Often litigation successes turn to profitless nightmares with the filing of a bankruptcy. A multi-million dollar judgment or a composite 20-year settlement agreement may be worthless against a defendant under bankruptcy protection, even if the defendant is completely solvent. In fact, because a worthless judgment or settlement still require the expenditures of costs and attorney's fees, it might be less costly to abandon rather than pursue litigation, even if the defendant is undeniably liable.
The filing of a bankruptcy petition stays all litigation pending an "orderly" resolution of the claims against the debtor. It often readjusts the pay-out to creditors (including a plaintiff) by ordering payment of only a portion of their claims or even of none at all and discharges the remaining debt. It may even permit the defendant to "reject" an ongoing settlement agreement as an executory contract.
Many litigation attorneys admit they are ignorant of the effects their actions may have in a later bankruptcy. Therefore, a plaintiff should insist that competent bankruptcy counsel review settlement documents and documents filed with the court.
Is the defendant a candidate? It is imperative to determine whether a defendant will likely frustrate a hard won victory with a bankruptcy. There are certain telltale signs which indicate bankruptcy may be imminent. The following are behaviors and circumstances which should be questioned:
- Is the defendant also a defendant in other lawsuits?
- Has the defendant stopped making payments, or made payments in abnormal amounts, to its ordinary trade creditors?
- Is the defendant actively marketing itself as a going, concern?
- Even if the debtor is a large, solid-looking company, is it subject to a substantial number of parasitic leases?
- Is the defendant's counsel a rec-ognized bankruptcy attorney?
Remember that some defendant entities will not even begin to explore the bankruptcy option until a looming judgment or unperformable settlement agreement forces them. The best tactic for the plaintiff is to anticipate bankruptcy before the defendant does.
The complaint. If properly drafted, the pleading filed to initiate litigation may protect the ultimate judgment from the effects of bankruptcy. However, a poorly drafted complaint can be destructive. For instance, one judicial interpretation of a series of interrelated court decisions is that a judgment obtained by default before bankruptcy requires a bankruptcy court to accept as true all facts pleaded in the complaint. If the complaint filed in the original action did not contain facts sufficient to form the basis of a cause of action, the default judgment cannot be relied upon for anything except the amount of the claim.
For instance, while a default judgment based upon fraud may be excepted from a bankruptcy discharge, the fraud issue may be subject to relitigation if the elements of fraud are not expressly identified in the complaint in the original lawsuit.
Settlements. The way a lawsuit is settled also dictates whether a com-promise will benefit the plaintiff after the defendant's bankruptcy. A settlement agreement can be thwarted by the avoidance powers of a trustee in bankruptcy (who, in a case under Chapter 11 of the Bankruptcy Code, is the defendant itself). If the defendant pays money under a settlement agreement, that payment may be avoidable - and the court may order the money returned to the trustee - if a bankruptcy is filed within 90 days after the payment. Moreover, if under the settlement agreement the defendant consented to the attachment and perfection of a security interest on its assets, this security interest can be avoided in the same way.
A safeguard against the avoidance trapdoor is to obtain a judicial determination (i.e., a consent to judgment) of the facts underlying the plaintiff's cause of action. In the alternative the plaintiff should secure a simple declaration from the defendant that monies were owed on a note or contract, or that certain tortious acts were committed. The benefits of this form of settlement are twofold. First, a judicial determination of the facts precludes the defendant - or a successor trustee in bankruptcy - from contesting the issues arising underlying the judgment. Second, the entry of judgment in many jurisdictions becomes a lien on real property interests owned by the defendant in the judicial district in which judgment was entered.
Another safe guard is patience. Many transactions are avoidable as preferential if they occur within 90 days before the defendant filed a bankruptcy petition. A structured settlement imposing a lien on the debtor's assets but not requiring payment until after the 90th day after perfection reduces the avoidance risk. However, it is critical that the location and status of the defendant's major encumbered assets be monitored closely. Although a lien will often take priority over the subsequent transferee of an asset, hens do not always survive transfers. And even a surviving lien on an asset is worthless if the asset cannot be located.
Competent bankruptcy counsel is aware of all these tactics and will seek to prevent them when able. Moreover, a defendant contemplating a Chapter 7 bankruptcy, in which all the defendant's assets would be transferred to and liquidated by a third-party trustee, might use this knowledge to gain leverage in cer-tain circumstances.
The bankruptcy process adds a series of obstacles and pitfalls which can frustrate the efforts of the unwary plaintiff. Without proper planning, even the ostensibly successful plaintiff may have obtained only a Pyrrhic victory, an unenforceable piece of paper called a judgment.
For more information on this issue, contact Alan M. Grochal at 410/752-9715, Robert A. Gordon at 410/752-9749 or Adam Hiller at 410/752-9739.