IN RE PIZZINI

ROBERT MAYER, Bankruptcy Judge

This case is before the court on the motion of The Mandell Law Firm ("Mandell") to approve a settlement between the law firm and the debtor. The complaint combines a single § 523(a)(2)(A) count with four § 727 counts. The settlement proposes to dismiss the entire complaint in consideration of the payment of Mandell's and its attorney's claims in full. Notwithstanding that no one has objected to the settlement, it cannot be approved.

This case involves the relationship between two corporations and the debtor. Mandell asserts that Direct Press Modern Litho, Inc., ("DPML") was wholly owned by the debtor. When it encountered financial reverses, the debtor's son organized Color Quest Litho, Inc., a company that directly competed with DPML, and to which all of DPML's assets, customers' work orders and corporate business opportunities were transferred. Both DPML and the debtor filed voluntary petitions under chapter 7 of the Bankruptcy Code in this court on February 25, 2002. Color Quest ultimately filed a voluntary petition under chapter 11 in this court on January 23, 2003.

Mandell represented DPML before it filed bankruptcy providing litigation, corporate and business law services. Also before DPML and the debtor filed bankruptcy, the lawyers constituting Mandell were hired by Pepper Hamilton, LLP. DPML followed the lawyers to Pepper Hamilton which provided further legal services. The debtor guaranteed DPML's outstanding legal bill of $17,940.06 to Mandell on January 26, 2002, agreeing that his guarantee would survive any bankruptcy of DPML. The debtor owed both Mandell and Pepper Hamilton legal fees when he filed his petition. Only Mandell filed a complaint. It is represented by Pepper Hamilton.

The settlement between the debtor and Mandell proposes that the debtor pay Mandell $17,940.00 and Pepper Hamilton $17,500.00, the amount of their scheduled claims. Mandell's memorandum in support of the proposed settlement does not discuss the merits of the settlement. The rationale for the settlement is, however, contained in paragraph 8. It states:

The settlement . . . was motivated, among other factors, by [Mandell's] unwillingness to settle on terms that did not also establish the non-dischargeability of Pepper [Hamilton's] debt, relief that would have resulted from a judgment entered on § 727 grounds, and by [debtor's] interest in avoiding two trials, and two bites of the same § 727 apple, one by [Mandell] and the second by the Office of the U.S. Trustee.

Pepper Hamilton did not file its own complaint. The United States Trustee filed a separate complaint which substantially follows Mandell's § 727 allegations.

Most civil litigation may be settled by the parties without court approval. See Protective Comm. for Indep. Stockholders of TMT Trailer Ferry, Inc. v. Anderson, 390 U.S. 414, 424, 88 S.Ct. 1157, 1163, 20 L.Ed.2d 1 (1968); Fed.R.Civ.P. 41(a). However, the parties' ability to settle complaints objecting to a debtor's discharge is limited by F.R.Bankr.P. 7041 which incorporates Rule 41 with certain modifications. Rule 7041 states:

Rule 41 F.R.Civ.P. applies in adversary proceedings, except that a complaint objecting to the debtor's discharge shall not be dismissed at the plaintiff's instance without notice to the trustee, the United States trustee, and such other persons as the court may direct, and only on order of the court containing terms and conditions which the court deems proper.

The restriction recognizes that a discharge is "the heart of the fresh start provisions of the bankruptcy law." Sen. Rept. No. 95-989, 95^th Cong., 2^nd Sess. (1978), at 99. "Dismissal of a complaint objecting to a discharge raises special concerns because the plaintiff may have been induced to dismiss by an advantage given or promised by the debtor." Advisory Committee Note to Rule 7041. A discharge objection can also be misused to gain leverage in a dischargeability objection. Rule 7041 requires court approval for these reasons. It also requires that notice of dismissal be given because the United States Trustee or others may have refrained from timely filing their own complaint objecting to discharge. Notice permits them to intervene and prosecute the complaint.

