NEW YORK, NY -- The rules regarding settlements of pre-bankruptcy lawsuits just got tougher for debtors as a result of the Supreme Court's 7-2 opinion reversing and remanding to the Fourth Circuit Court of Appeals its decision last year in re Warner (Archer v. Warner), 283 F.3d 230 (4th Cir. 2002). In so doing, the Supreme Court suggested unpaid settlement obligation arising out of business fraud litigation may be non-dischargeable in a chapter 7 bankruptcy case on the ground the settlement was "obtained by fraud."
In an opinion authored on March 31, 2003 by Justice Breyer, the Supreme Court held an unpaid settlement obligation may result in a non-dischargeable bankruptcy debt depending on the facts and circumstances. The majority determined 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 meaning of 11 U.S.C. §523(a). As a result, the Supreme Court remanded the case to the Fourth Circuit to determine whether the settlement debt in question arose out of "false pretenses, a false representation, or actual fraud," thereby rendering the debt unaffected by ordinary bankruptcy protections under section 523(a). Justice Thomas, joined by Justice Stevens, issued a dissenting opinion expressing the minority view in favor of the Fourth Circuit's "novation" theory.
In the case below, the Fourth Circuit, sitting in Richmond, held a debtor's prepetition settlement of fraud or intentional tort claims creates a new contractual agreement, or novation, substituting dischargeable contract claims for arguably non-dischargeable tort claims when the debtor later files for bankruptcy relief without having fully funded the settlement. Noting a split among the circuits concerning the issue, the Fourth Circuit followed prior decisions of the Seventh and Ninth Circuits. A dissenting opinion, ultimately embraced by Justice Breyer and six other justices, followed the contrary approach of the District of the Columbia and Eleventh Circuits. In declining to follow the line of cases holding a settlement does not extinguish a non-dischargeability claim under 11 U.S.C. §523(a), the Fourth Circuit reasoned Congress did not intend section 523(a) be construed to discourage settlements. The Supreme Court obviously disagreed, invoking a case-by-case threshold factual inquiry.
According to Michael L. Moskowitz and Richard E. Weltman, bankruptcy court litigators familiar with the issue, the Supreme Court failed to set forth a "bright line" or "per se" test for determining whether unfunded settlements are dischargeable as a matter of law in every case. "The Court confirmed the basic tenets of the Bankruptcy Code which, consistent with Congressional intent, requires the fullest possible inquiry to ensure that all debts arising from fraud are not discharged," said Moskowitz
Litigants are strongly cautioned to consider the impact of less than full payment in the event of the need for bankruptcy later. "If an adversary proceeding lawsuit objecting to dischargeability of the underlying debt is filed, the bankruptcy court will be obliged to look behind the settlement to determine if the debt is based on fraud," Weltman stated.
As a result of the Supreme Court's creditor-friendly approach, Moskowitz and Weltman both recommend that parties consult bankruptcy counsel familiar with this narrow issue to gauge the factual circumstances and help preserve a party's rights when considering the permanency of settlement of non-dischargeable claims.
Michael L. Moskowitz and Richard E. Weltman are members of the firm of Weltman & Moskowitz, LLP, having offices for the practice of law in New York and New Jersey, where the firm handles cases involving bankruptcy and creditors' rights, business litigation, business sales and transfers, Internet law and Cyberspace issues, real estate, and transactional matters. They can be reached at 212.684.7800 or 201.794.7500 or by e-mail.
