Settlements (Part 3 of 3): Dealing With a Defendant's Bankruptcy in Non-Compete Litigation

This is the third and final installment on my series devoted to settlements in non-compete litigation.

Today's topic is a little different.

This is largely a plaintiff-centric column, offering some practical points to consider when assessing the risk of bankruptcy in connection with non-compete (or other competition) litigation. Though many non-compete suits settle on straight equitable terms (such as injunctions enforcing the terms of an agreement), large-dollar settlements are not that unusual. This is particularly so if the defendant has moved a large volume of customer business in violation of a covenant, or if he has misappropriated valuable commercial data. In these cases, a plaintiff should be able to prove some consequential damages - and that may lead to a settlement comprised in part on the payment of money.

The threat of bankruptcy is a fairly significant lever for a defendant to pull. And even if a case settles on financial terms, it does not extinguish the possibility that a plaintiff will have to deal with the bankruptcy process at some point. Although there is nothing a plaintiff can do to prevent a defendant from filing for bankruptcy (such a promise or covenant would be void), it can take certain protective steps to ensure that it preserves as much of its claim as possible.

Here are some considerations:

1. Be Aware of the Preference Claim. Any time a plaintiff receives a cash payment settlement, there is a possibility it will be clawed back if the defendant files for bankruptcy within 90 days. Although there are defenses to this so-called preference action, the most common - the "ordinary course" defense - is almost certainly not available. A plaintiff can at least mitigate the risk of a preference claim by preserving the full value of a claim. For instance, if a plaintiff has a legitimate damages claim for $100,000, and settles for half of that, it should insist on a consent judgment of the full amount. After the 90 day period expires (following tender of the $50,000), it can release the full judgment. This way, if the defendant does file for bankruptcy in the preference period, the plaintiff has a larger claim to file in the bankruptcy estate and is entitled to a larger share of assets the trustee collects.

2. Obtain Personal Guaranties and a Pledge of Stock (Where Applicable). When there are corporate and individual defendants settling a non-compete case, special issues pertaining to guaranties and pledges of stock arise. Assume, for instance, that an ex-employee left to start her own company. If she is sued on a non-compete or related claim, the plaintiff may sue not only the individual, but also her new company. If the company commits to pay the settlement amount (which it would want to do to take advantage of a tax deduction), then the individual defendants should guaranty payment. A corporate bankruptcy won't affect the guaranty. Similarly, the plaintiff may want to take a pledge of the individual's stock in the defendant-company as further insurance against default on the payment obligation.

3. Obtain Admissions Where Possible. As discussed in points (4) and (5), some debts in bankruptcy are not dischargeable. Bankruptcy law contains limited exceptions to a debtor's goal of discharging her debts. Those suits - called "adversary" proceedings - are like trials, but courts will consider and give preclusive effect to admissions in related litigation. It's critical, therefore, to use admissions of the defendant where possible. If the defendant is willing to settle litigation, and bankruptcy is a real threat, a plaintiff should consider requiring the defendant to either: (a) concede in the settlement agreement that she violated her fiduciary duty of loyalty, or willfully stole confidential information; or (b) execute a consent judgment (often times in connection with an agreed injunction order) that contains similar admissions that a judge then signs off on. These can be used offensively in a later adversary proceeding.

4. Consider the "Fraud in a Fiduciary" Capacity Exception for an Adversary Proceeding. The Bankruptcy Code provides that a debt is not dischargeable if a defendant obtains property by way of fraud in a fiduciary capacity. This doesn't necessarily mean that every fiduciary defalcation is non-dischargeable. But if a plaintiff has a cognizable fiduciary duty claim and obtains strong admissions in the underlying suit (or in connection with settling the underlying suit), it may be able to pursue an adversary claim in the bankruptcy court.

5. Determine If There's a Willful or Malicious Injury. This is similar to the fraud exception, but it's far broader and captures fiduciary conduct that the previous exception might not. If a defendant commits a willful injury in tort, she can't discharge that debt. Simple as that. The common paradigm in competition cases for a non-dischargeable debt is the willful taking of a trade secret, since that is essentially a tort and would likely qualify for a strong adversary claim. A non-compete violation presents a tougher, closer question. I wrote back in February about an Ohio case where the bankruptcy court found that a straight non-compete breach did not amount to a willful injury, and the associated debt was dischargeable. But you can find cases to the contrary, such as In re Ketaner, 149 B.R. 395 (Bankr. E.D. Va. 1992). Likely, a plaintiff will need to couple a simple breach with some pre-termination conduct that smacks of unfair competition or misappropriation of company data. A simple breach of contract probably won't do, and there must be some evidence of an intent to injure and not just an intent to act. This is a terribly fine line to walk, since every breach of contract contemplates some financial gain to the detriment of others.