The general rule, understood by debtors and creditors, is that unsecured debts may be discharged as a result of a bankruptcy filing. The exception to this general rule is a determination by a bankruptcy court that the unsecured debt was the result of fraud. In other words, and by example, a debtor that borrows money from a lender, based upon the lender's reasonable reliance on a materially false financial statement presented by the debtor, will not result in the debtor being able to discharge that debt by the filing of a bankruptcy.

A variation on the fraud exception has caused a split among courts across the country. The variation is the following: a borrower has presented to a lender a materially false financial statement; the lender has reasonably relied upon the financial statement and has extended credit; the borrower fails to repay; the lender sues the borrower for the money and for fraud based upon the presentation of the materially false financial statement; the lender and the borrower enter into a settlement agreement whereby the borrower agrees to the entry of a judgment and to repay the money pursuant to a repayment plan; neither the settlement agreement nor the judgment make any reference to the fraud alleged in the lawsuit; and after defaulting on the settlement agreement and failing to pay the judgment, the borrower files bankruptcy and seeks the discharge of the debt that is represented by the settlement agreement and the judgment.

The foregoing having occurred, will the debt that was not previously dischargeable now be dischargeable because it is based upon a settlement agreement and judgment that were not the result of fraud? Prior to the recent decision of the United States Supreme Court in the case of Archer v. Warner (Docket No. 01-1418), 2003 WL 1611437, the answer was unknown and depended on where the bankruptcy case was pending. Now, there is a definitive answer.

The United States Supreme Court has held that bankruptcy courts may look behind a settlement agreement or judgment that makes no reference to the underlying fraud in order to determine if the debt arose under fraudulent circumstances. Justice Breyer, writing for the United States Supreme Court in a 7-2 decision, stated "[w]e conclude that the [creditor's] 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."

Manatt Attorney Contact: Ivan L.Kallick
310.312.4152
ikallick@manatt.com