There are three basic approaches to reviewing proposed settlements of § 727 complaints. In re de Armond, 240 B.R. 51, 55 (Bankr.C.D.Cal. 1999). The first approach is the per se rule. It holds that no settlement of a § 727 objection is permissible. See In re Levine, 287 B.R. 683, 692-93 (Bankr.E.D.Mich. 2002); In re Vickers, 176 B.R. 287, 290 (Bankr.N.D.Ga. 1994)("Discharges are not property of the estate and are not for sale."); In re Moore, 50 B.R. 661, 664 (Bankr.E.D.Tenn. 1985)("[A] discharge in bankruptcy is not an appropriate element of a quid pro quo."). The essential proposition is that as a matter of public policy the debtor is either entitled to a discharge or is not. There is no middle ground. If he is entitled to a discharge, he ought not be required to pay additional amounts to either a creditor or the estate for his entitlement. Payment for a discharge is inimical to his fresh start. If, on the other hand, he is not entitled to a discharge, he should not be permitted to purchase a discharge. This approach is appealing from a public policy perspective, however, it is difficult to reconcile with the absence of an express prohibition of settlement of § 727 complaints in the Bankruptcy Code and the language of Rule 7041 which specifically permits dismissal of § 727 complaints upon such "terms and conditions which the court deems proper." F.R.Bankr.P. 7041. It also does not account for the fact that the parties' perceptions of the likelihood of success often change during the course of litigation. Litigants make informed decisions based on the facts and law as they understand them, but those understandings change as new information becomes available through discovery. While there may well be smoke, the plaintiff may become unsure whether he will be able to prove if there is a fire and, if so, who set it. The debtor may also harbor uncertainties. Such circumstances are conducive for a settlement. The per se prohibition of settlement forces both parties to either expend the maximum financial resources to obtain a resolution of the matter or capitulate. Discharge litigation does not generate funds from which a chapter 7 trustee may be paid for his services. Similarly, debtors are apt to be impecunious and unable to afford the very legal services needed to vindicate their right to a discharge. These transactional costs can themselves deflect the course of the litigation away from the desired result of a final determination on the merits. Forcing the parties to fully and completely litigate § 727 complaints in which they no longer have full confidence may lead to desultory prosecutions or unnecessary capitulations.

The second approach is the "trustee" approach. It recognizes the tension between the "vindication of the public interest in upholding the policies behind § 727, and the public interest in fostering the peaceful, just, speedy and inexpensive resolution of disputes." In re Margolin, 135 B.R. 671, 673 (Bankr.D.Colo. 1992). Since the § 727 complaint is for the benefit of all creditors, the plaintiff is, essentially, trustee for the benefit of all the creditors. The plaintiff-trustee may discharge his fiduciary duties and resolve the tension between the public interests in the policies behind § 727 and in the consensual resolution of disputes and the additional tensions arising from the private interests arising under § 523 by giving notice of the settlement, making full disclosure of the terms of the proposed settlement and affording all creditors, the chapter 7 trustee and the United States Trustee the opportunity to become the plaintiff and conclude the litigation. If there is no objection or motion to substitute, the settlement will generally be approved. In re Margolin; Hage v. Joseph (In re Joseph), 121 B.R. 679 (Bankr.N.D.N.Y. 1990).

The third approach has been characterized as the "cautious but pragmatic" approach. It is similar to the trustee approach, but the terms of settlement are carefully reviewed to assure that they are in the best interests of the estate and that the settlement is not tainted. See In re Traxler, 277 B.R. 699, 705 (Bankr.E.D.Tex. 2002); Hass v. Hass (In re Hass), 273 B.R. 45 (Bankr.S.D.N.Y. 2002); Tindall v. Mavrode (In re Mavrode), 205 B.R. 716, 719-20 (Bankr.D.N.J. 1997); In re Bates, 211 B.R. 338, 348 (Bankr.D.Minn. 1997); Russo v. Nicolosi (In re Nicolosi), 86 B.R. 882 (Bankr.W.D.La. 1988). The best interests of the estate are met by considering the same factors a court considers in reviewing any proposed settlement: (1) the probability of success on the merits in the litigation; (2) possible difficulties of collecting any judgment which might be obtained; (3) the complexity, expense, and likely duration of any ensuing litigation; and (4) the interests of the creditors, giving proper deference to their reasonable views. See Protective Comm. for Indep. Stockholders of TMT Trailer Ferry, Inc. v. Anderson, 390 U.S. at 424-25, 88 S.Ct. at 1163-64; In re Three Rivers Woods, Inc., 2001 WL 720620 (Bankr.E.D.Va. 2001) ; In re Austin, 186 B.R. 397, 400 (Bankr.E.D.Va. 1995). A taint occurs when the benefits of the settlement do not accrue to all creditors, where there is concern that the § 727 complaint is not well founded and the settlement is tantamount to "extorting" money from the debtor for a discharge to which he is entitled, or where the § 727 complaint is so well founded that the settlement is tantamount to the debtor "buying" a discharge to which he is not entitled. See In re Hass, 273 B.R. at 52-53; In re de Armond, 240 B.R. at 60.

All three tests endeavor to distinguish between appropriate and inappropriate settlements. The cautious but pragmatic approach is best suited to allow a careful consideration of the multitude of factors that may occur, particularly where a § 727 complaint is joined with a § 523 complaint brought by a creditor. It is particularly sensitive to a determination of whether the consideration for the settlement of the § 727 count will go to the estate rather than an individual creditor even though the consideration may be attributed by the parties to the § 523 count. It is also best supported by the text of Rule 7041 which anticipates settlement of § 727 complaints after court review.

