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Potential bankruptcy landmines wait for unwary in Arizona
By Bryce Suzuki and Amanda Cartwright
The Record Reporter
July 16, 2014
It’s a situation familiar to many litigants and their counsel: After years of litigating claims against multiple corporate and individual defendants
in court, with discovery complete and hundreds of thousands of dollars expended in legal fees, you finally enter into settlement negotiations
with your litigation adversaries.
As the parties are negotiating drafts of the definitive settlement agreement, however, you learn that a key defendant is in financial distress,
with bankruptcy looming as a real possibility.
Should you press forward with the settlement? If so, what issues might be implicated by a bankruptcy filing? Dealing effectively with these
issues requires the expertise of an experienced insolvency lawyer, who can guide you through the potential minefield of bankruptcy and its
unique risks.
Risk of non-payment
The first risk is perhaps the most obvious. The financially distressed defendant may not be able to fulfill the payment terms of the settlement.
In fact, a request to make structured payments over time is often an indicator of a defendant’s financial distress. Absent a valid lien to secure
payment, the settling party’s liability will be considered “unsecured” in the bankruptcy context, and you are likely to receive only pennies on
the dollar. Further, even if the settling party’s obligation is collateralized, a lien granted within the 90 days prior to bankruptcy often can be set
aside (in bankruptcy terminology, “avoided”) by the bankrupt party or a bankruptcy trustee.
Risk of preference liability
Similarly, a settlement requiring any type of cash payment or property transfer inherently involves the risk that such payment or transfer will
be clawed back as a “preference,” if the payment or transfer is made within 90 days before the bankruptcy filing. Preference clawbacks are
particularly galling to a plaintiff who is forced to return payments, sometimes large payments, to the defendant who still owes the plaintiff
substantial sums of money under a settlement. While certain defenses exist to these preference clawbacks, the bankruptcy statutes generally
weigh heavily against the recipient of payments or transfers made outside the ordinary course of a debtor’s business within the 90 days
preceding bankruptcy.
Perhaps the simplest way to mitigate this risk is to “start the 90-day clock” as soon as possible, on the hope that the settling party won’t file
bankruptcy, if at all, until after the 90th day following payment. Because preferences are recoverable only if paid within the 90 days preceding
bankruptcy, on the 90-first day the preference risk disappears.
Another approach involves deferring cash payments and collateralizing assets. If the settling party is tight on cash but has some
unencumbered assets, you could defer payments for 90 days, allowing the settling party to use the cash for ongoing business needs, and
take a security interest in non-cash assets. Although the security interest itself would be vulnerable to avoidance as a preference within the 90
days after perfection, if the arrangement allowed the settling party to survive through the 90-day preference period, you could be assured of
ultimately realizing the value of the settlement through your collateral, even in bankruptcy. In the sometimes counter-intuitive world of
bankruptcy, a secured payment obligation, like the one in the foregoing example, may be preferable to a “cash on the barrelhead” settlement.
Rejection as an executory contract
In some cases, the settlement agreement itself may be subject to rejection as an “executory contract” under the bankruptcy statutes. A
contract is considered executory if the obligations of both the debtor in bankruptcy and the other party to the contract are so far unperformed
that the failure of either to complete performance would constitute a material breach excusing performance of the other.
Bankruptcy courts generally give substantial deference to a debtor’s decision to assume or reject an executory contract, absent a debtor’s
bad faith or a gross deviation from reasonable business judgment. If the settlement agreement is ultimately rejected, the bankruptcy court will
treat the contract as breached immediately prior to the bankruptcy filing, and the non-debtor contracting party generally is left with an
unsecured claim for damages resulting from the breach of the rejected contract.
The non-debtor party would be paid pro rata with the debtor’s other unsecured creditors (usually pennies on the dollar), and any remaining
obligations under the agreement are extinguished.
Extinguishment of original litigation claim
Preserving your litigation claim may be an issue outside the context of executory contract rejection as well. The typical situation involves the
plaintiff accepting the payment specified under the settlement agreement from the defendant, and in turn immediately gives the defendant a
full release of all claims and dismisses the underlying lawsuit with prejudice.
Later, after the defendant files a bankruptcy petition, the settlement payment is clawed back as a preference. What happens to the original
claim? In all likelihood, the plaintiff will be hard pressed to revive its original claim, leaving it with only an unsecured claim for the amount of
the preference plus any remaining amounts due under the settlement agreement, all to be paid cents on the dollar, rather than having the
ability to receive pro rata payment for the full amount of the original, much larger litigation claim.
One approach for avoiding this trap is to have the defendant stipulate to the entry of judgment for the full amount of the plaintiff’s litigation
claim, record the judgment, and covenant not to execute on the judgment provided that the defendant fulfills the terms of the settlement, some
or all of which conveniently will not occur until 91 days after recording the judgment. Even if a bankruptcy is filed within the 90-day window,
the plaintiff generally should be able to assert the litigation claim in full, as supported by the judgment (even though the effect of recording the
judgment may be subject to avoidance as a preference).
Get the advice of an insolvency specialist
In sum, the possibility of a bankruptcy filing by a party to a settlement agreement implicates many complex issues of bankruptcy law that may
directly impact your ability to recover the full amount to which you’re entitled under a settlement. If one of the parties to your proposed
settlement is in financial distress, contact counsel specializing in bankruptcy and insolvency issues to evaluate your options and help structure
the settlement agreement to survive the bankruptcy minefield.
Bryce A. Suzuki, a partner in Bryan Cave’s Phoenix office, represents secured and unsecured creditors, debtors, landlords,
vendors, bankruptcy investors, and equity security holders in all aspects of commercial restructuring and bankruptcy,
including non-bankruptcy business workouts, asset sales, Chapter 11 bankruptcy administration and reorganization,
liquidation, enforcement of creditors’ rights, distressed financing, bankruptcy litigation and appellate work. He regularly firstchairs trials in bankruptcy courts and has handled bankruptcy cases in jurisdictions across the country by admission pro hac
vice. Bryce can be reached at [email protected] or (602) 364-7285.
Amanda L. Cartwright, an associate in Bryan Cave’s Phoenix Office, practices in the Bankruptcy, Restructuring and
Creditors’ Rights Client Service Group. Prior to joining the firm, Amanda served as law clerk to the Honorable Kevin Gross,
United States Bankruptcy Court for the District of Delaware. Prior to law school, she was a financial consultant for a global
business advisory firm, providing corporate restructuring and transactional advisory services to multinational corporations.
Amanda can be reached at [email protected] or (602) 364-7308.