How to Bankruptcy-Proof Your Litigation Settlement

Jerrold S. Kulback 07-21-2010 (Reprinted with permission from the July 21, 2010, The Legal Intelligencer, Copyright 2010, ALM Media Properties LLC. Further duplication without permission prohibited. All rights reserved). Playing the bankruptcy card as a tactic to gain leverage in litigation is nothing new to defendants. However, the threat of bankruptcy by a defendant, especially in todays economy, is something that should not be lightly dismissed by a plaintiff. According to a recent news release from the Administrative Office of the U.S. Courts, bankruptcy filings for the 12-month period ending March 31, 2010, were up 27 percent over the prior year, the most since the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 took effect. Before deciding to call a defendants bankruptcy bluff, plaintiffs attorneys must be mindful of their clients rights and liabilities should the defendant indeed follow through with such a threat. This is especially important in bankruptcy-proofing settlement agreements. Settlement agreements are typically used to bring an end to parties disputes and provide a clear outline of the parties respective rights and obligations going forward. Attorneys often spend a great deal of time and energy in both trying to ensure that settlement agreements accurately reflect the resolution of the parties conflict, and also closing any potential loopholes that might exist for the adverse party. However, what is often less considered but perhaps equally as important to the parties agreement is how a future bankruptcy filing would affect the rights and obligations of the various parties to the settlement agreement. Although it is impossible to craft a completely bankruptcy-proof settlement agreement, this article outlines several aspects that parties to litigation and their attorneys should consider in the course of negotiating the terms of a litigation settlement.

Protecting Against Preferences

Under Section 547 of the Bankruptcy Code, certain payments made by a debtor prior to a bankruptcy filing may be avoided and recovered by the bankruptcy trustee. In order to avoid such payments, the trustee must demonstrate that the payments (1) were of the debtors property; (2) were made to or for the benefit of a creditor; (3) were made for or on account of an antecedent debt; (4) were made while the debtor was insolvent; (5) were made within 90 days before the bankruptcy was filed (or one year in the case of an insider); and (6) allowed the creditor to receive more than the creditor would receive in the bankruptcy had it not received the payments. In order to protect a payment made under a settlement agreement from later being avoided as a preference if the defendant subsequently files bankruptcy, the settlement agreement should structure the payment in such a way as to preclude or substantially hinder the trustee from proving his or her prima facie case. Certain tips are as follows: Amount of the Settlement Payment. In the context of a commercial debt, the threshold as of April 1, 2007 for a trustee to maintain a preference action is $5,475. Accordingly, a settlement agreement may be structured such that the aggregate of all payments made thereunder during any given 90-day period does not exceed that amount. Sometimes this is impossible given the amount in controversy, but it is a basic element often overlooked in smaller disputes. Source of Funds. In order to qualify as a preference, a settlement payment must be made from funds in which the defendant/debtor has an interest. The U.S. Supreme Court has interpreted this to be funds that would have been property of the bankruptcy estate had they not been paid before the commencement of the bankruptcy. Therefore, if the funds of a third-party are utilized to make the settlement payment, the payment may be protected from preference attack if the defendant later files bankruptcy.

Examples of third-parties that might act as the source of settlement funds are, in the case of a corporation or other business entity, an owner or principal of the defendant, guarantor of the underlying debt, or annuity fund created for the purpose of providing the stream of income. Likewise, the earmarking doctrine may insulate such settlement payments from preference claims. This doctrine is a courtmade concept that applies principally where a third-party lends money to the debtor for the purpose of paying such funds to an old creditor and thereby becomes a creditor itself, so that a new creditor is, in effect, substituted for the old creditor and the estates assets are not diminished. The central inquiry in connection with the earmarking defense is whether the debtor had any right to disburse the funds to whomever it wished, or whether the disbursement was limited to a particular old creditor or creditors under the agreement with the new creditor. In such circumstances, the funds are deemed earmarked and are not considered part the debtors estate, and the payment is protected from preference attack. If a plaintiff can structure a settlement in such a way that the funds utilized to pay the plaintiff are borrowed from a third-party that requires the funds be used to pay the plaintiff, then the settlement payment may be protected. Insolvency. As noted before, a settlement payment can only be avoided as a preference if it was made while the defendant was insolvent. There is a rebuttable presumption that the defendant/debtor is insolvent during the 90 days immediately preceding a bankruptcy filing. In order to overcome that presumption, a plaintiff is wise to request financial information from a defendant demonstrating solvency when the settlement payment is made. This may be difficult, in the context of litigation, where a defendant may be loath to provide prejudgment financials to a plaintiff. When faced with a reluctant defendant, a plaintiff should, at a minimum, request a representation of solvency in the settlement agreement. While such representation alone generally will not overcome the presumption, if the representation is not accurate, it may provide a direct claim against the individual making such representation, and thus another source of recovery. Security Interests. Payments made to a secured creditor may evade preference exposure, since the trustee may not be able to demonstrate the secured creditor received more than it would have in the bankruptcy had it not been paid beforehand. A secured creditor will generally receive at least the value of its collateral in a bankruptcy, regardless of whether the bankruptcy is a reorganization or liquidation. A plaintiff may seek to secure a structured settlement with collateral, such as a mortgage on the defendants real estate or a security interest in personal property. Although the granting of such mortgage or security interest may itself be a preference avoidable by a trustee in bankruptcy, if the security interest is properly perfected more than 90 days prior to the bankruptcy filing, payments made thereafter under the settlement agreement may be protected.

