the first payment on the promissory note and the Archers sued in state court. The Warners filed bankruptcy, and the Archers filed a complaint to find the debt nondischargeable. The Bankruptcy Court decided the debt could be discharged and the District Court and the Fourth Circuit affirmed. In its opinion, the Fourth Circuit reasoned that the debt under the settlement agreement amounted to a type of "novation" that replaced the original debt to the Archers for money obtained by fraud with a new debt that was dischargeable in bankruptcy.
The Supreme Court disagreed with the Fourth Circuit and found that a debt for money promised in a settlement agreement accompanied by the release of underlying tort claims can amount to a debt for money obtained by fraud within the nondischargeability statute's terms. In support of its decision, the Supreme Court looked at the holding in a similar case, Brown v. Felsen, 442 U.S. 127, 99 S.Ct. 205, 60 L.Ed.2d 767 (1979). In the Brown case, a state-court suit for fraud was settled prior to adjudication by a stipulated judgment providing that Felsen would pay Brown a certain amount. Neither the consent decree nor the stipulation provided that the payment was for fraud. Felsen did not pay and then filed bankruptcy. Brown asked the Bankruptcy Court to hold that the debt was nondischargeable because it was a debt for money obtained by fraud. The Court in that case found that, although claim preclusion would bar Brown from making any claim based on the same cause of action which had been brought in state court, it did not prevent the bankruptcy court from looking beyond the documents terminating the state-court proceeding to decide whether the debt was a debt for money obtained by fraud. Brown's holding means that reducing a fraud claim to judgment does not change the nature of the debt for dischargeability purposes. The Brown Court found that "the mere fact that a conscientious creditor has previously reduced his claim to judgment should not bar further inquiry into the true nature of the debt". The Supreme Court in both Brown and Archer also considered the changes in the Bankruptcy Code's nondischargeability provisions which indicated that "Congress intended the fullest possible inquiry" to ensure that "all debts arising out of" fraud are "excepted from discharge," no matter their form and that Congress also intended to allow the determination of whether a debt arises out of fraud to take place in bankruptcy court and not in state court where nondischargeability concerns "are not directly in issue and neither party has a full incentive to litigate them.” Brown at 138.
The Archer Court discussed that the only difference between Brown and the case at issue was that the relevant debt in Archer was embodied in a settlement agreement and not in a stipulation and consent judgment. The Court decided that this difference was not determinative, since the dischargeability provision applies to all debts that "aris[e] out of" fraud. A key question in this determination is the intent of the parties. Although the stipulated settlements in both Archer and Brown did not address the issue of fraud, such intent could be more easily determined if the stipulated settlement or judgment contained language clarifying that the parties agree the payment is for a claim of fraud. Plaintiffs wanting to more clearly preserve a future nondischargeability claim should provide language in any stipulation that clearly states that the parties agree the payment is for fraud. Of course, as a practical matter, defendants will probably balk at such language and that issue will have to be negotiated.
In a recent case, the Second Circuit has already had an opportunity to apply and extend the reasoning in the Archer case to an almost identical set of facts that was pending appeal when the Archer decision was issued. In In re DeTrano, 326 F.3d 319 (2d Cir. 2003), the Court discussed a situation similar to that in Archer involving a nondischargeability claim brought under Bankruptcy Code §523(a)(4), which involves a claim for fraud or defalcation committed while acting in a fiduciary capacity.2 The Court extended the holding in Archer to include claims arising under this Section of the Code and determined that a settlement agreement entered into where no corresponding judgment was obtained could be nondischargeable. See also, In re Nelson, 2003 WL 1989641(N.D. Il. 2003)(court applied principles of Archer to fiduciary fraud situation under §523(a)(4) where the creditors had obtained summary judgment prior to the bankruptcy).
The decision in Archer stands for the proposition that the settlement of fraud claims in any form (stipulation, consent judgment, offer of judgment, etc.) does not preclude litigation on the nondischargeability of such claims in bankruptcy unless the parties are clear that it was intended to have such an effect. Since bankruptcy is always a possibility, counsel for both potential debtors and creditors should keep the Archer holding in mind when drafting settlement documents and should try to specifically address the issue of fraud in those documents whenever possible.
Mr. Dow would like to acknowledge the assistance of Sheryl Reynolds in the preparation of this article.
FOOTNOTES
1 The releases stated that the parties did not admit any liability or wrongdoing, that settlement was the compromise of disputed claims and that payment was not to be construed as an admission of liability.
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2 The nondischargeability claim in Archer was based upon 11 U.S.C. §523(a)(2)(A).
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