Insider Guarantees: Emerging Theories of Preference Recoveries
Lenders relying on guarantees from insiders to secure loans beware! In 1989, the Seventh Circuit Court of Appeals held in Levit v Ingersoll Rand Financial Corp. (in re: V.N. Deprizio Construction Co.) that arms-length outside creditors can be required to disgorge payments received from an insolvent borrower more than 90 days, but less than one year prior to the borrower’s bankruptcy, if the debt is guaranteed by an insider of the borrower. Payments made on the same debt would be subject to a 90-day preference recovery period if the debt had not been guaranteed by an insider.
The implications of the Deprizio decision are broad enough to have an impact on virtually every type of credit facility secured by an insider guarantee. This article will analyze the statutory provisions supporting Deprizio and suggest precautionary measures which may be instituted by outside creditors to avoid derivative insider status and the resulting expanded preference recovery period.
Avoidable Transfers Under the Bankruptcy Code
Section 547(b) of the Bankruptcy Code permits trustees to avoid certain preferential transfers, as follows:
Except as provided in subsection (c) of this section, the trustee may avoid any transfer of an interest of the debtor in property –
(1) To or for the benefit of a creditor;
(2) For or on account of an antecedent debt owed by the debtor before such transfer was made;
(3) Made while the debtor was insolvent;
(4) Made – (A) on or within 90 days before the date of the filing of the petition; or (B) between 90 days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and
(5) That enables such creditor to receive more than such creditor would receive if – (A) the case were a case under chapter 7 of this title; (b) the transfer had not been made; and (C) such creditor received payment of such debt to the extent provided by the provisions of this title (Emphasis added.)
Section 550(a) of the Bankruptcy Code permits trustees to recover preferentially transferred property, as follows:(a) Except as otherwise provided in this section, to the extent that a transfer is avoided under section… 547, … of this title, the trustee may recover, for the benefit of the estate, the property transferred, or, if the court so orders, the value of such property, from –
(1) the initial transferee of such transfer or the entity for whose benefit such transfer was made; or
(2) any immediate or mediate transferee of such initial transferee. (Emphasis added.)
A creditor is defined by the Bankruptcy code to include any "entity that has a claim against the debtor that arose at the time or before the order for relief concerning the debtor." Additionally, a claim is defined to include "a 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." Finally, an insider is defined to include any relative, partner, officer, director, control person or entity similarly affiliated with a borrower.
These Bankruptcy Code Provisions are commonly utilized by trustees to avoid preferential transfers made directly to: (i) creditors outside the ordinary course of business during the 90-day period preceding bankruptcy and (ii) insiders of a borrower during the one-year period preceding a bankruptcy. However, there has been controversy surrounding the question of whether a trustee can recover transfers made to an outside creditor more than 90 days but less than one year prior to a debtor’s bankruptcy if the loan from the outside creditor was secured by a guarantee from an insider of the borrower.
Prior to Deprizio, a majority of district and bankruptcy courts held that Code §550(a)(1), which permits a trustee to recover property from "the initial transferee of such transfer or the entity for whose benefit such transfer was made," would not support a trustee’s claim to property transferred to an outside creditor more than 90 days but less than one year prior to bankruptcy, even if the underlying debt had been secured by an insider of the debtor. In Deprizio, the trustee argued for a reversal of this precedent by reasoning that any such transfers made to outside creditors were made "for the benefit of co-signors and guarantors, because every dollar paid to the outside creditor reduced the insider’s exposure by the same amount."
Pre-Deprizio Interpretations of the Bankruptcy Code
A number of pre-Deprizio district and bankruptcy courts precluded trustees’ attempts to recover from outside creditors by ruling that it would be inequitable to extend the preference recovery period for outside creditors with guaranteed loans when the same outside creditor would be subject to a 90-day preference recovery period if his loan had not been guaranteed. Some of these judges relied on the following quotation from the Collier treatise in rendering their decisions:
In some circumstances, a literal application of section 550(a) would permit the trustee to recover from a party who is innocent of wrongdoing and deserves protection. In such circumstances the bankruptcy court should use its equitable powers to prevent an inequitable result. For example ... if a transfer is made to a creditor who is not an insider more than 90 days but within one year before bankruptcy and the effect is to prefer an insider-guarantor, recovery should be restricted to the guarantor and the creditor should be protected. Otherwise, a creditor who does not demand a guarantor can be better of than one who does.
Another line of pre-Deprizio district and bankruptcy court decisions precluded trustees’ attempts to recover from outside creditors by holding that a single transfer from an insolvent debtor to an outside creditor greater than 90 days but less than one year prior to bankruptcy should be construed as two transfers: (i) an indirect transfer to an insider (i.e., reduced liability) which is subject to a one-year preference recovery period and is recoverable and (ii) a direct transfer to an outside creditor which is subject to a 90-day preference recovery period and is not recoverable.
For example, the lower court in Deprizio held that transfers made by the V.N. Deprizio construction Company to outside creditors should be treated as two transfers: "One being the money and the other the benefit." The lower Deprizio court held that only the indirect benefit to the debtor’s insider was recoverable.
