Congratulations, you’ve settled your case! After a lengthy discovery process and hard-fought negotiations, your client and the opposition finally achieved a meeting of minds and you’ve wrangled a great deal for your client. You’re thinking you deserve a pat on the back as you watch the ink dry on the settlement document memorializing the agreement. But have you thought of everything?
What happens if your debtor files bankruptcy before the settlement amount is paid in full? Is your settlement agreement up to the challenge? Here are a few practice tips that will help ensure that your settlement is as sticky as possible and provides your client with the most protection it can.
Practice Tip: Get the state court to approve the factual recitals in the settlement agreement.
Under the Rooker-Feldman doctrine, lower federal courts that are courts of original jurisdiction, such as bankruptcy courts, have no appellate authority to sit in review of state court decisions, whether issued by the district court or appellate court.1 The principle in play is whether the state court actually considered and rendered a decision on the issue presented. If consideration and decision were accomplished, action by a federal court is deemed an impermissible appeal from the state court decision. If no consideration has been given, or any decision on the matter is ambiguous, it is likely that the federal court can take jurisdiction.2
Because a bankruptcy court cannot disturb a state court’s factual findings, getting the state court to approve your factual recitals in the settlement agreement will significantly decrease the time and resources you must expend in the bankruptcy proceeding. The goal is to have your claim pass through the bankruptcy, and not be discharged, so that your client can still collect from the debtor defendant. To accomplish that, you must file an adversary proceeding (a lawsuit) in the bankruptcy case to deny the debtor his discharge either generally under bankruptcy code section 727, or specifically as to your particular claim under bankruptcy code section 523. In either case, with the factual issues already decided by the state court, the Rooker-Feldman doctrine narrows the issues in your lawsuit to the dischargeability elements, thereby short-tracking your time to get to trial and resolve the issues of law alone and preserving your client’s valuable resources.
Practice Tip: Protect your settlement from attacks for fraudulent or preferential transfer.
In a bankruptcy case, the debtor or a trustee has the power to avoid certain types of transfers of property of the bankruptcy estate that took place before the case was filed. For example, when a plaintiff settles a lawsuit creating an obligation for the defendant, he makes a transfer of the claim to the settling defendant for payment. If the debtor defendant later files bankruptcy, the “transfer” can be set aside if the debtor defendant:
- received less than a reasonably equivalent value3 in exchange for the transfer or obligation; and the debtor defendant:
- was insolvent on the date the transfer was made or such obligation was incurred, or became insolvent as a result of the transfer or obligation;
- was engaged in, or about to become engaged in, a business or transaction for which any property remaining with the debtor defendant was an unreasonably small capital; or
- intended to incur, or believed that he would incur, debts that would be beyond his ability to repay as such debts matured; or
- made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of the debtor defendant’s business.4
Another example of a transfer that may be avoided or unwound is a preference. “Preference” is a term of art in bankruptcy. To be avoidable, a preferential transfer must meet several requirements, including that it was made “to or for the benefit of a creditor” generally “on or within 90 days before the date of the filing of the petition” and made “for or on account of an antecedent debt” owed by the debtor defendant where such transfer was made “while the
debtor was insolvent.”5
So, how long before your settlement is safe from attempts to avoid or unwind it? A debtor or trustee may file an action for the avoidance of a fraudulent transfer at any time within two years from the filing date of the bankruptcy case and can reach back to fraudulent transfers made or obligations incurred any time in the two years preceding the bankruptcy filing.6 For preferences, as noted above, the reach back period is usually 90 days, although the time period can be extended 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.7
Because of the scope of the powers afforded the debtor or a trustee to avoid fraudulent and preferential transfers, it is a good idea to have an independent accountant or auditor render an opinion in the state court proceeding that the payments contemplated by the settlement agreement are fair and reasonable and will not render the debtor defendant insolvent.
Another principle that can prove helpful is the earmarking doctrine, especially when you know your debtor defendant is financing the payment of the settlement amount. A fundamental element of avoidance actions in bankruptcy is that the transfer under attack must be a transfer of the debtor defendant’s interest in property.8 Absent this element, an avoidance action cannot be sustained unless the transfer “diminishes directly or indirectly the fund to which creditors of the same class can legally resort for the payment of their debts, to such an extent that it is impossible for other creditors of the same class to obtain as great a percentage as the favored one.”9
The earmarking doctrine prevents property controlled by another and used to pay off a debt from being included in the debtor defendant’s bankruptcy estate. This rule applies even when property is briefly in the debtor defendant’s possession merely for bookkeeping, record-keeping or transmittal purposes. In this jurisdiction, “[t]he earmarking doctrine requires: (1) the existence of an agreement between the new lender and the debtor that the new funds will be used to pay a specified antecedent debt; (2) performance of that agreement according to its terms; (3) the transaction viewed as a whole does not result in any diminution of the estate.”10 The initial burden of proving that transferred property is part of the bankrupt’s estate rests on the trustee or the debtor pursuing the avoidance action. The trustee or debtor also has the burden of proving the non-applicability of the earmarking doctrine.11
Resurrection of Full Claim
Practice Tip: Incentivize your debtor defendant but guard against default.
