Unsettling issues

When people settle their disputes both parties usually give up something of value. In exchange they save the time and expense of lawsuits and minimize the risk that a court won't agree with their position. Courts with overburdened schedules encourage parties to settle. Some courts require that the parties try to settle their claims through mediation before they can get to trial. Therefore, it's alarming to realize that if one of the parties to the settlement subsequently files bankruptcy, the bankruptcy court and estate representative might second-guess the settlement and require that the payments and other consideration paid and received as part of the settlement be returned to the bankruptcy estate.

The Bankruptcy Code gives the estate representative (the "trustee" in Chapter 7 liquidation or the "debtor in possession" in a Chapter 11) the power to set aside "transfers" that the bankrupt made prior to the bankruptcy filing if the transfers meet certain requirements. A settlement involves these types of "transfers." Payment of money, release of claims, granting liens or other security as part of the settlement are all "transfers" under the Bankruptcy Code. Settling parties can take some simple precautions to protect the "transfers" that they negotiated for and received in the settlement.

Traps for the settling plaintiffs

Plaintiffs can protect their settlement by not giving up their claims against any person or property unless no bankruptcy is filed until all the settlement payments are made, and the exposure period expires. Wait for 91 days after you get the final settlement payment to sign any releases. If the defendant is a relative or affiliate, the exposure period is a year and a day. An affiliate can be a relative, partner, partnership, officer, director, major shareholder, managing agent or other person the bankruptcy court finds to be "in control of" the defendant.

The waiting period should be part of the settlement. The settlement should say that the settling defendant (and any guarantors) is not released from the full amount of the claim if any of them file bankruptcy during the exposure period. As part of the settlement, the defendant and the guarantors should acknowledge that if the settlement payments are not made or if the settlement payments are set aside for any reason the full amount of the plaintiff's claim remains due and payable from the defendant and the guarantors. Be careful if the settlement involves a lien on property. There are several traps here. The lien can be lost if the defendant files bankruptcy within the exposure period beginning from the date the lien is recorded. If the lien is not properly recorded, or if it contains errors that are misleading (such as misspelling the defendant's name) the lien can be set aside in a bankruptcy.

Sometimes the defendant will give a lien to secure installment payments of the settlement amount. If so, and if the property secured by the lien is worth as much as the settlement, the "exposure period" runs from the date the lien has been filed. If the settling defendant is paying in installments be careful not to push too hard for payment until the exposure period has passed. If a bankruptcy is filed within the exposure period the lien, as well as payments made during the exposure period, will be lost.

Traps for settling defendants

Settling defendants who extract a "great deal" from a financially distressed plaintiff are also at risk if the plaintiff files bankruptcy. The "exposure period" for these types of settlements is two years after the settlement is finalized. The Bankruptcy Code permits the estate to set aside the settlement if the plaintiff got less than "reasonably equivalent" value. The same test will be applied to asset sales and other situations where a financially distressed company parts with assets at bargain prices.

The best protection against losing the settlement is to have a hearing at the time you agree to the settlement so that the judge presiding over the lawsuit can find that the settlement was fair and reasonable. Sometimes courts are not willing to take time from their crowded dockets to hear evidence about a case that has been settled. Judges may not understand why they have to find that the settlement was "fair and reasonable," and the plaintiff might not want to let the public know that it is having financial problems. If the court won't conduct a hearing, an alternative is to have the plaintiff's representatives (for example, partners, officers and directors) adopt proper resolutions approving the settlement and sign affidavits with facts that show that the settlement is fair and reasonable and file them with the court. Then the order approving the settlement can state that the court has considered these affidavits and finds that the settlement is fair and reasonable. This procedure is not as persuasive to the bankruptcy court as a fill hearing but it is better than nothing.

If no lawsuit has been filed, you should get the same type of affidavits and resolutions and keep them as insurance. These affidavits have to list specific facts like defenses the defendant has to the plaintiff's claims. The bankruptcy court will review these affidavits, which are binding on the plaintiff, to determine if the facts in the affidavits demonstrate that the settlement was reasonable.

Settling defendants should also obtain financial information about the plaintiff. Audited financial statements and cash-flow statements prepared by independent accountants can establish that the plaintiff does not meet the level of financial distress required to have the settlement set aside. Appraisals can demonstrate the value of assets being exchanged. However, any financial information or other evidence relating to the reasonableness of the settlement or the financial condition of the other party to the lawsuit or business deal may prove valuable. Memories and financial information available to the bankruptcy estate may not be as persuasive as contemporaneous declarations of the people involved in the deal at the time the deal was done. A bankruptcy court's assumption regarding the financial condition of a troubled company can be changed if the court is presented with good financial information prepared at the time of the events in question.

Often a settlement comes after a lengthy battle. The last thing the parties want is to go through more negotiations about the reasons behind the settlement or to prolong the financial consequences of the claim they thought they were settling. However, the precautions to "bankruptcy-proof" the settlement may protect against a loss of the benefits of the bargain. If the bargain was worth making, it is worth protecting.

Kaaran E. Thomas is chairperson of McDonald Carano Wilson's creditors' rights, bankruptcy and corporate restructuring group and practices primarily in the areas of commercial bankruptcy, debt restructuring, workouts and commercial litigation.