In Busseto Foods, Inc. v. Charles Laizure (In re Laizure), No. 06-1112 (9th Cir. B.A.P., September 1, 2006), the Ninth Circuit Bankruptcy Appellate Panel affirmed a Bankruptcy Court decision holding that where a creditor receives a settlement payment on a nondischargeable debt within 90 days prior to bankruptcy but then is compelled to return that payment to the estate as a preference, the creditor’s nondischargeable claim against the debtor is not revived.

In Laizure, debtor Charles Laizure allegedly embezzled funds from Busseto Foods, Inc. ("BFI") while employed as its chief financial officer and controller.  Mr. Laizure entered into a settlement agreement with BFI, and made his final settlement payment of $38,833.70 in June 2005, less than 90 days before Mr. Laizure and his wife filed bankruptcy.  The trustee claimed that the final payment was preferential.  BFI settled the preference claim for $34,000 and filed a proof of claim in the bankruptcy for that amount.  BFI also filed a complaint for a determination of nondischargeability under Bankruptcy Code § 523(a)(4).  The Bankruptcy Court dismissed the complaint for failure to state a claim, reasoning that BFI was not owed a debt on the petition date and that, while Bankruptcy Code § 502(h) allows a creditor’s claim for property recovered under Bankruptcy Code § 502(h), this does not reinstate a personal claim against the debtor.

On appeal, BFI relied primarily on Bankruptcy Code § 502(h) to support its contention that its nondischargeable claim against the debtor was reinstated once it settled the preference action.  The Ninth Circuit Bankruptcy Appellate Panel noted that all but one of the cases cited by BFI held that the creditor has a claim against the estate by virtue of Bankruptcy Code § 502(h), not a claim against the debtor.  In In re Hackney, 93 B.R. 213 (Bankr. N.D.Cal. 1988), a bankruptcy court held that a transferee who pays back funds to a trustee has its nondischargeable claim against the debtor reinstated.  The Hackney court found Bankruptcy Code § 502(h) to be ambiguous on the issue of reinstatement of the claim and relied on underlying bankruptcy policy to hold that a creditor’s nondischargeable claim against the debtor is revived.  The Ninth Circuit Bankruptcy Appellate Panel found the policy arguments persuasive, but declined to extend Hackney, holding that the plain language of Bankruptcy Code § 502(h) refers to a claim against the estate, not the debtor.  The Ninth Circuit Bankruptcy Appellate Panel also noted that the bankruptcy court partially based its decision to dismiss the nondischargeability complaint on the basis that BFI did not have a claim on the petition.  The Panel declined to revisit this argument on appeal because the issue was not briefed by BFI.

In sum, it appears that to have a nondischargeable claim against a debtor, a creditor must have a claim against the debtor on the petition date.  To the extent a creditor receives final payment of a nondischargeable claim during the 90 days before the debtor’s bankruptcy, the trustee may seek to avoid the payment as a preferential transfer.  When the creditor returns the payment, or a portion of the payment, to the estate, Bankruptcy Code § 502(h) gives the creditor a claim against the estate, not a claim against the individual debtor.  Thus, the nondischargeable nature of the debt is not revived.

Laizure presents a Catch 22 for creditors.  This issue may arise when, for example, a creditor has a fraud claim against an individual on an unsecured claim, and the creditor suspects that the obligor may file bankruptcy.  If the creditor does not settle and attempts to obtain a fraud judgment that would be nondischargeable if successful, it will incur attorneys’ fees litigating the fraud claim and risk losing on the merits.  On the other hand, under Laizure, if the creditor settles and receives payment within 90 days of bankruptcy, it risks having to return the settlement payment as a preference without being able to pursue the obligor on a nondischargeability claim if the obligor subsequently files bankruptcy.

There is no obvious solution.  One possible approach is not to settle the fraud claim when the parties enter into the settlement agreement.  Rather, the creditor could agree to forbear for 91 days from pursuing the fraud claim in exchange for the payment made by the obligor so long as the obligor does not file bankruptcy during the preference period.  If the 91st day after the payment arrives without the obligor having filed bankruptcy, the obligor would receive a release at that time.  If the obligor files bankruptcy within the preference period, the fraud claim will still exist on the petition date.  At that point, the creditor can file a nondischargeability action or do so if the trustee sues the creditor to recover the preference.  If the creditor chooses to delay its nondischargeability action, it should obtain a court-approved stipulation to extend the nondischargeability deadline.

Another possible approach is to settle a fraud claim for a compromised amount, but retain the right to pursue the remainder of the claim in the event that the debtor files bankruptcy within 90 days of the settlement payment.  For example, a creditor might agree to settle a $1 million fraud claim for a lump sum of $400,000.  However, the settlement agreement would specify that the remaining $600,000 remains as a personal claim for fraud, but will be released 91 days after payment unless a bankruptcy is filed.  Under Laizure, if the trustee recovers the $400,000 settlement payment as a preference, the creditor would have a $400,000 claim under Section 502(h) against the estate and perhaps the creditor would retain a $600,000 nondischargeable fraud claim against the debtor under the settlement agreement.

Although these two approaches may provide protection to creditors who settle nondischargeable debts, it is unclear whether courts will indeed find that claims settled in this manner retain their nondischargeable nature.

Authored by:

Theodore A. Cohen

(213) 617-4237