Archer, A. Elliott, et ux. v. Warner, Arlene (03/31/2003)

Questions presented: Whether a promissory note given in settlement of pending litigation can constitue a nondischargeable debt "for money, or an extension, renewal, or refinancing of credit, obtained by false pretenses, a false representation, or actual fraud," within the meaning of 11 U.S.C 523 (a)(2)(A), where the parties execute a settlement agreement and general release of all claims of fraud or misrepresentation underlying the litigation and all future claims arising from the same facts, where the debtor has neither admitted nor been found to have engaged in fraud or misrepresentation underlying the litigation, and where the creditor has failed to allege fraud in connection with the procurement of the settlement.

BY COREY SIMPSON, MEDILL NEWS SERVICE

Arlene and Leonard Warner could not pay their debts. On Feb. 5, 1996, the Warners bills piled so high they felt they had no option but to seek federal bankruptcy protection. So they filed for protection under Chapter 13 of the Bankruptcy Code.

In October, the U.S. Bankruptcy Court for the Middle District of North Carolina converted the Warners claim to Chapter 7 protection. According to the U.S. Bankruptcy Code, all of the Warners debts were wiped out, or discharged.

One of the debts the Warners believed bankruptcy had discharged was the $100,000 they owed Elliott and Carol Archer. The Archers, however, wanted their $100,000. In 1997 they filed a complaint against the Warners in bankruptcy court, claiming the $100,000 debt was an exception to the debts the Warners could discharge.

The debt was a portion of a settlement the Warners and Archers reached in 1995 to resolve a suit between the two families. In 1992 the Archers bought the Warner Manufacturing Company from Leonard Warner. After the sale, the Archers filed suit against the Warners in Superior Court of Guilford County, North Carolina, alleging misconduct, fraud and misrepresentation of the company during the sale.

In the settlement with the Archers, the Warners agreed to pay a total of $300,000. The Warners paid the Archers $200,000 cash at the time of the settlement. The Archers also received a $100,000 promissory note and agreed to make two payments of $50,000 in the following year. The settlement also included two separate releases that relieved either party of an admission of fraud or misrepresentation.

The Warners did not pay either of the $50,000 payments before they filed for bankruptcy.

In their claim before the bankruptcy court, the Archers argued the Warners could not be released from their debt because the debt was a result of misconduct and fraud on the part of the Warners. Section 523 of the federal bankruptcy code explains which debts cannot be discharged if a person or corporation files for protection under Chapter 13. The debts that are obtained through "false pretenses, a false representation, or actual fraud" are exceptions to the dischargeable debts and are not allowed to be wiped out.

After the Archers filed their complaint, Leonard Warner filed a "consent order" reaffirming his debt to the Archers. Arlene Warner did not and argued in her defense that the Archers could not claim misconduct because the case dealing with fraud had been settled and her debt to the Warners was a dischargeable contract debt.

In August 1999, the bankruptcy court agreed with Warner and did not force her to pay the remaining $100,000 to the Archers. In response to the ruling, the Archers claimed before the U.S. District Court for the Middle District of North Carolina in Greensboro, NC., that the bankruptcy court had misinterpreted the exceptions to dischargeability.

The district court sided with the Warners and upheld the bankruptcy courts ruling. The court said the 1995 settlement agreement substituted a dischargeable contract debt, the $100,000, for a fraud-based tort debt that might not be dischargeable.

The court added that the only way they could have ruled in favor of the Archers would have been if they could have proved that Warner intended to declare bankruptcy when she entered the 1995 settlement. The court said it could not find any evidence to support the fraud claim because the Warners had already paid the Archers $200,000 of the settlement and had given them deeds-of-trust on their home and business property to secure the payment of the remaining debt.

On March 8, 2002, a divided 4th U.S. Circuit Court of Appeals panel ruled 2-1 in favor of the Warners. Judge Hiram Widener wrote for the court that "parties willing to settle disputes over fraud, misrepresentation, or like tort claims may do so by way of settlement through contract, and such contractual claims are then dischargeable in bankruptcy. Otherwise, the incentive to settle is gone."

The appeals court opinion also recognized a split among the federal circuits in deciding whether a tort settlement can become a dischargable debt. The 9th and 7th circuits agree with the 4th Circuit that when a settlement is reached in a fraud or any other tort case, the settlement becomes a contract, thus changing the bankruptcy status of the debt from non-dischargeable (tort) to dischargeable (contract). The D.C. and 11th circuits have a competing view on the dischargeabilty of the debt, because they believed a settlement could allow "a fraudulent debtor to transform into a non-fraudulent one" and escape the penalties of his or her fraud.

In his dissent, Judge William Traxler argued that in addition to the D.C. and 11th circuit precedents, three unanimous Supreme Court decisions have adopted reasoning more consistent with those circuits than with the majoritys.

On June 24, 2002, the U.S. Supreme Court accepted the case for review, and on March 31, 2003, the Court reversed by a 7-2 vote, holding that the debt for money promised in a settlement agreement can amount to a debt for money obtained by fraud, within the terms of the Bankruptcy Code's non-dischargeability statute.

Justice Stephen Breyer wrote the opinion for the Court. Justices Clarence Thomas and John Paul Stevens dissented.