Seventh Circuit Ruling in Deprizio: Insider Guarantees as Voidable Preferences
The Seventh circuit was the first circuit court to address the issue of whether transfers made by insolvent debtors to outside creditors are subject to the year-long preference recovery period provided for insider creditors, when the transfers are made "for the benefit of" insiders of the debtor. In rendering its opinion, the Deprizio court reasoned that "insider" guarantors of a debtor were also creditors within the meaning of Bankruptcy Code §547(b)(1) because they held contingent rights of subrogation and contribution from the debtor [See: Bankruptcy Code §§101(4)(A) and 101(9)] to the extent of any payments that might be made by the insider guarantor to an outside creditor whose loan was secured by a guarantee from the insider.
The Deprizio court used the following example to outline its analysis:
A payment ("transfer") by Firm to Lender is "for the benefit of" Guarantor under §547(b)(1) because every reduction in the debt to Lender reduces Guarantor’s exposure.
The court reasoned that insolvent debtors whose insiders had guaranteed debts to outside creditors might attempt to make "preferential" payments in reduction of these (guaranteed) debts in contemplation of a later (i.e., 91 days) bankruptcy filing. Since the court concluded that these payments were for the benefit of a creditor (i.e., the insider guarantor) it permitted the trustee to recover the transfer from either "the ‘initial transferee’ (Lender) or the ‘entity for whose benefit such transfer was made’ (Guarantor)." In its ruling, the Seventh Circuit set aside the "equitable" and "two-transfer" theories relied upon by lower courts in favor of a literal reading of the Bankruptcy Code.
Following the initial decision in Deprizio, several district and bankruptcy courts have permitted trustees to recover transfers made by insolvent debtors to outside creditors during the extended (i.e., greater than 90-day but less than one-year) preference recovery period. In addition, the Eight Circuit (Arkansas, Missouri, Nebraska, Iowa, North Dakota, South Dakota and Minnesota) and Tenth Circuit (Colorado, Kansas, New Mexico, Oklahoma, Utah and Wyoming) are currently considering appeals involving issues similar to those raised in Deprizio.
Potential Implications of Deprizio
The Deprizio decision is broad enough to have an impact on virtually every type of credit facility which is secured by an insider guarantee. For example, transfers made by debtors to outside creditors in payment of obligations on secured loans or subordinated debt could potentially be subject to attack by a bankruptcy trustee. The following examples are illustrated of the potentially broad reaching effect of Deprizio:
Example 1: Transfers made by an insolvent debtor to a senior secured creditor might be attacked if they benefit a junior secured creditor with an insider guarantee who holds an interest in the same collateral as the senior creditor. Applying the reasoning in Deprizio, a bankruptcy trustee could argue that transfers made by the debtor to the senior creditor would result in the release of collateral which could be used to pay the debtor’s obligations in the junior creditor and, as a result, benefit any insider guarantors by reducing their potential liability on the junior secured debt.
Example 2: Transfers made by an insolvent debtor to a creditor might be attacked if they benefit holders of subordinated debt. For example, in leveraged acquisitions investors may acquire subordinated debt as part of the capitalization of a corporation. Alternatively, selling shareholders may take subordinated debt as partial payment for their stock. Each of these parties could be considered an insider who would be benefited by transfers made by the debtor to senior creditors.
These examples are illustrative of the potentially broad reaching effect of Deprizio. To the authors’ knowledge, no court has ruled on a trustee’s attempt to recover property transferred from an insolvent debtor during the extended preference recovery period in the scenarios referred to above.
Avoiding Liability Under Deprizio
Secured lenders can take several steps to reduce the risk of potential derivative insider status and application of the extended preference recovery period applied by Deprizio.
1. Waiver of Reimbursement, Indemnity and Subrogation. Secured lenders may be able to reduce the risk of derivative insider liability by obtaining contractual waivers from insider guarantors of their rights to reimbursement, indemnity or subrogation. The insider guarantor would therefore not have a claim against the debtor and would not receive a benefit from any payment by the debtor to the lender. Because any such payment would not be to or for the benefit of an (insider) creditor, the extended preference recovery period would not apply.
2. Obtain Solvency opinion Prior to Transfer. Deprizio has no effect on a creditor’s ability to assert the normal statutory defenses to a trustee’s preference recovery action, including arguments that the debtor was not insolvent at the time of a challenged transfer. If a creditor is able to obtain a solvency opinion or other evidence of the debtor’s solvency at the time of transfer, the trustee will be unable to meet the requirements of Bankruptcy Code §547(b)(3) or successfully challenge the transfer as preferential.
3. Extend Guarantees to Payments Which a Lender May be Required to Disgorge. Creditors who choose to secure loans with insider guarantees, post-Deprizio, should amend their standard guarantee agreements to provide for specific extended guarantee coverage for any payments the creditor might be required to disgorge based on transfers it receives from the debtor during the period between 90 days and one year prior to any bankruptcy proceeding.