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 today’s 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 defendant’s “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 debtor’s 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.

request a representation of solvency in the settlement agreement. a plaintiff should. a plaintiff is wise to request financial information from a defendant demonstrating solvency when the settlement payment is made. Likewise. crediting same against those sums claimed by Plaintiff. Payments made to a secured creditor may evade preference exposure. While such representation alone generally will not overcome the presumption. This may be difficult. an owner or principal of the defendant. and a settlement payment is set aside as a preference. or whether the disbursement was limited to a particular “old” creditor or creditors under the agreement with the “new” creditor. As noted before. plaintiff’s 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 may provide a direct claim against the individual making such representation. the “earmarking doctrine” may insulate such settlement payments from preference claims. 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. The central inquiry in connection with the earmarking defense is whether the debtor had any right to disburse the funds to whomever it wished. It is therefore important that all settlements contain “springing” provisions providing that. There is a rebuttable presumption that the defendant/debtor is insolvent during the 90 days immediately preceding a bankruptcy filing. to the extent that any part of the settlement payment is avoided as a preference. • Insolvency. 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. and the payment is protected from preference attack. where a defendant may be loath to provide prejudgment financials to a plaintiff. can be asserted in the bankruptcy. • Security Interests. at a minimum. payments made thereafter under the settlement agreement may be protected. rather than the compromised amount. so that a new creditor is. A plaintiff may seek to secure a structured settlement with collateral. It is not unusual for a defendant to require a release in a settlement agreement. or annuity fund created for the purpose of providing the stream of income. if the security interest is properly perfected more than 90 days prior to the bankruptcy filing. In order to overcome that presumption. Although the granting of such mortgage or security interest may itself be a preference avoidable by a trustee in bankruptcy. which has not yet been tested in court. 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. a settlement payment can only be avoided as a preference if it was made while the defendant was insolvent.Examples of third-parties that might act as the source of settlement funds are. and thus another source of recovery. 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. the original claim is reinstated. regardless of whether the bankruptcy is a reorganization or liquidation. substituted for the old creditor and the estate’s assets are not diminished. When faced with a reluctant defendant.” The plaintiff might even request that the defendant expressly acknowledge the amount of the original claim so there is no . such as a mortgage on the defendant’s real estate or a security interest in personal property. Preserving Claims It is often said that the only “good” settlement is one in which neither party walks away happy. in effect. and Plaintiff repays or returns all or part of said money or property by reason of (a) any judgment. then the settlement payment may be protected. so that the full amount of the original claim. If a settlement agreement is not drafted carefully. 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. in the context of litigation. the funds are deemed “earmarked” and are not considered part the debtor’s estate. A secured creditor will generally receive at least the value of its collateral in a bankruptcy. except that Plaintiff may retain any portion of the Settlement Payment not repaid or returned. is: “If any claim is ever made upon Plaintiff for the repayment or return of any part of the Settlement Payment. in the case of a corporation or other business entity. guarantor of the underlying debt. The term “settlement” assumes a compromise of the plaintiff’s original demand. One such example. In such circumstances. if the representation is not accurate.

including junior lienholders. It is important to be aware of this distinction when drafting a settlement agreement. 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. 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. the Bankruptcy Code excepts from discharge claims based upon fraud or willful and malicious injury. On the other hand. Carefully Structuring settlements The threat of bankruptcy by a defendant in litigation is not something to be overlooked. and (4) the feasibility of the borrower’s bankruptcy plan. . the debt that arises under the settlement agreement may become a dischargeable contract claim in the bankruptcy. In a commercial context. a court will not necessarily look so much to quantify the amount given. 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. These suggestions are by no means an exhaustive list of solutions to the bankruptcy threat. contract claims are generally dischargeable in bankruptcy. or a source of greater frustration to creditors. including collection efforts and commencement or continuation of legal proceedings against the bankruptcy debtor. courts were unlikely to enforce a party’s voluntary waiver of the stay in a pre-petition contract or agreement. than the automatic stay. a “novation” may be deemed to have occurred. (3) whether any other party is affected. For instance. Although bankruptcy courts have wide discretion in deciding whether to enforce such a provision. Kulback focuses his practice on insolvency law. 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. in the past. The automatic stay has been considered so vital to the bankruptcy process that. Waiving the Automatic Stay No single aspect of a bankruptcy filing is likely more widely known. Recently. however. Protecting Against Dischargeability Not all claims are dischargeable in bankruptcy. but rather that it was what the debtor requested at the time the agreement was made. (2) the consideration given for the waiver provision. The third and fourth elements set forth above are more fact-intensive determinations made by a court on a case-by-case basis. as well as commercial foreclosures and real estate title and lien litigation. With respect to consideration. forbearance agreements that contain a waiver of automatic stay provisions are enforceable. per se. Kulback is a partner with Archer & Greiner and a member of the debtor/creditors rights group. However. Under Section 362 of the Bankruptcy Code. unenforceable. In order to avoid replacing a non-dischargeable debt with one that is dischargeable in bankruptcy. the filing of a bankruptcy triggers an immediate stay applicable to a variety of creditor activities.dispute as to the amount of that claim in the event of bankruptcy. A novation is generally defined as the substitution of a new debt. plaintiffs in litigation should be aware that a request for waiver of the automatic stay as part of a settlement agreement is not. corporate debt restructuring and bankruptcy litigation. contract. Nonetheless. or obligation for an existing one. Jerrold S. Once litigation has settled and a settlement agreement has been executed. 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. the following factors are generally relevant in determining the “totality of the circumstances”: (1) the sophistication of the party making the waiver. Once a novation has been deemed to have occurred. at least one bankruptcy court has recognized that under certain circumstances.

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