Congratulations on reaching that stellar settlement in your hard-fought litigation. Your client is relieved to have it all behind them and is looking forward to finally getting paid after all these years (and attorney fees). Then the call comes: “I got some sort of notice in the mail about a bankruptcy. What does this mean? What about our settlement? Am I going to get paid?” Oftentimes (depending on, among other factors, the nature of the underlying claims in the lawsuit, the structure of the settlement and the amount of time between settlement payment and bankruptcy filing) that stellar settlement will be discharged, and the obligated party is now untethered from all payment obligations despite your masterfully drafted settlement agreement.

So what can we as litigators do to plan for the worst when negotiating settlements? This article is intended to help navigate and reduce potential risks associated with a subsequent unexpected bankruptcy filing.

THE BANKRUPTCY DISCHARGE

Individual debtors are entitled to a discharge of all personal liability for certain types of debts unless the debtor can be shown to have engaged in one of the various enumerated types of bad behavior (more to come on this) that warrant denial of their bankruptcy discharge.[1] If a debt is discharged, that means the individual debtor is relieved from all personal liability to repay such debt. This applies to both secure and unsecured debt. However, “liens flow through bankruptcy,”[2] meaning that if the debtor fails to pay on a debt secured by collateral, the creditor retains its rights to enforce the lien and proceed in rem to liquidate the collateral and apply the proceeds to satisfy the debt.[3]

Entities (other than individuals) do not receive a discharge in bankruptcy.[4] Rather, business entities can use the bankruptcy system to reorganize or liquidate assets to pay creditors.

AVOIDANCE ACTIONS: PREFERENTIAL TRANSFERS

The ideal settlement involves a single prompt lump sum payment before any bankruptcy filing is likely to occur. However, such settlement payment still faces the risk of being treated as a preferential transfer and being clawed back into the bankruptcy estate for pro rata distribution to all creditors (yes, your client would actually have to return the payments made to them). Settlement payments are subject to avoidance under 11 U.S.C. §547. Pursuant to Section 547:

(b) … the trustee may, based on reasonable due diligence in the circumstances of the case and taking into account a party’s known or reasonably knowable affirmative defenses under Subsection (c), avoid any transfer of an interest of the debtor in property–

(1) to or for the benefit of a creditor;

(2) for or on account of an antecedent debt owed by the debtor before such transfer was made;

(3) made while the debtor was insolvent;

(4) made–

(A) on or within 90 days before the date of the filing of the petition;

(B) between 90 days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and

(5) that enables such creditor to receive more than such creditor would receive if–

(A) the case were a case under Chapter 7 of this title;

(B) the transfer had not been made; and

(C) such creditor received payment of such debt to the extent provided by the provisions of this title.[5]

As a result, settlement payments made within 90 days before the filing of a bankruptcy petition face the risk that a bankruptcy trustee may seek to avoid that transfer and require the creditor that received such payment(s) to disgorge such funds and pay them over to the trustee.

So what’s a litigator to do? Give up on settling cases? Hold one’s breath for 90 days in hopes the settlement will stick? Maybe. There are, however, some additional measures that can be incorporated into your settlement structure to reduce your 90 sleepless nights.

• Require payment as quickly as possible so that the clock is running to get past the 90-day avoidance risk period.
• Include a “springing release” that is not triggered until the 91st day following settlement. This release provision should provide that the claims will not be released until 91 days[6] after receipt of payment without a bankruptcy filing. The release provision should expressly contemplate that the original claims remain in effect and are not released. Such a provision provides some protection in a worst-case scenario where a creditor is subject to avoidance by the trustee and required to return the settlement payment. If included, this provision would permit the creditor to pursue a nondischargeability action (if the claims meet the necessary bad behavior criteria discussed below).
• Require a guaranty or direct payment from a third party. All legal and equitable interest of a debtor in property (less certain limited enumerated exceptions) become property of the bankruptcy estate upon commencement of a bankruptcy case.[7] Accordingly, only the debtor’s property may be recovered in an avoidance action. Settlement payment made by a non-debtor third party, e., the individual owner of a bankrupt entity, would not be subject to avoidance since such funds would not be considered property of the estate. Such payment structure could be included by making the third party a direct party to the settlement or a guarantor of the payments due thereunder.

