Settling into Bankruptcy

Settling into Bankruptcy

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When parties get into disputes, bankruptcy often looms at the edge of their negotiations and maneuverings—a little like an exit door that has been left ajar. The putative defendant may cast longing eyes at the escape route, while the putative plaintiff glances nervously in the same direction. Will the defendant shrug off these obligations—whatever they are—in bankruptcy? Will the value of any judgment be undercut by pro rata distribution? The answer to these questions profoundly affects the negotiations.


When the parties settle their disputes, the possibility of a bankruptcy filing is often very much in the heads of both. Some settlements may have bankruptcy clauses, and others may not. We deal here with one case of each kind.

The Supreme Court has now settled an important (and hotly disputed) question about the binding effect of settlements—and they came out with a distinctly not-binding tilt. In Archer v. Warner,1 Justice Breyer speaks for seven of the nine, settling what seems to him to be an easy case in less than two pages of substantive discussion.

The Warners sold their business to the Archers; a couple of years later, the Archers sued the Warners for fraud, misrepresentation, fraudulent conveyance, intentional infliction of emotional distress—the usual buy-sell stuff. The intensity of the dispute was high; a criminal prosecution arising out of these facts also pending against Mr. Warner. After discovery in the case, the parties settled for cash, notes and a security interest. The Warners defaulted on the note (surprise, surprise!) and then filed for bankruptcy.

In the subsequent chapter 7 action, the Archers claimed their settlement was non-dischargeable because it was in settlement of a claim that would have been non-dischargeable without the settlement. The Fourth Circuit said no, affirming the result of both the district court and the bankruptcy court. In re Warner, 283 F.3d 230 (4th Cir. 2002). The Supreme Court reversed.

The Court was obviously embarrassed into taking this case because of a big split in the circuit courts. That split nicely mirrors the split in principles that underlie the Code. One approach is a straight contracts-rule-all. It favors the basic principle of encouraging settlements by way of freedom to enter into settlement agreements, regardless of the nature of the claim subject to the settlement agreement.2 Under this theory, adopted by three of the circuits, 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 subject to discharge in bankruptcy. Without this, says the contracts-rule school, the incentive to settle is gone. The Fourth Circuit in Archer described the settlement in terms of a novation. Remember that from your "contract" class—the substitution of one claim for another, in this case, a contract claim for a tort claim. According to that court, the general release meant that the old obligations were gone—and with them went the non-dischargeability complaints.

But other circuit courts said that the characteristics of the underlying action control. A court should review the allegations of fraud that led to the settlement agreement in order to determine whether the debt is non-dischargeable.3 They reason this approach best effectuates the congressional policy expressed in the Bankruptcy Code, construing the statutes as not permitting the discharge of debts that Congress intended to survive bankruptcy. In Archer, the dissent in the Fourth Circuit had framed the issue as a question of form over substance; Congress has spoken to the question of whether liability for certain acts can be discharged—and it shouldn't matter whether the underlying action is currently held in the form of a tort or a contract.

Justice Breyer is not deeply engaged by this fundamental tension. He relies heavily on Brown v. Felsen,4 a 1979 case that chews up about 90 percent of his brief discussion in Archer. In Brown, the Court determined that a creditor filing a claim based on a consent decree that did not mention fraud might nonetheless late-raise the issue of fraud in the bankruptcy court and that the bankruptcy court should "weigh all the evidence." According to the Brown Court, the bankruptcy court would be permitted to "look behind the judgment" to see if it was based on facts that might make a case in fraud. Justice Breyer takes the analysis off into a "claim preclusion" issue (or, for the over-40 crowd, a res judicata issue). He declares that the rule in Brown makes the decision in Archer easy: If the parties can "go behind" a consent decree to determine the true nature of a claim, then they can certainly "go behind" a settlement.

To his credit, Justice Thomas tries to address the more complex underlying problem. He points out the ambiguity that inheres in treating the settlement as valid for determining the amount owed, but not valid for determining non-dischargeability.

