Friday, December 19, 2008

Can a Creditor Challenging Ch. 7 Dischargeability "Go Behind" a State Court Settlement Agreement to the Underlying Fraudulent Allegations?

By Andrew Toth-Fejel, Bankruptcy Litigation Support for Attorneys,

Archer v. Warner
538 U.S. 314 (2003)

An unpublished memorandum of the Ninth Circuit BAP of a few months ago, Weilert v. Parker (In re Weilert), looked at "the dischargeability of a debt in bankruptcy where the debtor may have committed fraud but the alleged fraud claim has been settled before the debtor’s bankruptcy filing." In this memorandum the BAP relied heavily on the 2003 U.S. Supreme Court decision of Archer v. Warner. So instead of discussing a recent but non-binding BAP decision, this Bulletin presents this important (and of course binding!) Supreme Court decision.

The Supreme Court's Statement of the Issue and its Holding
Can the language of § 523(a)(2)(A) of the Bankruptcy Code excluding a debt from discharge "to the extent" it is "for money . . . obtained by . . . false pretenses, a false representation, or actual fraud" also exclude from discharge "a debt embodied in a settlement agreement that settled a creditor's earlier claim 'for money . . . obtained by . . . fraud'?" In other words, can the bankruptcy court look behind a settlement agreement to allegations that the settled debt was based on fraud, if that settlement agreement was honestly entered into by both parties and made no reference to any fraud claim? Or does the settlement act as a kind of "novation" which replaces the original fraud-induced debt with a new non-fraud-induced, and therefore dischargeable, debt?

The Court concluded that the "settlement agreement and releases may have worked a kind of novation, but that fact does not bar the [creditors] from showing that the settlement debt arose out of 'false pretenses, a false representation, or actual fraud,' and consequently is nondischargeable." Thus, although the settlement documents--here a settlement agreement and promissory note--fully resolved the state law claims leaving only the debt agreed to in those documents, the Court held that the bankruptcy court could look beyond the record of the state court proceeding and those settlement documents in order to decide whether the debt at issue was a debt for money obtained by fraud. This holding reversed the decisions of the bankruptcy court, the district court, and the Fourth Circuit Court of Appeals.

The Facts and Decisions Below
Court outlined the facts as follows:
(1) A sues B seeking money that (A says) B obtained through fraud; (2) the parties settle the lawsuit and release related claims; (3) the settlement agreement does not resolve the issue of fraud, but provides that B will pay A a fixed sum; (4) B does not pay the fixed sum; (5) B enters bankruptcy; and (6) A claims that B’s obligation to pay the fixed settlement sum is nondischargeable because, like the original debt, it is for “money . . . obtained by . . . fraud.
To add a touch of helpful detail, A, the Archers, purchased a business from B, the Warners, and then just a few months later sued the Warners for, among other claims, fraud related to the sale. The parties settled the lawsuit with an agreement that the Warners would pay the Archers $300,000, and would receive a release as "to any and all claims . . . arising out of this litigation, except as to amounts set forth in [the] Settlement Agreement.” The Warners paid the Archers $200,000 and gave them a promissory note for the remaining $100,000. The parties signed releases “discharg[ing]” each other “from any and every right, claim, or demand” that the others “now have or might otherwise hereafter have against” them, “excepting only obligations under” the promissory note and related instruments. The Archers then dismissed the lawsuit with prejudice.

A few months later the Warners defaulted on their first payment on the promissory note and filed a Chapter 7 bankruptcy case. The Archers filed an adversary proceeding to declare the $100,000 nondischargeable under § 523(a)(2)(A). The bankruptcy court found the debt dischargeable, the District Court affirmed, and the Court of Appeals, in a 2-1 split decision, also affirmed.

