Should Bankruptcy Counsel Review a Settlement/Agreement Absent a Bankruptcy Filing?

When a company or individual is facing insolvency proceedings, often times the insolvent party will settle a lawsuit or reach an agreement on essential terms of a deal in advance of a filing. Why waste the money having a competent bankruptcy lawyer review a settlement or agreement in such a case? A recent Ninth Circuit decision is illustrative.

The Ninth Circuit Court of Appeals in In Re Richard L. Priddis, 2023 WL 2203562 (9th Cir. 2023) (Unpub.) reversed a bankruptcy court decision (which was affirmed on appeal by the district court) where the bankruptcy court granted summary judgment in favor of the involuntary debtor and dismissed an involuntary bankruptcy on the basis that the creditors failed to satisfy the numerosity requirement for an involuntary petition. In Priddis, 14 record companies settled a copyright infringement suit related to a karaoke business. As part of that settlement agreement, the record companies obtained the right to file a $3 million stipulated judgment if Priddis breached the settlement, which it did. Following entry of the stipulated judgment, the music companies instituted an involuntary bankruptcy proceeding against Priddis. Three or more creditors holding claims that are not contingent or subject to a bona fide dispute are required for an involuntary petition if there are 12 or more total creditors pursuant to Section 303(b)(1) of the Bankruptcy Code. Accordingly, the bankruptcy court granted the debtor’s motion for summary judgment holding that the $3 million agreed judgment was a single joint claim because it did not allocate the $3 million among each plaintiff/petitioning creditor (which the decision was later affirmed on appeal to the U.S. District Court). The petitioning creditors next appealed to the Ninth Circuit Court of Appeals.

The Court of Appeals reversed the bankruptcy and district courts finding that each of the 14 petitioning creditors had a claim to the $3 million judgment, and therefore the creditors satisfied the numerosity requirement. The Court of Appeals pointed out that a claim is a “right to payment, whether or not such a right is reduced to judgment.” 11 U.S.C. § 101(5)(A). Thus, the Court of Appeals found that under the text of Bankruptcy Code Sections 303(b) and 101(5), the petitioning creditors had “noncontingent, undisputed claims” because the $3 million amount was not in dispute, and they each had a “right to payment” of some portion of the judgment. Moreover, their right to payment was individually enforceable because the judgment was easily divisible, and the allocated portion was traceable to each creditor. The Court of Appeals also relied on the music publishers’ complaint in the underlying suit which contained a detailed list of each petitioning creditor’s ownership interests in the copyrights infringed by the debtor. Therefore, the Court of Appeals found that the $3 million judgment could be readily divided according to those established interests, as shown in the petition for involuntary bankruptcy.

The Court of Appeals further found the proposed division reflected the petitioning creditors’ original claims because they stipulated to statutory damages in the underlying suit. The Court of Appeals noted that when a copyright owner elects statutory damages for infringement under the Copyright Act, they receive a fixed amount according to their ownership interests for all infringements involved in the action, citing 17 U.S.C. § 504(c)(1). The distribution of the judgment operated the same way it would have for any judgment in the original action in that each petitioning creditor was entitled to a portion of the judgment based on its ownership interests, and only that portion. The Court of Appeals did not believe that a written agreement was required to make the judgment readily divisible because a copyright owner is only entitled to recover up to the amount owed. The Court relied upon the list of copyright interests attached to the complaint, which it believed made clear the amount that each individual creditor was owed.

While the petitioning creditors ultimately prevailed, it took the extraordinary expense of the bankruptcy court trial and two appeals to get there. This probably could have been avoided had the stipulation and judgment allocated the recovery among the plaintiffs in the first place.

Leech Tishman Business Restructuring & Insolvency Partner Sandford L. Frey was recently retained in a matter in which the parties had attended mediation prior to his involvement, which resulted in a settlement of an approximately $4 million dollar judgment for approximately $850,000 paid overtime. The terms of the mediation settlement were set forth in a term sheet. It appeared that the judgment creditor did not consult with bankruptcy counsel in connection with the term sheet. The term sheet contained a number of obligations and contingencies, which included settlement with a third-party and it contemplated a final settlement agreement. After entering into the mediation term sheet, the judgment creditor appeared to have had second thoughts about the settlement and disavowed it claiming failure of certain contingencies. Leech Tishman was retained to file chapter 11 for the debtor. Thereafter, Leech Tishman counsel argued that the term sheet contained all of the material terms of the settlement. Moreover, due to the wording of the term sheet and the absence of any deadlines on the contingencies, the firm prevailed in its argument (over the objection and shock of the judgment creditor) that the term sheet was an executory contract; that it could be assumed by the debtor pursuant to Bankruptcy Code § 365; and that any defaults (i.e., contingencies) could be cured. In its Memorandum of Decision, the bankruptcy court, among other things, had the following to say:

Section 365(a) permits a debtor to assume or reject any executory contract or unexpired lease. Within the Ninth Circuit, the “Countryman” definition is generally applied to determine whether, for purposes of § 365, a contract is executory. In re Hertz, 536 B.R. 434, 439 (Bankr. C.D. Cal. 2015); citing In re Pacific Express, 780 F.2d 1482, 1487 (9th Cir. 1986)). Under that standard, a contract is executory if the obligations of both parties to the contract “are so far underperformed that the failure of either would constitute a material breach excusing the performance of the other.” Id. (citing Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439, 460 (1973), cited in In re Alexander, 670 F.2d 885, 887 (9th Cir. 1982)).

. . . .

The parties dispute whether the mediation term sheet is an executory contract. . . . In sum, the mediation term sheet is an executory contract that remained in effect as of the petition date with obligations remaining on both sides. True, as discussed below, that contract is unenforceable as long as the continency in paragraph 10 continues to apply; but once that contingency is removed then the contract becomes enforceable, and then it would be proper for Debtor to assume that contract for the benefit of all creditors and the bankruptcy estate.

As it is clear from the two examples discussed in this alert, the language of any agreement or contract can have material consequences in any subsequent bankruptcy proceeding. That is not to suggest that a bankruptcy attorney will insulate the client from all unforeseen problems. However, an experienced bankruptcy attorney’s advance review of settlement and other agreements can certainly reduce foreseeable bankruptcy risks ultimately resulting in a significant cost savings compared to the cost of later litigation as demonstrated from the examples discussed above.

Leech Tishman’s Business Restructuring & Insolvency Practice Group regularly assists clients in bankruptcy and bankruptcy litigation matters. If you have any questions about bankruptcy agreements or contracts, or what it might mean for bankruptcy proceedings, please contact Sandford L. Frey.

Sandy is a Partner with Leech Tishman and Co-Chair of the Business Restructuring & Insolvency Practice Group, where he co-leads the Bankruptcy Chapter 11 Debtor and Bankruptcy Chapter 11 Subchapter V Debtor Groups. Sandy is based in the Los Angeles office and can be reached at 626.796.4000 or sfrey@leechtishman.com.

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Leech Tishman Fuscaldo & Lampl, Inc. is a national, full-service law firm dedicated to assisting individuals, businesses, and institutions. Leech Tishman offers legal services in business restructuring & insolvency, construction, corporate matters, employment & labor, estates & trusts, intellectual property, litigation & alternative dispute resolution, and real estate. In addition, the firm offers a wide range of legal services to clients in the aviation & aerospace, cannabis, emerging cyber technologies, energy & natural resources, entertainment, healthcare, hospitality, and life sciences industries. With offices in Los Angeles, Leech Tishman also has offices in Chicago, Philadelphia, Pittsburgh, Sarasota, Washington, D.C., and Wilmington, DE.