Preserving Claims
It is often said that the only good settlement is one in which neither party walks away happy. The term settlement assumes a compromise of the plaintiffs original demand. It is not unusual for a defendant to require a release in a settlement agreement. If a settlement agreement is not drafted carefully, and a settlement payment is set aside as a preference, plaintiffs counsel may find himself further embarrassed when he must explain to his client why he can only assert the reduced amount of the settlement in the bankruptcy. It is therefore important that all settlements contain springing provisions providing that, to the extent that any part of the settlement payment is avoided as a preference, the original claim is reinstated, so that the full amount of the original claim, rather than the compromised amount, can be asserted in the bankruptcy. One such example, which has not yet been tested in court, is: If any claim is ever made upon Plaintiff for the repayment or return of any part of the Settlement Payment, and Plaintiff repays or returns all or part of said money or property by reason of (a) any judgment, decree or order of any court or administrative body having jurisdiction over Plaintiff or (b) any settlement or compromise of any such claim between the Plaintiff and such claimant, then in such event the release given by Plaintiff to Defendant herein shall be automatically null and void and the parties shall be returned to their pre-Settlement Agreement positions, except that Plaintiff may retain any portion of the Settlement Payment not repaid or returned, crediting same against those sums claimed by Plaintiff. The plaintiff might even request that the defendant expressly acknowledge the amount of the original claim so there is no

dispute as to the amount of that claim in the event of bankruptcy. Protecting Against Dischargeability Not all claims are dischargeable in bankruptcy. For instance, the Bankruptcy Code excepts from discharge claims based upon fraud or willful and malicious injury. On the other hand, contract claims are generally dischargeable in bankruptcy. It is important to be aware of this distinction when drafting a settlement agreement. Once litigation has settled and a settlement agreement has been executed, a novation may be deemed to have occurred. A novation is generally defined as the substitution of a new debt, contract, or obligation for an existing one. Once a novation has been deemed to have occurred, the debt that arises under the settlement agreement may become a dischargeable contract claim in the bankruptcy, despite the fact that the settlement was of claims such as fraud or willful and malicious injury that may have been otherwise non-dischargeable in bankruptcy. In order to avoid replacing a non-dischargeable debt with one that is dischargeable in bankruptcy, a plaintiff should demand in the settlement agreement that the defendant admit to the specific allegations of the fraud or willful and malicious injury. The mere insertion of a clause stating that the settlement payment will be non-dischargeable in a bankruptcy has been deemed unenforceable as against public policy.

Waiving the Automatic Stay

No single aspect of a bankruptcy filing is likely more widely known, or a source of greater frustration to creditors, than the automatic stay. Under Section 362 of the Bankruptcy Code, the filing of a bankruptcy triggers an immediate stay applicable to a variety of creditor activities, including collection efforts and commencement or continuation of legal proceedings against the bankruptcy debtor. The automatic stay has been considered so vital to the bankruptcy process that, in the past, courts were unlikely to enforce a partys voluntary waiver of the stay in a pre-petition contract or agreement. Recently, however, at least one bankruptcy court has recognized that under certain circumstances, forbearance agreements that contain a waiver of automatic stay provisions are enforceable. Although bankruptcy courts have wide discretion in deciding whether to enforce such a provision, the following factors are generally relevant in determining the totality of the circumstances: (1) the sophistication of the party making the waiver; (2) the consideration given for the waiver provision; (3) whether any other party is affected, including junior lienholders; and (4) the feasibility of the borrowers bankruptcy plan. In a commercial context, a corporation or other business entity represented by counsel in the negotiation of a forbearance or settlement agreement will likely be deemed sophisticated enough to knowingly waive the provisions of the automatic stay. With respect to consideration, a court will not necessarily look so much to quantify the amount given, but rather that it was what the debtor requested at the time the agreement was made. The third and fourth elements set forth above are more fact-intensive determinations made by a court on a case-by-case basis. Nonetheless, plaintiffs in litigation should be aware that a request for waiver of the automatic stay as part of a settlement agreement is not, per se, unenforceable.

Carefully Structuring settlements

The threat of bankruptcy by a defendant in litigation is not something to be overlooked. However, a settlement agreement that is carefully structured may protect a plaintiff and insulate settlement payments from subsequent attack if indeed a bankruptcy is subsequently filed. These suggestions are by no means an exhaustive list of solutions to the bankruptcy threat, but instead comprise a general roadmap of the issues of which any plaintiffs counsel should be aware when drafting a relatively bankruptcy-proof settlement agreement.

Jerrold S. Kulback is a partner with Archer & Greiner and a member of the debtor/creditors rights group. Kulback focuses his practice on insolvency law, corporate debt restructuring and bankruptcy litigation, as well as commercial foreclosures and real estate title and lien litigation.