Applying the cautious but pragmatic test in this case, it is apparent that the proposed settlement cannot be approved. The settlement is clearly tainted by the provision that permits Mandell's attorney, which is also a creditor, to receive a benefit not shared by the other creditors of the estate. The settlement proposes to pay Pepper Hamilton $17,500, the full amount of its claim. The memorandum in support of the settlement motion states that Mandell did not want to settle the § 727 complaint unless Pepper Hamilton's claim was also addressed. It argues that payment of Pepper Hamilton as part of the settlement is no more than it would receive if the case were tried and the debtor were denied a discharge. That may be true as far as it goes. But, Pepper Hamilton would receive payment of its claim while all other creditors would only maintain their right to sue the debtor and compete over scarce resources to enforce their judgments. The debtor is insolvent. It is unlikely that all creditors will achieve the same result as Pepper Hamilton — full payment of their claims. More fundamentally, the risk remains that the debtor will receive his discharge. If he does, none of the other creditors will even have the right to sue the debtor. This provision of the settlement agreement is tainted because it misdirects a payment that should benefit all creditors to one creditor.

In the absence of a § 727 count, settlement of a § 523 complaint is not usually reviewed by the court. Except for the potential for abuse by creditors in bringing frivolous dischargeability claims, the matter is generally a private one between a specific creditor and the debtor. A § 727 complaint is not a private matter. It affects all creditors. Where a § 523 count is joined with a § 727 count, a proposed settlement must be examined. Assuming, as one initially must, that the § 727 count was not filed frivolously or brought for an improper purpose — such as gaining additional leverage to settle a § 523 county — there must be some merit to it. Thus, dismissing both the § 523 and § 727 counts with the consideration flowing only to the individual creditor, purportedly under the § 523 count, raises a red flag suggesting a tainted settlement. A close examination is appropriate.

In this case, Mandell alleges the debtor's obligation to it is nondischargeable under § 523(a)(2)(A) and that the debtor is not entitled to a discharge under § 727(a)(2) (fraudulent transfers), § 727(a)(3) (falsified records); § 727(a)(4) (false schedules) and § 727(a)(7) (false oaths in a related case).

Mandell alleges that in 1999 and thereafter, the debtor represented to Mandell that DPML had stopped certain fraudulent accounts receivable practices; that prior to and after DPML filed its bankruptcy petition, the debtor was employed by Color Quest Litho, Inc., an entity formed by the debtor and his son; that Color Quest engaged in the same business as DPML; that DPML fraudulently transferred its assets and business to Color Quest; and that the debtor arranged to have compensation due to him from Color Quest paid to his wife.

Mandell also alleges that on January 22, 2001, DPML and Mandell entered into an agreement to pay past due legal fees owed by DPML. The agreed upon payment schedule was not maintained. A year later, only $7,500.00 of the agreed fee of $25,268.37 had been paid notwithstanding that the entire fee should have been paid before then. On January 26, 2002, the debtor guaranteed the unpaid fee in order to induce Mandell to forbear from taking collection action against DPML and to induce Pepper Hamilton, by whom the Mandell lawyers were then employed, to continue to perform legal services for DPML. Less than a month later, on February 25, 2002, DPML and the debtor filed bankruptcy. Mandell alleges that the debtor never intended to honor his guarantee and that his statements that DPML had ceased its fraudulent accounts receivable financing and reporting practices were false.

The motion does not discuss the usual considerations for approving a settlement. There is no discussion of balancing the risks and costs of further litigation against the benefits of an immediate settlement. There is no discussion about the probability of success on the merits of the § 523 count or the § 727 counts. In fact, the settlement motion, by arguing that Pepper Hamilton should receive $17,500 because that is what it would obtain if the debtor's discharge were denied, strongly suggests that Mandell expects the debtor to be denied a discharge, that is, that success on the § 727 counts is likely. The § 523 count, on the other hand, may encounter difficulties. The settlement motion does not discuss the impact on the allegation in the complaint that the guarantee was made one month before the debtor filed bankruptcy and the fact that the schedules and statement of financial affairs reflect that both the debtor and DPML were clearly insolvent a month after the debtor made his guarantee. It is not immediately clear the extent, if any, of any loss occasioned by the 30-day delay. Moreover, if Mandell had been able to effect a recovery within that time, it may well have been a preference. There is also a question, in light of all the red flags and Mandell's apparent knowledge of DPML's affairs, whether Mandell justifiably relied upon the debtor's statements. In short, the § 523 objection may be on weaker grounds than the § 727 objection, yet all the consideration is apportioned to the § 523 claim. In these circumstances the Mandell portion of the settlement is also tainted because it, too, misdirects a benefit that should go to all creditors to only one creditor. The motion to approve the settlement will be denied.