SECURED VERSUS UNSECURED DEBTS

As discussed, bankruptcy only discharges personal liability (in personam liability) and does not wipe out secured interests in the property (in rem liability) of the debtor.[8] Taking a security interest in the property of the debtor is one of the best ways to protect your settlement, especially if the settlement involves structured payments over time. Beware though: Similar to monetary payments received within the 90-day period immediately before a bankruptcy filing, transfers of property of the debtor within the 90-day lookback period are also subject to avoidance under Section 547(b).[9]

This combination of payment and secured interest in property could prove particularly helpful if the creditor is concerned that the debtor is not liquid enough to support the settlement payment but has unencumbered assets that could be pledged. While unconventional, the settlement terms could require the debtor to provide a security interest in a particular property immediately upon settlement, with the first payment not due until the 91st day (beyond the preference period). This would allow the secured interest in the debtor’s property to become non-avoidable and allow the debtor to have the cash necessary to stay in operations for the 90-day period. In the event the debtor later (post 90-day risk period) defaults on payment and ends up in bankruptcy, the creditor would have the lien on the non-avoidable collateral available to satisfy the settlement obligation.[10]

NONDISCHARGEABILITY

Certain types of legal claims are not subject to the discharge. The U.S. Supreme Court has found that “Congress intended the fullest possible inquiry to ensure that all debts arising out of fraud are excepted from discharge, no matter their form.”[11] Accordingly, the bankruptcy court is not prohibited from looking beyond the settlement documents to decide whether the underlying debt was nondischargeable.[12]

There are two bankruptcy code sections that govern whether a debtor may receive a discharge. One type is individual claim/creditor specific,[13] and the other results in a denial of discharge in its entirety (i.e., no claims are discharged).[14]

11 U.S.C. §523

Section 523 of the Bankruptcy Code sets forth the categories of bad behavior that could result in a claim arising out of such behavior being excepted from the discharge. In relevant part to this article, Section 523 provides that a debtor is not entitled to discharge the following types of debt:

(a)(2) for money, property, services or an extension, renewal or refinancing of credit, to the extent obtained by–

(A) false pretenses, a false representation or actual fraud, other than a statement respecting the debtor’s or an insider’s financial condition;

(B) use of a statement in writing–

(i) that is materially false;

(ii) respecting the debtor’s or an insider’s financial condition;

(iii) on which the creditor to whom the debtor is liable for such money, property, services or credit reasonably relied; and

(iv) that the debtor caused to be made or published with intent to deceive; or

…

(4) for fraud or defalcation while acting in a fiduciary capacity, embezzlement or larceny;

(5) for a domestic support obligation;

(6) for willful and malicious injury by the debtor to another entity or to the property of another entity;

…

(9) for death or personal injury caused by the debtor’s operation of a motor vehicle, vessel or aircraft if such operation was unlawful because the debtor was intoxicated from using alcohol, a drug or another substance;

…

(19) that–

 

(A) is for–

(i) the violation of any of the federal securities laws (as that term is defined in Section 3(a)(47) of the Securities Exchange Act of 1934), any of the state securities laws or any regulation or order issued under such federal or state securities laws; or

(ii) common law fraud, deceit or manipulation in connection with the purchase or sale of any security; and

(B) results, before, on or after the date on which the petition was filed, from–

(i) any judgment, order, consent order or decree entered in any federal or state judicial or administrative proceeding;

(ii) any settlement agreement entered into by the debtor; or

(iii) any court or administrative order for any damages, fine, penalty, citation, restitutionary payment, disgorgement payment, attorney fee, cost or other payment owed by the debtor.[15]

Regardless of the basis asserted to seek nondischargeability, the creditor will be required to institute an adversary proceeding within the bankruptcy case[16] and present evidence to the bankruptcy court demonstrating the elements giving rise to nondischargeability.