We don't want to get too carried away with Justice Breyer's quick work in Archer, but we think the case has some pretty interesting implications.

If parties cannot determine by contract whether a debt is non-dischargeable—that is, if they cannot agree they will waive a fraud claim for a payment of money and have it enforced in bankruptcy—then the settlement value of any claim for which fraud might be alleged, currently or in the future, just dropped. We can hear the contracts-rule school folks groaning.

They might describe it this way: The majority opinion suggests that someone may pay $50 for a dog and his bowl, but discover that the law says that all he bought was the bowl. So someone settling a claim may believe he is settling both the kind of claim and the dollar value, only to discover that the court says only the dollar value was settled. The majority in Archer says the dog (dischargeability) is never for sale. People who like to do everything by contracts would think that is a pretty lousy outcome. In that sense, Justice Breyer's opinion is very important. It suggests that those bankruptcy principles are bedrock—and that they override contractual arrangements to the contrary.

Without attempting a law review article here, the basic theory seems clear. Every dischargeability objection involves the facts, non-bankruptcy law as applied to those facts, and bankruptcy law with regard to dischargeability. It seems clear that the first two may be governed by a state court judgment or settlement agreement, but the last is always a matter of bankruptcy law. The bankruptcy-law decision, in turn, seems to us to involve two issues: determining the combination of facts and non-bankruptcy law that equals a non-dischargeable obligation under the Bankruptcy Code, and determinating what, if any, safeguards should be imposed on that determination to protect debtors from overreaching and creditors from a discharge scam, while still permitting settlements.

Whether he says so explicitly or not, Justice Breyer is taking a position on the role contracts may play to get around the rules of bankruptcy. We wonder if it might work the other way—that is, what if the debtor wants to get out of any pre-bankruptcy deal that affects basic bankruptcy principles? We are put in mind of those contract-out-of-bankruptcy clauses that various folks want to put into their deals: The debtor promises either never to file for bankruptcy or, if filing, not to allege defenses to motions to lift stay, not to contest valuation and so on. The Ninth Circuit took up one of these recently—In re Huang, 275 F.3d 1173 (9th Cir. 2002). In 1991 and 1992, Mrs. Huang and her husband had borrowed some money from the Bank of China (wholly owned by the government of China, by the way) for their business. The deal went south, and in 1996, Bank of China sued Mrs. Huang, her husband and a couple of cousins over a complex series of deals. The grounds alleged included failure to pay the debt, fraud, fraudulent conveyance and the Racketeer Influenced and Corrupt Organizations Act (RICO).

In 1997, the parties entered into a settlement agreement. The bank's attorney had not only considered bankruptcy; he clearly had been reading the bankruptcy cases. The disclaimer was a model waiver, including such passages as:

Defendants are familiar with the law concerning the non-dischargeability of debts in bankruptcy.... Defendants understand, represent and promise to the bank that the judgment and the debt, and all other amounts owing to the bank, are not dischargeable in any bankruptcy or bankruptcies filed by any of the individual defendants, and defendants shall not, and represent that they have no factual or legal basis to, challenge or otherwise dispute the bank's request for an order in any bankruptcy court to establish the non-dischargeability of such obligations...

Mrs. Huang promised 16 ways to Christmas that not only would she not file for bankruptcy, but that if she did file, she pre-acknowledged that the debt was non-dischargeable.

The Ninth Circuit gave that clause a boot in the backside. In fact, it was fairly eloquent about the non-enforceability of these waivers. What Code provision did they cite? Good old public policy. "This prohibition of pre-petition waiver has to be the law; otherwise, astute creditors would routinely require their debtors to waive." This is a strong circuit court opinion on non-waiveability of bankruptcy rights. It is consistent with the holding in Archer.

But the majority opinion in Archer leaves the door open to some contractual control of the facts and law on which the first bankruptcy decision—application of §523 as such—must rest. The Court remands to the circuit court arguments about the issue-preclusion effect of the agreement under state law. It does not address at all the second part of the bankruptcy issue, relating to debtor and creditor protection.

