Minimizing Bankruptcy Risks in Settlement Agreements

Creditors often enter into structured settlement agreements without ever giving heed to the possibility of bankruptcy.  This is an unfortunate, albeit common mistake that I have witnessed first-hand from clients in Orange County and elsewhere in California.  The defendant may enter into a settlement agreement, make a few payments, and then decide to stop making payments and file for bankruptcy.  Unless the debt is one that would be considered non-dischargeable under Bankruptcy Code §523, then there is a high probability that it will be discharged and the creditor will be unable to collect.  Furthermore, the creditor is actually at risk of losing any payments that were made to it within 90 days of the bankruptcy filing under a preference action by the bankruptcy trustee.  For these reasons, it is important for creditors to take precautions to secure payment from debtors.

Preserving the Claim – In the settlement agreement, be sure to insert language that preserves and revives all claims against the debtor to their original status automatically in the event that payment ceases.  If this language is not included, it is possible that a court might consider the creditor’s claim no longer valid or reduced to the lower settlement amount.

Preserving Non-Dischargeability – If the creditor is fortunate enough to have a debt that qualifies as non-dischargeable under Bankruptcy Code §523 then the creditor will want to be very certain that it does not inadvertently bargain away its future rights in the settlement agreement.  In re Warner, 283 F.3d 230 (4th Cir. 2002), the U.S. Court of Appeals for the Fourth Circuit held that the plaintiff had given up its claim for a non-dischargeable debt by entering into a settlement agreement and substituting a new contractual obligation. The simplest way to address this risk is for the settlement agreement to clearly state the grounds for the debt being paid, so that the debtor will be find it difficult to later dispute those grounds. Rather than simply stating that the debt is non-dischargeable, the actual grounds for non-dischargeability (e.g. fraud, child support payments, etc.) should be stipulated, using the relevant language in Bankruptcy Code §523 as a guide.  Generally, this type of language will aid in preserving and even supporting a later claim for non-dischargeability.  However, keep in mind that any kind of agreement attempting to bargain for non-dischargeability is unenforceable as violating public policy; and that an agreement of non-dischargeability alone is not enforceable.  In re Huang, 275 F.3d 1173 (9th Cir. 2001).

It is quite possible that the creditor may be unable to get the defendant to agree to the inclusion of explicit language in support of a claim for non-dischargeability.  At the very minimum though, creditors should require that the settlement agreement expressly state that it is not the creation of a new obligation, and that the plaintiff preserves its right to assert the non-dischargeable nature of the debt in the future.

The specific language contained in settlement agreements is critical when creditors resolve debts with debtors via payments over time.  If you have questions regarding your debt collection matter in Orange County or elsewhere in California, please feel free to contact us.

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