Despite the recent wave of corporate bankruptcies, the overwhelming number of bankruptcy cases in the United States are filed by individuals seeking to discharge their debts and avail themselves of the “fresh start” offered by the federal bankruptcy laws. Not all of an individual’s debts, however, are dischargeable in bankruptcy. Section 523 of the United States Bankruptcy Code lists various types of debts for which an individual remains liable post-bankruptcy, one of the most significant being debts arising from fraud.

As is the case with most types of legal disputes, fraud claims often are settled privately out of court or as a resolution of a lawsuit, with the ongoing responsibilities of each party set forth in a written agreement. A persistent problem within bankruptcy law has been the treatment of settlements that resolve claims of fraud, with courts disagreeing about whether a debt arising from the settlement of a fraud claim could be discharged.

Some courts held that upon entering a settlement agreement, the parties forego any underlying tort claims and, instead, accept the contractual obligations as set forth in a written settlement agreement. Because the settlement contract is not itself obtained by fraud, these courts reasoned that settlement debts necessarily fall outside of Section 523, and are therefore fully dischargeable in bankruptcy. Conversely, other courts held that settlement agreements retain the character of their underlying claims. Following this reasoning, these courts ruled that settlement debts are non-dischargeable when they stem from legitimate fraud claims. Therefore, bankruptcy courts remained free to determine the legitimacy of underlying fraud claims when deciding whether a particular debt was dischargeable, even when the resolution of the underlying claim was memorialized in a settlement agreement.

The appropriateness of each approach was hotly debated among bankruptcy practitioners, and the U.S. Supreme Court recently evaluated the issue in the case Archer v. Warner. In Archer, purchasers of a business sued the sellers alleging fraud in connection with the sale. The lawsuit settled and, as part of the settlement, the sellers issued a note that obligated them to make monthly payments to the buyers in exchange for a release of all claims. The sellers defaulted after making only one payment, and the purchasers filed a second suit to collect on the settlement note. Meanwhile, the sellers filed personal bankruptcies, and one seller sought to have her settlement debt is charged.

The bankruptcy court, the district court and the Fourth Circuit Court of Appeals held that the seller could obtain a discharge of the settlement debt, reasoning that the debt embodied by the settlement contract did not arise from fraud. Because the settlement obligations arose from a contract that was not tainted by fraud, these courts held the obligations necessarily were dischargeable. The Supreme Court disagreed with this reasoning and ruled that the settlement agreement did not extinguish the fraudulent nature of the underlying debt, leaving the settling-creditor free to demonstrate to the bankruptcy court that the underlying fraud claims were valid, and the settlement debt non-dischargeable.

The court, however, recognized two ways in which a settlement agreement could, by its own terms, determine the issue of dischargeability. First, the court acknowledged the possibility that state law regarding settlements might preclude a creditor from arguing the validity of settled fraud claims in a later proceeding. Second, the court noted that the parties themselves might express a clear intent to conclusively resolve issues of fraud. Therefore, when settling claims of fraud, parties must consider state law regarding settlements. Parties also must exercise care when drafting settlement agreements to accurately reflect their intentions and protect their interests in the event a settling defendant defaults on his obligations and files for bankruptcy.

Finally, the Supreme Court’s reasoning in Archer likely will extend to all types of claims listed in Section 523. For example, Section 523 also exempts from discharge any debt “for willful and malicious injury by the debtor to another entity or to property of another entity.” Therefore, parties must not only keep the Archer decision in mind when settling claims involving fraud, but also when settling any other type of claim that might fall within the scope of Section 523.