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Two weeks ago, the Supreme Court heard argument in a 4th Circuit case holding that the settlement of a lawsuit claiming fraud converted the defendant’s obligation from a potentially nondischargeable debt for fraud to a contract obligation that is dischargeable under bankruptcy law. In a misguided attempt to encourage settlements, the U.S. Court of Appeals for the 4th Circuit in Archer v. Warner adopted the approach taken by the 7th and 9th circuits and rejected the opposite result reached by the D.C. and 11th circuits. The facts are these: Elliott and Carol Archer purchased a business owned by Arlene Warner and her then-husband, Leonard Warner. Several months later, the Archers sued the Warners for fraud and misrepresentation in connection with the sale. After extensive pretrial discovery, the suit was settled. The settlement documents included an agreement, a promissory note, and mutual releases. The Archers gave the Warners broad releases of any claims arising out of or relating to the litigation. The settlement did not, however, make specific mention of nondischargeability claims in the event of bankruptcy. When the Warners failed to make either of the payments required by the promissory note, the Archers sued. The Warners then filed under Chapter 13 of the U.S. Bankruptcy Code. The Archers, in turn, filed an adversary proceeding to have the debt evidenced by the promissory note declared nondischargeable. But Arlene Warner persuaded both the Bankruptcy Court and, on appeal, the U.S. District Court that the promissory note created a new debt, or novation. Thus the note effectively substituted a dischargeable contract debt for the potentially nondischargeable claims of fraud and misrepresentation. When the case reached the 4th Circuit, the court characterized the issue of whether a novation had occurred as one of fact, such that the District Court’s decision could only be reversed if it constituted clear error. Given the broad language of the releases, as well as the terms of the settlement agreement and promissory note, the 4th Circuit held that the lower court had not clearly erred when it found that the promissory note constituted a new obligation. The 4th Circuit also addressed broader public policy arguments. In the 4th Circuit’s view, the approach taken by the courts with which it joined — the 7th and 9th circuits — encourages settlements. If, on the other hand, the settlement obligation is nondischargeable, “the incentive to settle is gone.” It is difficult to understand how the 4th Circuit reached this conclusion. While the result in Archer might encourage the defendant to settle, it will discourage the plaintiff from settling, for fear that the defendant might subsequently file for bankruptcy. Indeed, Archer might even encourage defendants to settle nondischargeable debts and then file for bankruptcy as a strategy to avoid the debt altogether, raising issues of fraud in the inducement with respect to the settlement. This is such a significant concern that the federal government, 30 states, and the AARP have filed amicus briefs in favor of the nondischargeability of the settlement debt. The D.C. and 11th circuits, in reaching the opposite result, focused on the general policy underlying the bankruptcy discharge provisions — that only an honest debtor should receive a discharge — and held that a fraudulent debtor should not be permitted to transform himself into an honest debtor simply by settling a nondischargeable claim. Under these cases, if the claim that gave rise to the settlement was nondischargeable, then the settlement debt is also nondischargeable. Hopefully, the Supreme Court agrees with the D.C. and 11th circuits. Janet M. Meiburger is the managing partner of Meiburger & Associates, a McLean, Va., firm specializing in bankruptcy, business law, real estate, and trusts and estates matters. She can be reached at [email protected].

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