NEW YORK, NY -- Even bankruptcy experts and courts can disagree about whether and how to settle a potentially non-dischargeable fraud or intentional tort claim.

A decision last month by a Richmond federal appeals court is likely to make pre-bankruptcy planning even harder, according to Michael L. Moskowitz, a New York bankruptcy attorney.

The Fourth Circuit Court of Appeals considered a debtor's ability to discharge a pre-bankruptcy settlement of an alleged fraud or intentional tort claim. The debtor previously settled the claim and argued the taint was removed and substituted by a dischargeable contract claim due to debtor's pre-bankruptcy default under the settlement agreement. Moskowitz has been closely following the split between the circuit courts regarding this important issue. Until the recent decision of the Fourth Circuit in re Warner, 2002 WL 369926 (4th Cir. 2002), there was an even split between the federal appeals courts with the District of Columbia Circuit and the Eleventh Circuit disfavoring the ability of a debtor to extinguish what purportedly was a non-dischargeable claim prepetition. Contrary decisions have emerged from the Seventh and Ninth Circuits.

Neither the Second Circuit covering New York, Connecticut and Vermont, nor the Third Circuit covering New Jersey, Pennsylvania, Delaware and the Virgin Islands have squarely faced this issue. While decisions of other circuit courts are persuasive, they can be disregarded by courts outside their territory.

According to Moskowitz, this issue is "red hot" and likely to reach the United States Supreme Court during its next term or early the following year. Until then, Moskowitz urges any party in this situation to seek advice concerning a potential settlement with competent bankruptcy counsel. Until this issue has been finally resolved by the Supreme Court, Moskowitz cautions litigants to be aware of the dangers before signing settlement agreements, and to suggest to their counsel that the bankruptcy impact be considered. "Litigants and their attorneys should pay close attention to the wording of any settlement agreement and talk to a bankruptcy attorney to preserve rights in compromising potentially non-dischargeable claims."

This issue can be enormously important to persons considering seeking creditor relief in bankruptcy. Simply put, creditor relief is often denied when the debt is based on the debtor's fraudulent conduct or certain other conduct, such as embezzlement, defamation, intentional or malicious actions, or driving while impaired.

According to Moskowitz, the facts in Warner were as follows:

The debtors were sued prepetition in state court by the purchasers of their manufacturing business's corporate assets, who claimed that the debtors had engaged in fraudulent misrepresentation and like misconduct in connection with the sale. The parties settled this litigation and the debtors executed a $100,000 promissory note as part of the settlement. Later, after the debtors defaulted on their first installment payment, the purchasers brought a collection suit against them. The debtors then sought chapter 13 relief and eventually converted the case to chapter 7. The purchasers filed an adversary proceeding complaint seeking a judgment for the amount due under the note and a determination that such debt was excepted from discharge under 11 U.S.C. §523 (a)(2)(A), relying on the multiple allegations contained in their original state-court lawsuit as grounds for non-dischargeability. The debtor-wife denied any misconduct on her part and asserted an affirmative defense of settlement of the original state-court suit. The bankruptcy court upheld this defense and decided in favor of the debtor-wife and the district court affirmed. The purchasers appealed.

The Fourth Circuit examined the split among the circuit courts concerning whether a prepetition settlement of alleged fraud or intentional tort claims against a debtor extinguishes a creditor's subsequent non-dischargeability claims. Under one line of cases, including U.S. v. Spicer, 57 F. 3d 1152 (D.C. Cir. 1995), and Greenberg v. Schools, 711 F.2d 152 (11th Cir. 1983), a settlement agreement does not extinguish a dischargeability claim under §523(a). According to this line of cases, examining the underlying fraudulent allegations leading to the settlement agreement best effectuates Congressional policy by its construction of the statutes as not permitting the discharge of debts that Congress intended to survive bankruptcy. The theory espoused by the opposing line of cases, In re Fischer, 116 F. 3d 388 (9th Cir. 1997), and In re West, 22 F. 3d 775 (7th Cir. 1994) encourages the settlement of claims. According to Moskowitz, the Seventh and Ninth Circuits have held 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.

Moskowitz noted the Fourth Circuit agreed with the bankruptcy court and the district court that the better reasoned decisions were those of the Seventh and Ninth Circuits stating "we are of the opinion that Congress did not intend that 11 U.S.C. §523(a) be construed, as a reversal here would require, so as to discourage settlement of claims because they might be subject to freedom from discharge under §523(a)." Following the novation theory, the court of appeals in Warner examined the settlement package agreed to by the parties and found that it completely released the debtor-wife from potential non-dischargeability claims under §523(a)(2)(A). According to Moskowitz, the court concluded the settlement agreement and promissory note, coupled with the broad language of the release, completely addressed and released each and every underlying state law claim.

The Warner panel was not unanimous. The dissent believed that the approach employed by the D.C. and Eleventh Circuits in Spicer and Greenberg accomplished the congressionally enacted policy objective embodied in the non-dischargeability provisions. The dissenting opinion stated the Supreme Court precedent "strongly suggests" that the Spicer approach is the correct one. This precedent clearly indicates that, "[i]n deciding cases dealing with the fraud exceptions to dischargeability, courts should effectuate congressional policy objectives by conducting the fullest possible inquiry into the nature of the debt and limiting relief to the honest but unfortunate debtor." According to the dissent, "[t]he Spicer approach is squarely grounded in these policy interests." Under any other approach, the dissent noted, a defendant could "completely immunize" himself or herself from §523 by settling fraud claims with a promise to pay, having the plaintiff release the underlying tort action as part of the settlement, and then filing for bankruptcy. Consequently, the dissent would have elevated substance over form and would have allowed the purchasers to offer such proof as they might have had to show that the debtor-wife's debt resulted from a fraud perpetrated upon them.

Michael L. Moskowitz, is a member of the firm of Weltman & Moskowitz, LLP, having offices for the practice of law in New York and New Jersey, where it handles cases involving bankruptcy and creditors' rights, business litigation, organization, sale and transfer, intellectual property protection, real estate, and other transactional matters. He can be reached at 212.684.7800 or 201.794.7500 or by e-mail.