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Payments Benefitting Insider Guarantors Can Be Protected from Recovery by Artful Loan Drafting

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Most bankruptcy practitioners know that Deprizio3 has been effectively overruled by the Bankruptcy Reform Act of 1994. The Act applies to transfers occurring after Oct. 22, 1994.4 However, what does that really mean? Frankly, when forced to review the issue recently, it was surprising to see the broad application that has been given to §550 of the Code. Specifically, the 1994 Act added a new subsection (c) to §550 of the Code, which provides:

If a transfer made between 90 days and one year before the filing of the petition
(1) is avoided under §547(b) of the title, and
(2) was made for the benefit of a creditor that at the time of such transfer was an insider, the trustee may not recover under subsection (a) from a transferee that is not an insider.

This new section effectively eliminated the likelihood that lenders would be obligated to turn over payments made up to one year before the filing. While §550(c) effectively took a bite out of Deprizio, much to the relief of the lending community, it provided no relief to the insider guarantor. Although the lenders had escaped the danger of disgorgement after the 90-day period, an insider guarantor can still be liable for any payments to the outside lenders for transfers during the one-year preference period. By way of example: If a debtor transfers $100,000 to a bank to pay off a line of credit that is guaranteed by Insider B, §550(c) provides that A's estate cannot recover $100,000 from the bank if it was made between 90 days and one year. However, §550(c) does still allow recovery of the $100,000 from Insider B if it was made between 90 days and one year from the petition date. Generally, a guarantor is a "creditor" of the debtor's bankruptcy estate because in most circumstances the debtor would have agreed to indemnify the guarantor for any payments made to the creditor under the guarantee. Because the payment of the guaranteed obligation indirectly benefits the insider guarantor, the guarantor is liable for all such payments up to one year prior to filing.

It did not take lenders long to realize that the operation of §550(c) was having a harmful, if indirect, impact on their security. While the lenders were no longer exposed to recovery under the extended preference period under the reign of Deprizio, their guarantors were. This, of course, weakened the guarantors' financial position, which meant that less money was available to the lenders when they had to call on their guarantees. Not surprisingly, the lenders found a way to contract around the guarantor recovery provisions under §550(c). The answer is simple: Do not let the guarantors be creditors of the estate, thus avoiding the §547 preference analysis in its entirety.5 The lenders accomplished their goal by having the guarantor waive all rights of indemnification, subrogation, contribu-tion or exoneration against the debtor in the guaranty loan documents.

Looking at the prior example, where Insider B has waived his subrogation rights to assert a claim against the debtor, the $100,000 may not be recoverable from Insider B if made during the insider preference period because Insider B is not a "creditor" of the debtor for the purposes of §547(b)(ii). The court in In re Northeastern Contracting Co., 187 B.R. 420 (Bankr. D. Conn. 1995), recently endorsed the waiver of subrogation as a means of avoiding insider preference liability. In that case, a secured creditor had two guarantors of a debtor's obligations: a father and a son. Included in the father's guaranty was an extensive waiver provision in which the father waived all rights of subrogation against the debtor. The court held that the language was effective to insulate the creditor from extended preference liability vis-a-vis the father's guaranty. Northeastern Contracting, 187 B.R. at 423. However, because the son's guaranty did not have an extensive waiver, but merely postponed the son's rights of subrogation until the creditor was paid in full, the court held that the creditor was liable for payments made through the extended preference period because such payments, under Deprizio, benefited the son by reducing his guaranty liability. Id. at 425.

Perhaps contrary to common sense, the insider guarantor's status as a creditor is determined only considering the outside creditor's obligation. Put another way, with respect to the waiver of subrogation rights, the insider guarantor's status as a general or equitable creditor of the debtor is effectively ignored; instead, the courts will only consider the creditor's relationship with the debtor in relation to the outside creditor. If the insider guarantor effectively waived its rights with respect to that obligation, then it is not a "creditor" for purposes of §547(b).

