Published Article

Minimize Risks in Contractor Dispute Settlement Agreements

April 23, 2024

Disputes between contractors, subcontractors, and/or owners are relatively common in the construction industry. Although you should not appear over-eager in rushing into a settlement to avoid the time, costs, and stress that come with protracted litigation, when settlement appears likely and in your company’s best interests, full attention to reaching a mutually agreeable resolution should be given. Tip: If a case has already been filed, consider asking the court to “stay” (i.e., pause) the case via joint motion to allow the parties to remain focused on reaching a settlement.

Although you should remain involved, engaging a lawyer early on in a dispute or anticipated dispute to lead the process can reduce stress and save time and money in the long run. Don’t make the proverbial “penny-wise, pound-foolish” mistake.

Settlement agreements serve as an expedient tool to resolve disputes. Settlements are also not constrained by the traditional legal remedies of a court. Tip: Focus on settlement in principle first, using of a “term sheet.”

While settlement agreements offer an efficient means of resolving disputes, they can become more complex when there is distrust between the parties about the defendant’s willingness or ability to pay, including in the face of solvency concerns. By understanding the potential risks and implementing proactive strategies to address them right within a settlement agreement, parties can minimize the likelihood of encountering obstacles and achieve more secure and sustainable resolutions. To effectively minimize these risks, parties should ensure that settlement agreements are comprehensive and carefully drafted, including addressing potential bankruptcy scenarios and baking protective measures into the settlement agreement.

Benefits and Risks of Structured Settlements

While simple settlements involving a prompt one-time lump sum payment to fully resolve the dispute can achieve the type of certainty and finality contemplated by the parties, this settlement structure is not always available. When cash flow is an obstacle, parties can still reach a settlement not otherwise available through the use of “structured settlements,” which feature a payment schedule over time.

For the defendant, a structured settlement allows finality at a smaller upfront cost, but it often comes with unfavorable terms that impose liens, encumber assets, and/or risk additional costs.

For the plaintiff, a structured settlement may facilitate a greater overall settlement value but creates the risk of non-payment through a payment schedule. The plaintiff can mitigate the risk of non-payment in a variety of ways through added protections, as covered more fully below. This is common and arguably important when there is distrust about the defendant’s willingness or ability to pay under the payment schedule and where there are concerns of potential future bankruptcy.

Securing Payments

To mitigate the risk of non-payment in structured settlements, parties can consider securing payments with collateral. This provides a safety net in case the paying party runs out of money to pay and/or declares bankruptcy before fulfilling its obligations. Collateral can take various forms, which may be used to impose liens on real estate, securities, or other valuable assets. Additionally, parties may explore alternative payment structures, such as annuities or third-party guarantees, to ensure a more reliable payment stream.

Consideration to the particular defendant’s assets and any existing liens on those assets should be given when tailoring the secured obligations to the relevant circumstances. Tip: Before entering into the settlement agreement, when warranted, a party may seek a greater assessment of the financial health of the other party. This can involve reviewing financial statements, credit reports, Uniform Commercial Code (UCC) filings, and any other relevant financial information to gauge their ability to fulfill their obligations.

A plaintiff will want a broad definition of “collateral” to include, for example, “all assets” of the defendant. A defendant will want to negotiate a narrower definition of “collateral” to include any number of subcategories, as may be appropriate, up to a certain value, such as accounts receivable, equipment, goods or particular goods, fixtures, tangible or intangible property, or a specific deposit account. Tip: The plaintiff should consider running a UCC search to ensure there is not an existing lien or perfected security interest on the defendant’s assets, as this will trump the security interest in the collateral claimed in the settlement agreement, regardless of what the settlement agreement actually says (due to the UCC’s “first to file” and other priority rules).

A settlement agreement will often include a Security Agreement as an exhibit to reflect the above priority interest for “attachment.” Tip: Also, make sure to properly “perfect” that interest under the UCC to ensure it is enforceable and has priority over other potential creditors and claims. Many security interests can be perfected through the filing of a financing statement (i.e., UCC-1), although some collateral types can or must be perfected by other means, such as by “control” or by “automatic perfection” pursuant to the UCC.

