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

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Oct 2001

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Most bankruptcy practitioners know that Deprizio<a href="#3" name="3a">3</a> has been effectively overruled by the
Bankruptcy Reform Act of 1994. The Act applies to transfers occurring after Oct.
22, 1994.<a href="#4" name="4a">4</a> 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:

<blockquote>
If a transfer made between 90 days and one year before the filing of the
petition
<blockquote>
(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.
</blockquote>
</blockquote>

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.<a href="#5" name="5a">5</a> 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 <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
re Northeastern Contracting Co., 187 B.R. 420 (Bankr. D. Conn.
1995)</a>, 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. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
Contracting, 187 B.R. at 423</a>. 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. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 425</a>.

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).<a href="#6" name="6a">6</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re C-L Cartage Co. Inc., 899
F.2d 1186 (7th Cir. 1990)</a>. 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)." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Associated Commercial
Corp. (In re Fastrans), 142 B.R. 241 (Bankr. E.D. Tenn.
1992)</a>; see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Northeast Contracting, 187 B.R. at 421</a>.
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."

<blockquote><blockquote>
<hr>
<big><center>
...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.
</center></big>
<hr>
</blockquote></blockquote>

<h3>Conclusion</h3>

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.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> 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. <a href="#1a">Return to article</a>

<a name="2">2</a> 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. <a href="#2a">Return to article</a>

<a name="3">3</a> In 1989, the U.S. Court of Appeals for the 7th Circuit in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Ingersoll Rand Financial Corp. (In re
Deprizio), 874 F.2d 1186 (7th Cir. 1989)</a>, 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. <a href="#3a">Return to article</a>

<a name="4">4</a> 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., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Inc., 49 F.3d 546 (9th Cir. 1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Conner Home Sales
Corp., 190 B.R. 255 (E.D.N.C. 1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Blevins Electric Inc., 185 B.R. 250 (Bankr. E.D. Tenn.
1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Austin Truck Rental Inc., 177 B.R. 827 (Bankr. E.D. Pa. 1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Air Forwarding Systems
Inc., 176 B.R. 638 (Bankr. M.D. Fla. 1995)</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> The first requirement of preference recovery is that the transfer must be "to or for the benefit of a creditor." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C.
§547(b)</a>. <a href="#5a">Return to article</a>

<a name="6">6</a> 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." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §101(10)</a>. 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." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §101(5)</a>. <a href="#6a">Return to article</a>

Journal Authors

Jo Ann J. Brighton

Peter N. Tamposi

Journal Date

Monday, October 1, 2001 - 12:00

Bankruptcy Rule

2001