The history of this limitation may be traced to the Sixth Circuit Court of Appeals, which ruled that a creditor/guarantor of a debtor is a creditor within the meaning of §547(b) because it holds a claim or contingent claim against the debtor under §§101(10) and 101(5).6 In re C-L Cartage Co. Inc., 899 F.2d 1186 (7th Cir. 1990). Using C-L Cartage as a springboard, the bankruptcy court for the Eastern District of Tennessee ruled that it is "not enough that an insider be a creditor of the debtor in a general sense; the insider must have a claim against the debtor attributed to the specific debt he or she guaranteed in order to render transfers made by the debtor on account of that debt to the non-insiders transfer avoidable under §547(b)." Hendon v. Associated Commercial Corp. (In re Fastrans), 142 B.R. 241 (Bankr. E.D. Tenn. 1992); see, also, In re Northeast Contracting, 187 B.R. at 421. However, Fastrans ruled that it is not enough that an insider be a creditor of the debtor in a general sense; the insider must have a "claim" against the debtor attributable to the specific debt he or she guaranteed in order to render transfers made by the debtor on account of that debt to the non-insider transferee avoidable under §547(b). Absent such a claim, the insider is not a "creditor," and such transfers cannot have been made "for the benefit of a creditor."


...the insider guarantor's status as a general or equitable creditor of the debtor is effectively ignored; instead, the courts will only consider the creditor's relationship with the debtor in relation to the outside creditor.

Conclusion

The result of the Fastrans, Deprizio and Cartage cases is that in order to satisfy the burden of proof under §547(b)(1), the trustee/debtor must establish that the insider/guarantor has a "claim" against the debtor arising from his obligations under the guaranty and is not just a creditor of the debtor generally. Unless the guaranty produces a right on the part of the insider to recover from the debtor, the insider has no "claim in bankruptcy." With the express waiver of any such subrogation rights, the insider has no "claim," cannot be a creditor and, accordingly, the trustee/debtor cannot meet its burden of proof under §547(b).

From a practical perspective, this line of cases potentially affords a guarantor and his counsel greater flexibility in minimizing the impact of an impending insolvency. If the guaranty includes a broad waiver of subrogation and related rights, the guarantor is much less likely to be the target of preferential transfer litigation. However, as this is a developing area of law, one would be well advised to educate (early and often) trustees, committee counsel or whoever may raise such a claim about the defenses to be raised in such an attack.


Footnotes

1 Ms. Brighton is a partner at Nixon Peabody LLP in the Manchester, N.H., office. She focuses her practice on bankruptcy and creditors' rights. She is certified by the American Board of Certification in business bankruptcy. Return to article

2 Mr. Tamposi is an associate at Nixon Peabody LLP in the Manchester, N.H., office. He focuses his practice on bankruptcy and litigation concerning creditors' rights. Return to article

3 In 1989, the U.S. Court of Appeals for the 7th Circuit in Levit v. Ingersoll Rand Financial Corp. (In re Deprizio), 874 F.2d 1186 (7th Cir. 1989), held that the extended one-year preference period applied to outside creditors when the payment produced a benefit for an insider creditor, including a guarantor. Return to article

4 Although there had been some confusion concerning cases involving transfers that occurred before the 1994 Act's effective date, a vast number of courts that have ruled on Deprizio since the enactment of the 1994 Act have opted to apply the Deprizio rule to cases filed before the effective date. See, e.g., Skywalkers Inc., 49 F.3d 546 (9th Cir. 1995); In re Conner Home Sales Corp., 190 B.R. 255 (E.D.N.C. 1995); In re Blevins Electric Inc., 185 B.R. 250 (Bankr. E.D. Tenn. 1995); In re Austin Truck Rental Inc., 177 B.R. 827 (Bankr. E.D. Pa. 1995); In re Air Forwarding Systems Inc., 176 B.R. 638 (Bankr. M.D. Fla. 1995). Return to article

5 The first requirement of preference recovery is that the transfer must be "to or for the benefit of a creditor." 11 U.S.C. §547(b). Return to article

6 Section 101(10) defines the term "creditors," in material part, as an "entity that has a claim against the debtor that arose at the time of or before the order for relief concerning the debtor." 11 U.S.C. §101(10). Bankruptcy Code §101(5) defines the term "claim," in material part, as the "right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured or unsecured." 11 U.S.C. §101(5). Return to article

Journal Date: 
Monday, October 1, 2001

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