Protecting Settling Plaintiffs When a Defendant Goes Bankrupt

Most settlement agreements ignore a risk faced by settling plaintiffs - that the defendant will file for bankruptcy shortly after settlement. This article shows plaintiffs how to craft an agreement that helps protect the plaintiff against the defendant's bankruptcy.

Litigators know that most lawsuits settle. The parties then place the terms of settlement into a form settlement agreement. And while form agreements contain useful boilerplate, most ignore a risk faced by the settling plaintiff - that the defendant will file bankruptcy shortly after settlement. This presents the plaintiff with several unpleasant problems. Two are addressed here.

First, bankruptcy preference law might force the return of some or all of the plaintiff's settlement proceeds to a bankruptcy trustee. Second, if the settled claims involve specified torts, notably fraud, the plaintiff may have to relitigate those in bankruptcy court to avoid their discharge.

Plaintiff's counsel should consider and counsel their clients on these risks at settlement, especially if the client is basing business decisions on its use of the settlement funds and the belief that litigation is over. In the end, plaintiff's counsel should consider these concepts "boilerplate" language for all future settlement agreements.

The bankruptcy preference action

The Bankruptcy Code (the "Code") created the "preference."¹ Broadly, preference law prevents a debtor from paying (or preferring) some creditors over others in the 90 days prior to bankruptcy through the payment of some debts but not others.

To this end, the Code allows the recapture of those "preferential" payments by the bankruptcy trustee through a lawsuit associated with the underlying bankruptcy case called a preference action.² And while the Code provides statutory defenses to a preference action, for instance, to trade creditors who receive payments in the ordinary course of business with the debtor,³ our hypothetical plaintiff who received settlement payments after a dispute or lawsuit cannot normally use those defenses because the payment(s) are not related to the parties' normal business affairs.⁴ A few examples illustrate this problem.

Examples of the risk to plaintiffs

The first case, In re Florence Tanners, Inc.,⁵ demonstrates how the defendant's bankruptcy after settlement places the plaintiff's recovery at risk.

There, an ex-employee sued Florence alleging sex discrimination. The case settled and Florence made two settlement payments. Within 90 days after payment, Florence filed chapter 11. Under bankruptcy law, Florence became a "debtor in possession" entitled to commence preference actions and recover assets it transferred within 90 days of its bankruptcy. Florence sued the ex-employee to recover the settlement payments.

The employee asserted that the ordinary course defense, which protects transfers from debtors to creditors in the ordinary course of business, protected the payment. The court disagreed, holding that the payments arose from an "agreement entered into by the debtor and the creditor in settlement of a sex discrimination suit" and that "[t]here is no indication that this type of debt is ordinary for the debtor."⁶ To the contrary, the debtor sold fur and leather goods.⁷

In another case,⁸ the defendant supplied steel products to the debtor. The account became delinquent so the supplier sued. The case settled and the debtor agreed to pay $130,000 in six monthly installments. The debtor made five payments and then filed bankruptcy. The bankruptcy trustee brought a preference action because the last two payments fell within the 90 days prior to bankruptcy, and the defendant asserted, among other things, the ordinary course defense.⁹

The court held that although the defendant incurred the debt in the ordinary course of business, buying steel, it did not make the payments in the ordinary course. Instead, the court found that the lawsuit and the debtor's counterclaim was "not only was unusual and out of the ordinary course of business as between the Debtor and (the trustee), but also as between the debtor and all of its other suppliers."¹⁰

Finally, in a case where the State of Arkansas was the preference defendant,¹¹ the court held that the debtor's $243,328 pre-bankruptcy settlement payments to the state for its beverage distribution tax were recoverable preference payments, made only because of the state's threat to close it down if it did not pay the tax.¹²

How to reduce the impact of a preference action

Tanners, Huntco, and Scully show the problem - many plaintiffs settle lawsuits for what is viewed as an unsecured promise to make cash payments, enforceable only by the right to sue on the settlement agreement. Further, even assuming the plaintiff receives payment, it could be subject to preference law. So our plaintiff needs other ways to mitigate the effect of a preference suit since it cannot control the defendant's choice to file bankruptcy or the timing. The following devices are often used alone or together.