Similarly, Huang dealt only with an explicit waiver. The court simply noted that the settlement did not involve confession of fraud or RICO charges. The implication—although not the holding—is that such a confession of fraud might have made a significant difference in whether the waiver would have been effective. The court rested its decision on the simple ground that the settlement was global, covering contract and fraud charges, so who knows what issues prevailed? Just like the cases in which a judgment from a jury is unclear about whether the basis of the verdict was fraud or contract, there could be no collateral estoppel effects in this settlement.

But can the Ninth Circuit's distinction hold up? If Mrs. Huang had said, "and I defrauded the Bank of China," would the settlement suddenly have become non-dischargeable? The Ninth Circuit certainly seems to imply so, and the large number of cases applying issue preclusion to state-court judgments are consistent with that result. But then we arrive at the bankruptcy policy issues lurking, but not decided, in Archer. Wouldn't clever creditors always ask for the waiver? The only difference now is that instead of asking for a waiver, they would ask for an admission of facts leading to a conclusion of non-dischargeability. We think the Huang court got to the right result on these facts, but the underlying premises make the opinion war with itself.

What should be the right answer? Archer lays down one absolutely clear rule: Consent judgments and contractual agreements follow the same rules. Justice Breyer says a court should inquire into the underlying facts each time. If that is so, it would seem that the implication of the Ninth Circuit is that confession of sin does not bind the party who files for bankruptcy. The person gets another look. A distinction between consent judgments and litigated judgments could be sustained on the policy ground that we trust state court process, but we do not trust state courts to be careful about the bankruptcy implications of a state consent judgment or settlement contract. The reason is that the state courts have every cause to be careful about a contested fraud decision, and we assume they usually are, but the settlement recitals that would preclude discharge under §523 are largely irrelevant under state law, so we can't expect state judges to police the process for the protection of debtors or of creditors like the Archers.

But that conclusion takes us to unexpected places. We are still trying to think through exactly what Justice Breyer means when he says, "look behind the decree."

We confess to a bias for rules that assure that bankruptcy courts have the final word on these questions on the public policy ground that Congress has articulated what acts should and should not be deemed to result in dischargeable claims. The bankruptcy courts are the right place to protect all parties with respect to dischargeability. Otherwise, the cases will be inconsistent in principle and, more importantly, they run the risk that parties will be misled into giving up rights that Congress determined they should have. But we realize that this position will have a big echo effect throughout the system.

A Final Note from Texas

We have a little treat for those who read to the end. In re Harco Energy Inc., 270 B.R. 658 (Bankr. N.D. Tex. 2001), is a neat reminder about settlements of any kind. The debtor was involved in extensive litigation pre-petition, which settled on the eve of trial. Or did it? Evidently things fell apart when the parties got ready to sign the documents. When the debtor filed for bankruptcy, it claimed that there was no enforceable settlement agreement. Several other parties agreed, but the plaintiff in the lawsuit and many of the attorneys disagreed. The court went through the state law rules of settlements, concluding that the statement in open court that a settlement had been reached was sufficient to create an enforceable settlement, even if the parties did not subsequently exchange written documents.

For those who have a wavering client, this case is a good reminder of basic contracts: The settlement occurs before the parties actually sign the releases, and settlements may be binding even if the releases never get signed. If that happens, the claim in bankruptcy shall be the amount of the settlement, not the underlying claim as determined by the bankruptcy court or as tried by a state court judge.


1 2003 Lexis 2492 (March 31, 2003). Return to article

2 See In re Fischer, 116 F.3d 388 (9th Cir. 1997); In re West, 22 F.3d 775 (7th Cir. 1994); Maryland Casualty Co. v. Cushing, 171 F.2d 257 (7th Cir. 1948). Return to article

3 United States v. Spicer, 313 U.S. App. D.C. 67, 57 F.3d 1152 (D.C. Cir. 1995); Greenberg v. Schools, 711 F.2d 152 (11th Cir. 1983). Return to article

4 442 U.S. 127 (1979). Return to article

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Thursday, May 1, 2003