The Precedent: Brown v. Felsen
The difference in this 7-2 decision between the majority and the dissent was that the majority found the Court's 1979 opinion, Brown v. Felsen, 442 U.S. 127, applicable here in spite of factual differences, while the dissent distinguished the Brown case because of those factual differences. Brown also involved a debt allegedly obtained through fraud, a suit by the creditor in state court to collect that debt, a subsequent bankruptcy filing by the debtor, and the creditor seeking a declaration of nondischargeability. But in Brown that debt had not been resolved by settlement but rather "the state court entered a consent decree embodying a stipulation" that the debtor would pay creditor a certain amount. As in the present case, the documents that resolved the state court lawsuit did not make any mention that the underlying allegations were based on fraud.

The Court interpreted Brown to have held that
[c]laim preclusion did not prevent the Bankruptcy Court from looking beyond the record of the state-court proceeding and the documents that terminated that proceeding (the stipulation and consent judgment) in order to decide whether the debt at issue (namely, the debt embodied in the consent decree and stipulation) was a debt for money obtained by fraud.
. . . .
The reduction of Brown’s state-court fraud claim to a stipulation (embodied in a consent decree) worked the same kind of novation as the “novation” at issue here.
. . . .
The dischargeability provision applies to all debts that “aris[e] out of” fraud. [Citations excluded.] 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.
Most importantly the Court reasoned that "what has not been established here, as in Brown, is that the parties meant to resolve the issue of fraud or, more narrowly, to resolve that issue for purposes of a later claim of nondischargeability in bankruptcy." The Court's majority opinion relied on its understanding that the settlement did not resolve these issues, in spite of language in the releases "discharg[ing] the [subsequent debtors] "from any and every right, claim, or demand" that the [subsequent creditors] "now have or might otherwise hereafter have against" them, other than the settlement obligation).

Critical Issues NOT Decided
A careful reading of the decision here reveals this important limitation: although in Brown the Court had specifically held, as described by the Court here in the quotation above, that claim preclusion did not stop the bankruptcy court from looking to the facts beyond the state court stipulation and judgment, in contrast here the Court was able to sidestep both claim and issue preclusion issues and remand them to the Circuit Court. The claim preclusion argument by the debtor was "that the settlement agreement and releases . . . included a promise that [the creditor] would not make the present claim of nondischargeability for fraud." The issue preclusion issue was that because the creditor "dismissed the original fraud action with prejudice, [state] law treats the fraud issue as having been litigated and determined in [debtor's] favor, thereby barring the [creditors] from making their present claim . . . ." The Court said "that the Court of Appeals did not determine the merits of either argument, both of which are, in any event, outside the scope of the question presented and insufficiently addressed below." It remanded for the Circuit Court "to determine whether such questions were properly raised or preserved, and, if so, to decide them." It left unresolved not only "whether the parties intended their agreement and dismissal to have issue-preclusive, as well as claim-preclusive, effect," but also "to what extent such preclusion applies to enforcement of a debt specifically excepted from the releases." Thus the Court's holding was more limited than may appear without close analysis.

The Bottom Line
Although this Court held that settlement agreements do not necessarily preclude creditors from getting bankruptcy courts to look behind them to debtors' alleged fraudulent conduct, that alleged conduct may well be able to be precluded with sufficiently specific language in settlement agreements together with state law which supports the preclusive effect of such specific language. To turn the Court's language around, if "the parties [made clear in their settlement documents that they] meant to resolve the issue of fraud or, more narrowly, to resolve that issue for purposes of a later claim of nondischargeability in bankruptcy," the creditor would seem not to be able to raise the fraud issue after all.

by Andrew Toth-Fejel
Bankruptcy Litigation Support for Attorneys

Please note that this writer is not licensed to practice law in Oregon. This means that he is not legally permitted to give any legal advice or provide and legal services. This Bulletin and the entire contents of this website is written only for attorneys. and is not intended for the public. If any non-attorney is reading this, you must consult an attorney about ANYTHING you read here. Nothing in this website is intended to be nor should be read as being legal advice to anyone.

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