Preserve the claim's full value. The plaintiff should preserve the claim's full value (not the settlement amount) until the preference period (90 days) passes. For example, suppose the plaintiff in Huntco claimed damages of $500,000, but settled for $130,000. The defendant could consent to a judgment for $500,000, which the plaintiff would hold for 90 days after the final settlement payment. Then, if the defendant files bankruptcy within 90 days, the plaintiff has a judgment (and a claim against the bankruptcy estate) for $500,000 in the bankruptcy case, rather than $130,000.¹³ If the 90-day period runs with no bankruptcy, the plaintiff keeps the settlement funds and releases the judgment or lien.

Although a claim of $500,000 or $130,000 are often equally worthless in a typical no-asset bankruptcy case, where there are assets and there is a distribution, the claim's value might be important, as the bankruptcy estate pays unsecured creditors on a pro rata basis.

Request a guaranty. A plaintiff should also require a guaranty that would take effect upon the defendant's bankruptcy or a preference action. While bankruptcy protects the debtor from collection actions, it usually does not protect a guarantor.¹⁴

For example, where the defendant is a business, the plaintiff could request that one or more of the owners guarantee the settlement payments. This allows the plaintiff to sue the guarantor notwithstanding the bankruptcy.

Use the earmarking doctrine. Plaintiffs should also ask that the defendant make the settlement payments from funds provided by a third party via the earmarking doctrine rather than the defendant. The earmarking doctrine provides that the debtor's use of borrowed funds to pay a pre-existing debt is not a transfer of the debtor's property.¹⁵ And, if the debtor did not transfer its property, the trustee cannot satisfy all the elements of a preference action.¹⁶

So for example, the plaintiff could ask that, rather than receiving settlement payment(s) from the defendant, the payments come from a third-party party and only "flow through" the defendant. This requires (1) an agreement between the debtor and third-party through which the third-party will pay a debt, (2) performance, (3) the debtor's lack of dispositive control over the property, and (4) that the transfer has no negative impact on the bankruptcy estate.¹⁷

Request certified funds immediately, with the largest payment first. Request payment in certified funds delivered immediately to begin the 90-day reach back period. The "reach back" period is 90 days from the date of bankruptcy.¹⁸ Payment by certified funds starts the preference clock sooner as payment by regular check occurs, for preference purposes, when the check clears the debtor's bank, not the date that the debtor receives the check.¹⁹ The payment date for a cashier's check is upon physical possession.²⁰ This difference could be significant. And besides, certified funds reduce the chance of a bad check and related delays.

Challenge the debtor's insolvency at the time of the transfer. A preference suit requires that the defendant/debtor was insolvent at the time of the transfer.²¹ Although the Code presumes insolvency within 90 days before bankruptcy, it is a rebuttable presumption that, at a minimum, prompts a review of the debtor's bankruptcy schedules.

For example, in one case, the bankruptcy trustee sued a law firm that received payments from the debtor prior to bankruptcy based on an already accrued legal bill.²² In its successful defense, the law firm used the debtor's own schedules to show that at the time of the transfer he was solvent, thereby rebutting the presumption of insolvency.²³

Special note to mechanics lien claimants. Mechanics lien claimants who face a preference action should review Golfview Developmental Center, Inc. v. All-Tech Decorating Company (In re Golfview Developmental Center, Inc.)²⁴ That case, too lengthy to discuss here, is an in-depth analysis on the relationship between mechanics lien claimants and preference law, helpful to those claimants defending a preference action.

Preserving tort claims through collateral estoppel

A plaintiff who dodges the preference bullet might face another problem if the defendant files bankruptcy - having the claim discharged in bankruptcy. As most know, the ultimate goal of a debtor in bankruptcy is to come out on the other end with its debts discharged, meaning those with claims against it cannot collect. And, since the debtor cannot prospectively waive its right to a bankruptcy discharge,²⁵ the problem is how to prevent discharge.

While the claims based on contract are ordinarily discharged, it might be possible to preserve certain related tort claims listed in section 523 of the Code through litigation brought in the bankruptcy court.

Section 523 of the Bankruptcy Code. Section 523 of the Code provides that a debtor cannot discharge certain claims for public policy reasons or when the claim arises from certain torts or "bad acts." For instance, you cannot discharge domestic support obligations²⁶ or claims from injuries caused by drunk driving.²⁷ Besides the claims that are automatically non-dischargeable, section 523 contains three more exceptions to discharge that apply to tort or fraud cases. Those exceptions require a lawsuit by the creditor in the bankruptcy court to prevent discharge.