11 U.S.C. §727

An alternative basis for obtaining a determination of nondischargeability is to file an adversary to have the entirety of the debtor’s discharge denied as to all claims and all creditors. Beware that taking this course of action may obligate you (depending on the case law and local rules in your jurisdiction) to pursue the case through trial on behalf of all creditors in the bankruptcy case.[17] The sorts of bad behavior that give rise to nondischargeability under Section 727 typically arise out of actions by the debtor in connection with the bankruptcy proceeding itself. Section 727 provides as follows:

(a)The court shall grant the debtor a discharge, unless–

(1) the debtor is not an individual;

(2) the debtor, with intent to hinder, delay or defraud a creditor or an officer of the estate charged with custody of property under this title, has transferred, removed, destroyed, mutilated or concealed, or has permitted to be transferred, removed, destroyed, mutilated or concealed–

(A) property of the debtor, within one year before the date of the filing of the petition; or

(B) property of the estate, after the date of the filing of the petition;

(3) the debtor has concealed, destroyed, mutilated, falsified or failed to keep or preserve any recorded information, including books, documents, records and papers, from which the debtor’s financial condition or business transactions might be ascertained, unless such act or failure to act was justified under all of the circumstances of the case;

(4) the debtor knowingly and fraudulently, in or in connection with the case–

(A) made a false oath or account;

(B) presented or used a false claim;

(C) gave, offered, received or attempted to obtain money, property or advantage, or a promise of money, property or advantage, for acting or forbearing to act; or

(D) withheld from an officer of the estate entitled to possession under this title, any recorded information, including books, documents, records and papers, relating to the debtor’s property or financial affairs;

(5) the debtor has failed to explain satisfactorily, before determination of denial of discharge under this paragraph, any loss of assets or deficiency of assets to meet the debtor’s liabilities;

(6) the debtor has refused, in the case–

(A) to obey any lawful order of the court, other than an order to respond to a material question or to testify;

(B) on the ground of privilege against self-incrimination, to respond to a material question approved by the court or to testify, after the debtor has been granted immunity with respect to the matter concerning which such privilege was invoked; or

(C) on a ground other than the properly invoked privilege against self-incrimination, to respond to a material question approved by the court or to testify;

(7) the debtor has committed any act specified in paragraph (2), (3), (4), (5) or (6) of this subsection, on or within one year before the date of the filing of the petition, or during the case, in connection with another case, under this title or under the Bankruptcy Act, concerning an insider;

(8) the debtor has been granted a discharge under this section, under Section 1141 of this title, or under Section 14, 371 or 476 of the Bankruptcy Act, in a case commenced within eight years before the date of the filing of the petition;

(9) the debtor has been granted a discharge under Section 1228 or 1328 of this title, or under Section 660 or 661 of the Bankruptcy Act, in a case commenced within six years before the date of the filing of the petition, unless payments under the plan in such case totaled at least–

(A) 100% of the allowed unsecured claims in such case; or

(B)

(i) 70% of such claims; and

(ii) the plan was proposed by the debtor in good faith, and was the debtor’s best effort;

(10) the court approves a written waiver of discharge executed by the debtor after the order for relief under this chapter;

(11) after filing the petition, the debtor failed to complete an instructional course concerning personal financial management described in Section 111, except that this paragraph shall not apply with respect to a debtor who is a person described in Section 109(h)(4) or who resides in a district for which the United States trustee (or the bankruptcy administrator, if any) determines that the approved instructional courses are not adequate to service the additional individuals who would otherwise be required to complete such instructional courses under this section (the United States trustee or the bankruptcy administrator, if any) who makes a determination described in this paragraph shall review such determination not later than 1 year after the date of such determination, and not less frequently than annually thereafter.; or

