The Ninth Circuit Court of Appeals, in addressing “an unresolved issue of bankruptcy law,” recently held that a waiver by an insider guarantor of its reimbursement right against an affiliated obligor on the guaranteed debt, for the purpose of absolving the guarantor from preference liability on the guaranteed debt, can be enforceable. Stahl v. Simon (In re Adamson Apparel, Inc.), 2015 WL 2081575 (9th Cir. May 6, 2015) (“Adamson”).
Prior to the Adamson decision, bankruptcy courts were split on whether an insider guarantor’s waiver of its reimbursement rights against the obligor on the guaranteed debt was valid. Such waivers, as explained further below, are designed to prevent the guarantor from being a “creditor” of the related obligor so the guarantor does not receive, and does not become liable to repay, a preferential transfer of the obligor. The Ninth Circuit in Adamson held that an insider guarantor’s waiver of its reimbursement rights against the obligor can be enforceable in cases where the guarantor absolutely waives its reimbursement rights, has a bona fide basis for such waiver and takes no action after the waiver to assert a claim against the obligor.
Background
Lenders who loan funds to corporate entities commonly require guarantees from affiliates of the corporate obligor. The guarantees are often personal guarantees from individual owners, officers or other insiders of the corporate obligor. In the event the corporate borrower becomes a debtor under the United States Bankruptcy Code, 11 U.S.C. §§ 101 et seq., as amended (the “Bankruptcy Code”), the borrower’s pre-petition payments may be subject to avoidance as preferential transfers of the borrower under Section 547(b) of the Bankruptcy Code. A borrower’s pre-petition payments may be avoided as preferential transfers under Section 547(b) of the Bankruptcy Code if, generally speaking, such payments were (1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt; (3) made while the debtor was insolvent; (4) made (i) on or within 90 days before the filing of the petition or (ii) between 90 days and one year before 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 in a chapter 7 liquidation if the transfer had not been made. In instances involving a borrower’s pre-petition payments on the guaranteed debt, the guarantor may be required to repay the amount of the borrower’s preferential transfers to the borrower’s bankruptcy estate.
The potential liability of an insider guarantor to repay a debtor’s bankruptcy estate for certain pre-petition payments made by a debtor on the guaranteed obligation stems generally from the reasoning of Levit v. Ingersoll Rand Fin. Corp. (In re Deprizio), 874 F.2d 1186 (7th Cir. 1989) (“Deprizio”). Based on the Deprizio case, a pre-petition payment by a debtor on a guaranteed obligation may constitute a preferential transfer to the guarantor (as opposed to a preferential transfer to the creditor receiving the payment) on the basis that the transfer is “to or for the benefit of” the guarantor as a creditor of the debtor under Section 547(b) of the Bankruptcy Code.[1] 11 U.S.C. § 547(b). The guarantor is considered a “creditor” of the debtor for purposes of the preference provisions of Section 547(b) because the guarantor will hold a contingent claim against the debtor to be reimbursed for payments the guarantor makes or will make under the guaranty, based either on an agreement of the debtor to reimburse the guarantor or theories of subrogation, contribution, setoff or similar bases. The pre-petition payments made by a debtor on the guaranteed obligation benefit the guarantor for purposes of the preferential transfer analysis because the debtor’s payments reduce the guarantor’s contingent liability on the guaranty and the guarantor’s contingent reimbursement claim against the debtor. The benefit received by the guarantor can be referred to as an “indirect preference.” Thus, a guarantor who benefits from a debtor’s pre-petition payments on the guaranteed debt, by a reduction in the amount of the guarantor’s contingent liability, may be deemed to receive a preference from the debtor under Section 547(b) of the Bankruptcy Code and may be required to repay the amount of the preference to the debtor’s bankruptcy estate.
The potential preference liability of an insider guarantor for payments the affiliated obligor makes on the guaranteed debt can be adverse to the interests of a lender who required the guaranty. The lender will rely on, among other things, the creditworthiness of the guarantor to pay under the guaranty if the primary obligor defaults. The ability of the lender to recover under the guaranty could be adversely affected if the guarantor is required to repay amounts to the debtor’s bankruptcy estate that the debtor paid on the guaranteed obligation during the pre-bankruptcy preference period. Given the insider guarantor’s potential preference liability for payments the primary obligor makes on the guaranteed debt, lenders requiring an insider guaranty often also require the guaranty to contain a waiver by the guarantor of its reimbursement rights against the affiliated obligor, which waiver may be referred to as a “Deprizio waiver.” This waiver from the insider guarantor, if effective, nullifies or terminates the guarantor’s status as a “creditor” of the debtor for purposes of Section 547(b) of the Bankruptcy Code. As noted by the Ninth Circuit in Adamson, Section 547(b)(1) “requires that the transfer of assets in question must be ‘to or for the benefit of a creditor’ in order for preference liability to attach.” Adamson at *3. However, if the insider guarantor has no reimbursement claim against the debtor, then the guarantor should not be considered to be a creditor of the debtor for purposes of Section 547(b) of the Bankruptcy Code, should not receive an indirect preferential transfer under Section 547(b) based on the debtor’s pre-petition payments on the guaranteed obligation, and should not be required to repay such amounts to the debtor’s bankruptcy estate.[2] Thus, a Deprizio waiver from an insider guarantor could, if effective, protect the lender’s ability to recover under the guaranty, especially in the context of a borrower bankruptcy when payments under the guaranty are critical to the lender.