Note that, as relevant to contractors, subcontractors, suppliers, and others in the construction industry, each state has its own statutory scheme and body of law that prescribes the specific rules, procedures, and protections arising from the provision and payment of labor, materials and the like, through the imposition of liens and bonds (e.g., bid bonds, performance bonds, and payment bonds). Because individual circumstances may vary widely and state laws are constantly changing, readers should consult attorneys familiar with your jurisdiction for any specific advice.

Generally speaking, if the assets of a defendant company are already encumbered or otherwise risky in and of themselves, a plaintiff may insist on creating security through personal property owned by an officer or individual owner of the defendant company; think real estate, boats, or even ownership interest in the company (e.g., one may pledge membership interests in an LLC). This may also include a third-party personal guarantee in the event of the defendant’s default of settling payment obligations. Additional security could be created via a right to payment of any settlement or judgment awarded in a different pending lawsuit, or under a separate contract with a third party.

Another place where a settling plaintiff can mitigate the risks or obstacles of non-payment and collection is through a stipulated judgment (referred to in some jurisdictions, with some variations, as a consent judgment, agreement for judgment, or confession of judgment), which may be filed or made conditional depending on the terms of the agreement.

Contemplation of Bankruptcy

Special consideration can be made within the settlement agreement to a defendant’s risk of future bankruptcy. When one party files for bankruptcy after entering into a settlement agreement, it introduces a level of uncertainty into the process. The agreed-upon payments may be jeopardized, potentially leaving the other party with significant financial losses.

Payments made shortly before a bankruptcy filing may be vulnerable to preference claims. For example, there is risk that the payment received by the plaintiff will be “voidable” as a preference if the defendant files bankruptcy within 90 days after the payment. To minimize this risk, parties should aim to initiate payments promptly after reaching a settlement. Alternatively, structuring payments in smaller, periodic installments rather than a lump sum can reduce exposure to preference challenges.

A plaintiff can negotiate a term whereby the defendant stipulates to the entry of judgment for the full amount of the plaintiff’s claim. The plaintiff could agree not to execute on the judgment for 90 days and to file a satisfaction of judgment if the defendant has not filed bankruptcy within that time. If bankruptcy is filed within that period, the plaintiff can assert its full claim, as supported by the amount of its judgment, in the defendant’s bankruptcy. If the 90-day period passes without a bankruptcy filing, the plaintiff then has an affirmative contractual obligation to file the satisfaction of judgment, allowing the settlement to be realized in the manner intended by the parties.

If a defendant will not agree to a stipulated judgment, a plaintiff can mitigate its preference risk by providing in the settlement that the case is not dismissed with prejudice and the claims are not released until 90 days have passed with no bankruptcy filing.

A settlement agreement can also account for potential bankruptcy by expressly providing that the plaintiff’s original claim in the lawsuit is preserved if the plaintiff is not permitted to receive and/or retain the full settlement payment amount bargained for under the settlement agreement.

Moreover, settlements involving debts that would typically survive bankruptcy may require special attention to boost their likelihood of protection. Guided by the bankruptcy code and interpreting case law, parties should clearly articulate the reasons why the debt is nondischargeable within the settlement agreement. Additionally, the plaintiff can negotiate that the settlement agreement explicitly preserves the right to assert nondischargeability in any subsequent bankruptcy proceedings, safeguarding their interests. The agreement can be made to expressly state that it is not the creation of a new obligation, and that the plaintiff preserves its right to assert the nondischargeable nature of the debt.

Additional Strategies

Parties can also explore other strategies to minimize payment and bankruptcy risks in settlement agreements. These may include conducting thorough due diligence on the financial health of the other party, obtaining insurance coverage to mitigate potential losses, and incorporating dispute resolution mechanisms that prioritize swift resolution and minimize the likelihood of bankruptcy-related delays. Last, parties should recognize that the best practice for minimizing risks in settlement agreements is to treat it as an ongoing process that requires continuous monitoring and review.

Reprinted with permission from the April 2024 edition of The Contractor’s Compass.