(12) the court after notice and a hearing held not more than 10 days before the date of the entry of the order granting the discharge finds that there is reasonable cause to believe that–

(A) Section 522(q)(1) may be applicable to the debtor; and

(B) there is pending any proceeding in which the debtor may be found guilty of a felony of the kind described in Section 522(q)(1)(A) or liable for a debt of the kind described in Section 522(q)(1)(B).[18]

Should a creditor choose to pursue nondischargeability based on Section 727, the creditor will also be required to file a separate adversary proceeding within the bankruptcy case and put on evidence at a trial presented to the bankruptcy judge to determine if the requirements for complete denial of the discharge have been satisfied.[19]

CONCLUSION

Settlement is and will remain “the dominant outcome[ ] of civil litigation in the United States.”[20] Litigators should not only take into account achieving the most lucrative settlement for the clients but must also carefully evaluate the financial status of the opposing party in order to appropriately plan for the possibility of a future bankruptcy filing. Navigating settlement negotiations with these potential bankruptcy risks in mind can help the savvy litigator provide additional protections for their clients.

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ABOUT THE AUTHOR

Lysbeth L. George serves as CEO of the Oklahoma City law firm of Liz George and Associates. Her areas of practice include bankruptcy and commercial litigation. She is an active member of several community service leadership boards, and she is a past recipient of the Oklahoma County Bar Association Pro Bono Award. She is a 2011 graduate of the OCU School of Law, where she served as an adjunct professor of civil procedure.

 

 

 

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ENDNOTES

[1] See, e.g., 11 U.S.C. §§523 and 727.

[2] This quote can be attributed to every bankruptcy law professor’s opening statement of Bankruptcy 101.

[3] Liens that have not been avoided survive the bankruptcy discharge. Accordingly, a lienholder may enforce the surviving lien against such collateral after the bankruptcy case is closed. See Johnson v. Home State Bank, 501 U.S. 78, 82, 111 S.Ct. 2150, 115 L.Ed.2d 66 (1991).

[4] 11 U.S.C. §727(a)(1).

[5] 11 U.S.C. §547(b).

[6] Keep in mind that the lookback period for payments to insiders is actually one year, not 90 days, so if the settlement is made in favor of an insider of the debtor, 90 days won’t do the trick. See 11 U.S.C. §547(b)(4)(B). Insiders are defined in the Bankruptcy Code at 11 U.S.C. §101(31).

[7] 11 U.S.C. §541(a)(1).

[8] See endnote 3.

[9] 11 U.S.C. §§541(a)(1) and 547(b).

[10] In this situation, the debtor would either have to continue to pay current the obligation secured by the debtor’s property (the settlement) in order to retain the property, or the creditor could file stay relief to exercise its state law rights to liquidate the collateral and apply it to satisfy its debt. See 11 U.S.C. §362(d).

[11] Archer v. Warner, 538 U.S. 314, 315, 123 S. Ct. 1462, 1464, 155 L. Ed. 2d 454 (2003)(internal citations omitted).

[12] Id.

[13] 11 U.S.C. §523.

[14] 11 U.S.C. §727.

[15] 11 U.S.C. §523(a).

[16] See Fed. R. Civ. P 7001 et seq.

[17] “In filing a §727 claim a plaintiff takes on a fiduciary duty to the creditor body. A plaintiff violates this fiduciary duty when it appropriates for itself the settlement of such litigation.” In re de Armond, 240 B.R. 51, 53 (Bankr. C.D. Cal. 1999).

[18] 11 U.S.C. §727.

[19] See endnote 15.

[20] Eisenberg, Theodore and Lanvers, Charlotte, "What is the Settlement Rate and Why Should We Care?" (2009). Cornell Law Faculty Publications. Paper 203.
https://bit.ly/3syvbtz.