Can a settlement agreement be nondischargeable as debt obtained by fraud?

In Archer v. Warner, — U.S. —, 123 S.Ct. 1462, 2003 WL 1611437 (2003), the Supreme Court followed Brown v. Felsen, 442 U.S. 127, 99 S.Ct. 2205, 60 L.Ed.2d 767 (1979) in holding that a debt for money promised in a settlement agreement accompanied by the release of underlying tort claims can amount to a debt for money obtained by fraud, within the § 523(a)(2)(A) nondischargeability statute's terms. The Court did not address whether parties to a settlement could enforceably contract regarding the nondischargeability of the settlement debt in a subsequent bankruptcy. The Syllabus of the case is as follows:

A debt is not dischargeable in bankruptcy "to the extent" it is "for money ... obtained by ... fraud." 11 U.S.C. § 523(a)(2)(A). Petitioners, the Archers, sued respondent Warner and her former husband in state court for (among other things) fraud connected with the sale of the Warners' company to the Archers. In settling the lawsuit, the Archers executed releases discharging the Warners from all present and future claims, except for obligations under a $100,000 promissory note and related instruments. The Archers then voluntarily dismissed the lawsuit with prejudice. After the Warners failed to make the first payment on the promissory note, the Archers sued in state court. The Warners filed for bankruptcy, and the Bankruptcy Court ordered liquidation under Chapter 7. The Archers brought the present claim, asking the Bankruptcy Court to find the $100,000 debt nondischargeable, and to order the Warners to pay the sum. Respondent Warner contested nondischargeability. The Bankruptcy Court denied the Archers' claim. The District Court and the Fourth Circuit affirmed. The latter court held that the settlement agreement, releases, and promissory note worked a kind of "novation" that replaced (1) an original potential debt to the Archers for money obtained by fraud with (2) a new debt for money promised in a settlement contract that was dischargeable in bankruptcy.

Held: A debt for money promised in a settlement agreement accompanied by the release of underlying tort claims can amount to a debt for money obtained by fraud, within the nondischargeability statute's terms. 123 S.Ct. 1462, 1466-1468.

(a) The outcome here is governed by Brown v. Felsen, 442 U.S. 127, 99 S.Ct. 2205, 60 L.Ed.2d 767, in which (1) Brown filed a state-court suit seeking money that he said Felsen had obtained through fraud; (2) the court entered a consent decree based on a stipulation providing that Felsen would pay Brown a certain amount; (3) neither the decree nor the stipulation indicated the payment was for fraud; (4) Felsen did not pay; (5) Felsen entered bankruptcy; and (6) Brown asked the Bankruptcy Court to look behind the decree and stipulation and hold that the debt was nondischargeable because it was a debt for money obtained by fraud. Id., at 128-129, 99 S.Ct. 2205. This Court found that, although claim preclusion would bar Brown from making any claim " 'based on the same cause of action' " that he had brought in state court, id., at 131, 99 S.Ct. 2205, it did not prevent the Bankruptcy Court from looking beyond the state-court record and the documents terminating the state-court proceeding to decide whether the debt was a debt for money obtained by fraud, id., at 138-139, 99 S.Ct. 2205. As a matter of logic, Brown's holding means that the Fourth Circuit's novation theory cannot be right. If reducing a fraud claim to settlement definitively changed the nature of the debt for dischargeability purposes, the nature of the debt in Brown would have changed similarly, thereby rendering that debt dischargeable. This Court's instruction that the Bankruptcy Court could "weigh all the evidence," id., at 138, 99 S.Ct. 2205, would have been pointless, as there would have been nothing for the court to examine. Moreover, the Court's statement in Brown that "the mere fact that a conscientious creditor has previously reduced his claim to judgment should not bar further inquiry into the true nature of the debt," ibid., strongly favors the Archers' position. Finally, Brown's basic reasoning applies here. The Court noted that a change in the Bankruptcy Code's nondischargeability provision indicated that "Congress intended the fullest possible inquiry" to ensure that "all debts arising out of" fraud are "excepted from discharge," no matter their form. Ibid. Congress also intended to allow the determination whether a debt arises out of fraud to take place in bankruptcy court, not to force it to occur earlier in state court when nondischargeability concerns "are not directly in issue and neither party has a full incentive to litigate them." Id., at 134, 99 S.Ct. 2205. The only difference between Brown and this case--that the relevant debt here is embodied in a settlement, not in a stipulation and consent judgment--is not determinative, since the dischargeability provision applies to all debts that "aris[e] out of" fraud. Id., at 138, 99 S.Ct. 2205. Pp. 1466-1468.