These exceptions are for property obtained by false pretenses (section 523(a)(2)); fraud in a fiduciary capacity, larceny, or embezzlement (section 523(a)(4)); and willful or malicious injury (sections 523(a)(6)).²⁸ These sections require that the plaintiff actually file suit in the bankruptcy court and ask for that determination - relief is not automatic.²⁹

While the prospect of litigating again in bankruptcy court is not appealing, plaintiffs can shorten their time in bankruptcy court by foreclosing the debtor's ability to defend through (1) settlement documents that contain the defendant's admissions of, for instance, fraud, and (2) the doctrine of collateral estoppel.

Collateral estoppel. Collateral estoppel, or issue preclusion, bars or forecloses the re-litigation of an issue decided in an earlier case³⁰ and applies in proceedings under section 523(a).³¹ Thus, even though bankruptcy courts can determine the dischargeability of debt, "it does not mean that every last fact issue bearing on dischargeability must be re-litigated, re-tried, and again decided when there has been a prior determination of the same facts by a court of competent jurisdiction."³²

Accordingly, if a prior court has already made certain determinations during settlement, the bankruptcy court's job is not to be fact-finder, but only to determine whether it should give the documents from the prior proceeding collateral estoppel effect and enter judgment.

Most states, including Illinois, require that (1) the issues previously decided are identical to issues presented in the current proceeding; "(2) there be a final judgment on the merits; and (3) the party against whom estoppel is asserted was a party or in privity with a party in the prior action."³³ A recent case, KI O. Son v. Heung Ser Park, illustrates the potent combination of well-crafted settlement documents and collateral estoppel.³⁴

There, the parties settled several claims including fraud requiring the defendant's payment of $380,000 in installments. It further required that he execute a stipulated judgment for the full amount that the plaintiff could enter ex parte if the defendant breached the agreement. Most important, the stipulated judgment contained the defendant's admissions of fraud and the court's findings of fraud.

After settlement, the defendant failed to make any payments and filed bankruptcy so the plaintiff moved the state court for entry of the stipulated judgment.

The plaintiff then filed a complaint under section 523(a) in the bankruptcy court and a motion for summary judgment. It argued that the state court judgment established all of the elements required for a finding of fraud and that collateral estoppel allowed the bankruptcy court to determine that the debt is not dischargeable without any further proceedings.

The bankruptcy court and, on appeal, the district court, agreed, finding that the debt arose out of a judgment based on fraud and that the state court "issued a judgment per the terms of the settlement agreement...which provided specifically that the judgment was for fraud."³⁵

Precise drafting needed. While the documents and language necessary to achieve the results in KI O. Son might vary depending on the court, it seems clear that the plaintiff must err on the side of very detailed and unambiguous language as demonstrated in Northwest Bank & Trust Company v. Edwards.³⁶

That case involved a bank's suit to collect a defaulted loan that also alleged the borrowers committed fraud. The case settled under terms that required the borrowers make monthly payments and execute a consent judgment that contained language indicating that the borrowers admitted to fraud and misrepresentation. After settlement, the borrowers made some of the required payments and then filed bankruptcy leaving a substantial amount unpaid.

The bank filed a complaint in the bankruptcy court under section 523 and moved for summary judgment arguing the debt should not be discharged based on the borrowers' admissions of fraud in the consent decree and the doctrine of collateral estoppel.³⁷

Although the bank appeared ready for the borrowers' bankruptcy with consent judgment in hand, the court denied the motion.

The court reviewed the elements of fraud that included intent to deceive. It also reviewed the language from the consent judgment and held that the consent judgment lacked the borrowers' specific and unequivocal admissions of their intent to deceive the bank. The court noted that "the "application of the doctrine of collateral estoppel to consent judgments places an undue premium on draftsmanship" but given the "harshness of the remedy of denial of dischargeability," it is necessary.³⁸

It seems clear that the bank might have avoided this result with minor changes in the consent judgment.

Conclusion

The documents associated with settlement can protect the plaintiff against the defendant's bankruptcy. First, they can enable a plaintiff to avoid or at the very least reduce the impact of a preference action. Second, they can let a plaintiff reduce the expense and time involved in preserving settled tort claims, including fraud, through the execution of admissions and findings by the trial court.

Christopher Lega <clega@jnlegal.net> is a Chicago attorney practicing primarily in the areas of bankruptcy and commercial litigation.