In the case of structured settlements (those involving more than a single payment), a powerful tool in negotiating the payment structure of your settlement is to provide a discount to your debtor defendant if payment is timely made or even paid off early. You must be aware of the possibility that your debtor defendant will default on the settlement payments at some point before he has paid the full amount owed under the agreement.
With that in mind, protect your client by including a provision in the settlement agreement providing that if the debtor defendant defaults on the settlement payments, or any or all of the settlement payments are avoided in a bankruptcy action, then the full amount of your client’s claim is resurrected and once again becomes due and owing. You should recognize that your client may still be vulnerable to discharge as an unsecured creditor in a subsequent bankruptcy case. However, if there should be a distribution to creditors in the case, your client will have a larger claim initially that will yield a larger pro rata share in the asset distribution. Which brings us to our final practice tip:
Secure the Stream of Settlement Payments
Practice Tip: Secure your client’s interests by taking collateral for your settlement.
A general rule of thumb is that it is better to be a secured creditor than an unsecured creditor. That is especially true in the bankruptcy context. Secured creditors come ahead of unsecured claims because their claims relate to an interest in the debtor defendant’s property that arose before the bankruptcy filing. In short, fully secured creditors get paid in full in bankruptcy. Moreover, a fully secured creditor (that is, a creditor having collateral whose value exceeds or at least equals the amount of debt secured) will defeat a preference action. This makes common sense because a payment to a fully secured creditor made by the debtor before bankruptcy does not “enable [the] creditor to receive more” than it would receive in the bankruptcy had the pre-bankruptcy payment not been made. In addition, a fully secured creditor or an oversecured creditor (if the collateral is valued at more than the secured creditor is owed) is entitled to adequate protection of the secured claim and such protection usually takes the form of monetary payments.12 Alternatively, a debtor may return collateral to a secured creditor for the purpose of lowering his monthly living expenses.13
The bankruptcy code orders the priority of distributions that may be made to unsecured creditors in a case. Domestic support obligations are paid first, ahead of all other claims. Allowed administrative expenses, such as professionals’ fees and costs, are paid next. After that, there are various other categories of unsecured claims that are paid, with general unsecured claims being paid last.14
Obviously, if your debtor defendant files bankruptcy before paying the settlement amount in full, your client may not realize the full benefit of the bargain you worked so hard for. That’s why, for the reasons discussed above, getting collateral for your settlement for the term of the repayment period is your best means of maximizing your client’s chances for receiving full payment. Although the transfer of the debtor defendant’s property in providing security for the settlement is vulnerable to attack as a preferential transfer for a period of time (as discussed above), once that time period expires, the collateral will provide your client with protection for future settlement payments that can withstand a bankruptcy proceeding.
Being cognizant of as many contingencies as possible while working to minimize your client’s risk is the practice of every good attorney. The practice tips provided here are just a few examples that you should keep in mind when structuring settlements for your clients. Happy negotiating!
1. Nevada Civil Practice Manual, § 2.02, (2007), Matthew Bender & Company, Inc. citing Dist. of Columbia Ct. of App. v. Feldman, 460 U.S. 462, 486-87 (1983); Rooker v. Fidelity Trust Co., 263 U.S. 413, 415-16 (1923); see also Angle v. Legislature of State of Nev., 274 F. Supp. 2d 1152, 1154-55 (D. Nev. 2003); Mirin v. Justices of Sup. Ct. of Nev., 415 F. Supp. 1178, 1193 (D. Nev. 1976).
2. G.C. & K.B. Invs., Inc. v. Wilson, 326 F.3d 1096, 1103 (9th Cir. 2003).
3. In the Ninth Circuit, reasonably equivalent value is determined by either looking at the totality of the circumstances or by making a comparison of the values exchanged. See In re BFP, 132 B.R. 748 (9th Cir. BAP 1991); In re United Energy Corp., 944 F.2d 589 (9th Cir. 1995). In comparing the values exchanged, a court looks to what the debtor received versus what debtor surrendered and whether the unsecured creditors are any worse off because of the transfer. See generally United Energy, 944 F.2d 589.
4. 11 U.S.C. § 548.
5. 11 U.S.C. § 547(b).
6. 11 U.S.C. §§ 546(a)(1), 548(a)(1).
7. 11 U.S.C. § 547(b)(4)(B).
8. Lehtonen v. Time Warner, Inc. (In re Purchasepro.com, Inc.) 332 B.R. 417, 423 (Bankr. D. Nev. 2005) (recognizing that “the term ‘property of the debtor’ in avoidance powers is coextensive with ‘property of the estate.’”).
9. Adams v. Anderson (In re Superior Stamp & Coin Co., Inc.),223 F.3d 1004, (9th Cir. 2000) citing Hansen v. MacDonald Meat Co. (In re Kemp Pacific Fisheries Inc.), 16 F.3d 313, 316 (9th Cir. 1994).
10 Adams v. Anderson (In re Superior Stamp & Coin Co., Inc.), 223 F.3d at 1008 (9th Cir. 2000) citing In re Kemp, 16 F.3d at.316.
12. 11 U.S.C. §§ 361-364; United Savings Ass’n v. Timbers of Inwood Forest Associates, Ltd., 108 S. Ct. 626 (1988).
13. In re Makres, 380 B.R. 30, 35 (Bankr. D. Okla. 2007).
14. 11 U.S.C. § 507(a).