(b) The Fourth Circuit remains free, on remand, to determine whether Warner's additional arguments were properly raised or preserved, and, if so, to decide them. Pp. 1468.

283 F.3d 230, reversed and remanded.

BREYER, J., delivered the opinion of the Court, in which REHNQUIST, C. J., and O'CONNOR, SCALIA, KENNEDY, SOUTER, and GINSBURG, JJ., joined. THOMAS, J., filed a dissenting opinion, in which STEVENS, J., joined.

Dissent
Justice Thomas filed a dissenting opinion in which Justice Stevens joined. Justice Thomas reasoned:

In this case, the parties have made clear their intent to replace the old "fraud" debt with a new "contract" debt. Accordingly, the only debt that remains intact for bankruptcy purposes is the one "obtained by" voluntary agreement of the parties, not by fraud. Pp. 1470

Third Circuit

May a debtor agree to indemnify financial advisors against claims of negligence?

An Indemnification provision contained in a chapter 11 debtors' retention agreement with financial advisor, which exempted advisor from liability for its own ordinary negligence, but not gross negligence, was reasonable and, thus, permissible under the Bankruptcy Code. In re United Artists Theater Company, 315 F.3d 217 (3rd Cir. 2003).

The United Artists case raises the issue of what, if any, indemnification of a financial advisor by a debtor is a reasonable term of employment. Chapter 11 debtors filed application to retain financial advisor. United States Trustee (UST) objected on grounds that the retention agreement exempted advisor from liability for its own ordinary negligence. The United States District Court approved application, and subsequently confirmed plan of reorganization. The UST appealed. The Court of Appeals, held that the subject indemnification agreement was reasonable and, therefore, permissible under the Bankruptcy Code.

The U.S. Trustee objected, claiming, inter alia, that the retention agreement exempted the financial advisor Houlihan Lokey from liability for its own negligence, thus violating the Bankruptcy Code, public policy, and basic tenets of professionalism. Specifically, it argued that the agreement was unreasonable under two provisions of the Bankruptcy Code, 11 U.S.C. §§ 327(a) and 328(a), because allowing a debtor's estate to indemnify a financial advisor for its own negligence undermines the principal purpose of bankruptcy--conserving the debtor's assets in order to pay its creditors.

Indemnification of financial advisors against their own negligent conduct is becoming a common market occurrence. In re Joan and David Halpern Inc., 248 B.R. 43, 47 (Bankr.S.D.N.Y.2000), aff'd, No. 00-3601 JSM, 2000 WL 1800690 (S.D.N.Y. Dec. 6, 2000). These provisions are of relatively recent origin, spurred by the In re Merry-Go-Round Enterprises, Inc. settlement of a suit against accountants advising the estate. 244 B.R. 327 (Bankr.D.Md.2000). Where previously there was no great concern with bankruptcy professionals being sued for negligence, after Merry-Go-Round professionals worried that suits would occur frequently, and they sought to lessen their potential liability by contracting for indemnification. See Joseph A. Guzinski, The United States Trustees: Ongoing Challenges, in 23rd Annual Current Developments in Bankruptcy and Reorganization 251, 274 (PLI Commercial Law and Practice Course, Handbook Series No. 820, 2001) ("In re Merry-Go-Round served as a kind of wake up call for bankruptcy specialists.... Fearing exposure to similar claims, specialists ... have sought indemnification by the company filing the bankruptcy."); Kurt F. Gwynne, Indemnification and Exculpation of Professional Persons in Bankruptcy Cases, 10 ABI L.Rev. 711, 727-29 (2002); Shanon D. Murray, U.S. Trustee Watchdog Starting to Bite, Some Say, N.Y.L.J., May 3, 2001, at 5 (stating that "the current movement of restructuring advisers who want to be indemnified for their bankruptcy work stems from a $4 billion fraud, negligence and malpractice case that a regional trustee brought against Ernst & Young for its role in the bankruptcy proceedings of Merry-Go-Round"). The Merry-Go-Round suit settled for $185 million on eve of trial.

