Carefully Drafted Settlement Can Minimize Bankruptcy Risks

The peace of mind that comes with settlement can quickly be extinguished if the defendant files for bankruptcy. This article discusses how attorneys should take bankruptcy laws into account when drafting settlement agreements.

The peace of mind that comes with settlement can quickly be extinguished if the defendant files for bankruptcy, even if full payment has already been received. The plaintiff may not receive any or all of the settlement — or may have to pay back all or a portion of it, at least temporarily.

To avoid this result, attorneys should take bankruptcy laws into account when drafting settlement agreements. A preemptive agreement should address collectability and preference exposure, as well as preservation and dischargeability of the original claim.

Protecting Collectability
Collectability is a risk with all settlements, especially structured settlements. After all, defendants that push for extended payments may already be in a shaky financial position. One way to reduce the risk is to take a security interest in collateral sufficient to compensate the plaintiff for any future nonpayments. Of course, a security interest may still fall prey to a preference challenge in bankruptcy. Another option is to take an assignment of the defendant’s accounts receivable.

If the plaintiff seeks a structured settlement — to ensure a regular income stream, for example — it might ask the defendant to purchase an annuity to secure its future payment obligations.

Even when a defendant has fulfilled its obligations under a single-payment settlement, the plaintiff can face difficulties under Section 547 of the Bankruptcy Code. This section requires creditors to pay the bankruptcy estate an amount equal to payments received in the 90 days prior to the bankruptcy filing. These payments generally are treated as voidable preferences — that is, transfers of a debtor’s property to a creditor in satisfaction of a pre-existing debt at a time when the debtor is insolvent. So plaintiffs should take payment as early as possible to start the 90-day clock running.

Preserving the original claim
A plaintiff that releases the defendant from all claims and dismisses the suit with prejudice is in for a rude awakening if the defendant later files for bankruptcy. If the plaintiff pursues its claim in bankruptcy, the claim will be valued at the settlement amount, not the original claim amount. At pennies on the dollar, any actual recovery will represent only a sliver of the original claim.

To protect itself, a plaintiff should incorporate a claim preservation clause in the settlement agreement. Under a preservation clause, a plaintiff is not required to dismiss its claim until the bankruptcy court rules that the settlement is not a voidable preference. If the court finds that the settlement payment is a preference, the original claim is reinstated in full. The clause deters the bankruptcy trustee from bringing a preference action against the plaintiff because it may reduce the net recovery available to other creditors.

Another option is to persuade the defendant to stipulate to the entry of judgment or sign a confession of judgment for the full amount of the original claim. The plaintiff agrees not to execute for 90 days and to file a satisfaction of judgment at that time, provided the defendant hasn’t filed for bankruptcy. If the defendant does file, the plaintiff can assert the full claim, supported by the judgment, in bankruptcy.

At the very least, a settlement agreement should provide that the original claim is preserved if the plaintiff fails to receive and retain the full amount of cash consideration that it bargained for.

Building a case for nondischargeability
Smart settlement agreements also address the dischargeability of debts in bankruptcy. Absent an explicit reservation of the right to object to discharge, the plaintiff may inadvertently waive that right. Plus, the right to assert nondischargeability may be lost if the settlement agreement is viewed as a novation that creates a new obligation.

The agreement should state the grounds for the payment and make clear that the debt is not dischargeable, tracking the language of the applicable bankruptcy law exception. It should preserve the right to assert nondischargeability and state that it does not create a new obligation.

Countering the defendant’s claims
In addition to the protections discussed above, a settlement agreement should include a waiver of all potential claims against the plaintiff. Favorable settlements can blow up if a defendant claims the plaintiff violated the Fair Debt Collection Practices Act, the Truth in Lending Act or other laws related to creditor practices.