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1. 11 U.S.C. § 547(b) provides in relevant part that the trustee may 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; or
   (B) between ninety 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.
   11 U.S.C. § 547(b).
2. In the Matter of Tolona Pizza Products Corp., 3 F.3d 1029, 1032 (7th Cir. 1993).
3. 11 U.S.C. § 547(c).
4. The common defenses are: (1) "ordinary course" where the payment was made on a typical debt between the debtor and the creditor for service or product made under ordinary terms; (2) "contemporaneous exchange" for transfers made for a contemporaneous transfer of goods or services; and (3) "new value" where after the payment the debtor received additional services. 11 U.S.C. § 547(c).
5. 184 B.R. 520 (Bankr. E.D. Mich. 1995).
6. Id. at 521.
7. Id.
8. Maloney-Crawford, Inc., v. Huntco Steel, Inc., (In re Maloney-Crawford, Inc.), 144 B.R. 531 (Bankr. N.D. Okla. 1992).
9. Id. at 533
10. Id. at 536.
11. Scully v. State of Arkansas Department of Finance & Administration (In re Valley Food Services, LLC), 389 B.R. 685 (Bankr. W.D. Mo. 2008).
12. Id. at 690.
13. Under bankruptcy law, unsecured creditors receive a pro rata distribution so the creditor with the largest dollar amount will receive the largest payout. See 11 U.S.C. § 726(b).
14. 555 M Manufacturing, Inc., v. Calvin Klein, Inc., 13 F. Supp. 2d 719, 722 (N.D. Ill. 1998)(generally the automatic stay applies to the debtor, not its insurers, guarantors, or sureties).
15. Steinberg v. NCNB Nat'l Bank of North Carolina (In re Grabill Corp.), 135 B.R. 101, 108 (Bankr. N.D. Ill. 1991); In re BNT Terminals, Inc., 125 B.R. 963, 970 (Bankr. N.D. Ill. 1990).
16. Brown v. First National Bank of Little Rock, Arkansas (In re Ark-La Materials, Inc.,), 748 F.2d 490, 491 (8th Cir. 1984)(no preference where funds used to pay corporate obligations were not property of the debtor corporation, but from the personal bank accounts of individual owners).
17. Adams v. Anderson (In re Superior Stamp & Coin Co., Inc.), 223 F.3d 1004, 1008 (9th Cir. 2000).
18. 11 U.S.C. § 547(b)(4)(A).
19. Barnhill v. Johnson, 503 U.S. 393, 401 (1992).
20. Vasquez v. Mora (In re Mora), 218 B.R. 71, 73 (B.A.P. 9th Cir. 1998).
21. 11 U.S.C. § 101(32).
22. Fokkena v. Winston, Reuber, Byrne, P.C. (In re Johnson), 189 B.R. 744 (N.D. Iowa 1995).
23. Id. at 747.
24. 309 B.R. 758 (Bankr. N.D. Ill. 2004).
25. Paneras v. Sterna (In re Paneras), 195 B.R. 395, 403 (Bankr. N.D. Ill. 1996).
26. 11 U.S.C. § 523(a)(5).
27. 11 U.S.C. § 523(a)(9).
28. This article will focus on the fraud component of 523(a)(2), but collateral estoppel is also applicable to (a)(4) and (a)(6). See for example In re Davis-Rice, 2008 WL 8444807 (9th Cir. B.A.P.) where a prior criminal conviction served as the basis under 523(a)(4) for the court to hold debt non-dischargeable.
29. In re Miller, 228 B.R. 203, 207 (Bankr. N.D. Ill. 1999).
30. Ellis v. Board of Jewish Education, 722 F. Supp. 2d 1006, 1010 (N.D. Ill. 2010).
31. Grogan v. Garner, 498 U.S. 279, 284 n.11 (1991).
32. Union National Bank of Marseilles v. Leigh (In re Leigh), 165 B.R. 203, 218 (Bankr. N.D. Ill. 1993).
33. Brokaw v. Weaver, 305 F.3d 660, 669 (7th Cir. 2002); Northwest Bank & Trust Company v. Edwards (In re Edwards), 439 B.R. 870, 873-74 (Bankr. C.D. Ill. 2010).
34. 2010 WL 4807089 (N.D. Cal); See also Fifth Third Bank v. Baumhaft (In re Baumhaft), 271 B.R. 523 (Bankr. E.D. Mich. 2001).
35. KI O. Son, 2010 WL 4807089, *6.
36. 439 B.R. 870, 873-74 (Bankr. C.D. Ill. 2010).
37. Id.
38. Id. at 876.