In United Artists Theater the United States Court of Appeals for the Third Circuit became the first circuit court to address the issue. The court affirmed a chapter 11 debtor's retention of its financial advisor under terms that indemnified the financial advisor from its own negligence. In so doing, however, the court defined limits to the reasonableness of such indemnification provisions.

The indemnification of a financial advisor to a chapter 11 debtor is not, per se, an unreasonable term of employment under 11 U.S.C. § 328(a). Such provisions may be expected in the market, and reorganizing debtors should not be denied the opportunity to retain a financial advisor on marketplace terms that are reasonable. As pointed out in United Artists, however, although the standard of reasonableness may be market driven, it is not market determined. United Artists, 315 F.3d at 230.

A financial advisor to a reorganizing debtor should not be artificially constrained from giving its best financial advice by a fear of liability for being second-guessed. Decisions in a reorganization case often must be made in dynamic and fluid situations, under time pressures, and with only the best information then available. In these circumstances, the estate is most likely to benefit from financial advice that is not artificially constrained by a fear of being sued.

As discussed in United Artists, it may be reasonable to indemnify a reorganizing debtor's financial advisor from something commonly described as ordinary negligence, without tolerating actions akin to gross negligence, by focusing on the process used to reach decisions rather than on the results achieved. Id. at 230-33. In so doing, the United Artists court applied principles that closely equate to what is commonly known in corporate law as the business judgment rule.The Court opined that testing the reasonableness of an indemnity provision for a financial advisor to a reorganizing debtor by principles akin to the business judgment rule makes sense. It provides needed flexibility, and it provides important safeguards. United Artists, 315 F.3d at 230-33. First, the financial advisor would be culpable for a breach of its duty of loyalty, which includes conflicts of interest and nondisinterestedness. See id. at 233. Such a breach by financial consultants was alleged, inter alia, in the Merry-Go Round Enterprises, Inc. case that spurred the heightened interest by bankruptcy financial advisors in indemnity protection. Second, the financial advisor would be culpable for a breach of the duty of care in the process by which it rendered advice to the reorganizing debtor. See United Artists, 315 F.3d at 233. Third, an indemnification would not cover contractual disputes with the debtor, including disputes over the services the financial advisor has agreed to perform. As stated in United Artists, "To the extent that [the financial advisor] seeks indemnity for a contractual dispute in which the Debtors allege the breach of [the financial advisor's] contractual obligations, this is hardly an indemnity-eligible activity." Id. at 234. Fourth, limiting words, such as "solely," that would expand a reorganizing debtor's indemnification obligation are "out of bounds for acceptable public policy." Id.

Judge Rendell concurred in the result but rejected the majority's ruling on the merits. According to Judge Rendell the opinion ventures into the arena of corporate law and fashions an open-ended good faith business judgment rule, based upon Delaware corporate law principles, as the test for the "reasonableness" of advisors' indemnity. It does so because it finds the concepts of negligence and gross negligence to be too results-oriented. He further stated: “And why should we concern ourselves with Delaware law applicable to directors, when the retention agreement here was specifically governed by New York law and was meant to govern a relationship not with directors, but between a company and its professional financial advisors?” Id. at 236.

For comments on the case, see In re Baltimore Emergency Services II, — B.R. —, 2003 WL 1479388 (Bankr. D. Md. 2003); Third Circuit: Code § 328(a) Does Not Prohibit Debtor's Indemnification of Financial Advisor for Negligence, 2003 WL 282673 (Bankr. Service Current Awareness Alert))(Feb., 2003); Indemnification of Financial Advisors in Chapter 11 (and Judicial Musings Afield Therefrom): How Far Is Too Far?, 23 No. 4 Bankruptcy Law Letter 1 (April 2003).