Adamson Case
In the Adamson case, Adamson Apparel, Inc. (the “Debtor”) obtained a multimillion-dollar loan from CIT Group Commercial Services, Inc. (“CIT”). As a condition to making the loan, CIT obtained a guaranty from Arnold H. Simon (“Simon”), the Debtor’s president and CEO, and required that the guaranty contain a Deprizio waiver from Simon. Simon thus waived his right to be reimbursed from the Debtor for any payments Simon makes under the guaranty. The Debtor caused approximately $5 million to be paid in partial satisfaction of the CIT loan within the one-year period before filing bankruptcy. Simon paid the balance of the CIT loan under his guaranty in the amount of approximately $3.5 million.
After the Debtor filed bankruptcy, the creditor’s committee that was appointed in the Debtor’s bankruptcy case commenced an action against Simon as guarantor to recover the $5 million pre-petition payment made by the Debtor on the CIT loan. The committee alleged that the $5 million payment by the Debtor within one year before the bankruptcy filing constituted an avoidable preferential transfer to Simon under Section 547(b) of the Bankruptcy Code, on the basis that Simon was an insider of the Debtor who received a preferential transfer during that period by the corresponding $5 million reduction of Simon’s liability under his guaranty of the CIT loan.
The bankruptcy court determined, after a trial on the issues, that the Deprizio waiver provided by Simon in his guaranty was an unconditional waiver of Simon’s reimbursement right against the Debtor and that the committee “failed to carry its burden of establishing Simon’s ‘creditor’ status under” Section 547(b). Id. at *2. The committee appealed the decision to the district court and the district court affirmed the conclusion of the bankruptcy court.
On appeal to the Ninth Circuit, the court examined the “[t]wo separate lines of cases developed in Deprizio’s wake” on the issue of whether an insider guarantor’s Deprizio waiver is enforceable to absolve the guarantor from preference liability. Id. at *6. Several courts conclude that an insider guarantor’s bona fide waiver of reimbursement is valid and excuses the guarantor from preference liability. See O’Neil v. Orix Credit Alliance, Inc. (In re Ne. Contracting Co.), 187 B.R. 420, 423–24 (Bankr. D. Conn. 1995); Hostmann v. First Interstate Bank of Or., N.A. (In re XTI Xonix Techs. Inc.), 156 B.R. 821, 833–34 (Bankr. D. Or. 1993); Hendon v. Assocs. Commercial Corp. (In re Fastrans), 142 B.R. 241, 245 (Bankr. E.D. Tenn. 1992).
On the other hand, other courts decline to enforce Deprizio waivers on public policy grounds. See In re USA Detergents, Inc., 418 B.R. 533, 542 (Bankr. D. Del. 2009); In re Pro Page Partners, LLC, 292 B.R. 622, 631 (Bankr. E.D. Tenn. 2003); In re Telesphere Comm., Inc., 229 B.R. 173, 176 n.3 (Bankr. N.D. Ill. 1999). The court in In re Telesphere stated that Deprizio waivers are unenforceable because:
such a waiver has no economic impact—if the principal debtor pays the note, the insider guarantor would escape preference liability, but if the principal debtor does not pay the note, the insider could still obtain a claim against the debtor, simply by purchasing the lender’s note rather than paying on the guarantee. Thus, the “Deprizio waiver” could only be seen as an effort to eliminate, by contract, a provision of the Bankruptcy Code. The attempted waiver of subordination rights was thus held to be a sham provision, unenforceable as a matter of public policy.
Id. at *7 (quoting In re Telesphere, 229 B.R. at 176 n.3).
While the Ninth Circuit agreed that the potential for “sham” waivers is a valid concern, the court stated that the “mere possibility” a Deprizio waiver could in a specific case be a “sham” (to escape preference liability but still permit a purchase of the debt or a reimbursement claim against the debtor) is not a reason to declare such waivers invalid as a whole. In rejecting the line of cases that decline to enforce such waivers as a whole, the Ninth Circuit stated that such courts:
would establish a bright-line rule based on a fear of what could happen. We believe the sounder approach is to consider what actually has happened. Rather than negating every Deprizio waiver based on a hypothetical scenario, the courts should instead examine the totality of the facts before them for evidence of “sham” conduct in the circumstances presented. In the present case, all evidence in the record indicates that the waiver at issue was not a sham.
Id. The court then noted several facts presented in Adamson supporting the conclusion that Simon’s waiver of reimbursement was not a sham. The court noted that the claim of CIT was secured, at least in part, by collateral of the Debtor. The claim would be paid in part from the collateral, and not constitute a preference to the extent of such collateral, even without Simon’s guaranty. Thus, the existence of collateral, which minimized the effect of the guaranty and any preference liability, tended to show the waiver was not a sham. The court also noted that Simon did not file a proof of claim in the Debtor’s bankruptcy case. In addition, the court stated that Simon did not have a contractual right with CIT that permitted Simon to purchase the debt from CIT in the event the Debtor defaulted.
In addition to facts which supported the conclusion that Simon’s waiver was not a sham, the Ninth Circuit also based its ruling on the language of Section 547(b) of the Bankruptcy Code. The court reasoned that this Section requires Simon to be a creditor of the Debtor to impose preference liability on Simon and “when faced with a clearly drafted statute, we are not at liberty to deviate from the text in favor of a generalized notion of public policy.” Id. at *9. Accordingly, instead of invalidating Deprizio waivers as a whole, the Ninth Circuit held, based on the facts presented and the “clearly drafted statute,” that “when an insider guarantor has a bona fide basis to waive his indemnification rights against the debtor in bankruptcy and takes no subsequent actions that would negate the economic impact of that waiver, he is absolved of any preference liability to which he might otherwise have been subjected.” Id.
The dissenting opinion in Adamson stated that the court should “follow every bankruptcy court to have decided the issue and hold that insider-guarantors such as Simon are ‘creditors.’” Id. at *10.
Conclusion
The Adamson decision supports the conclusion that a Deprizio waiver must be unconditional to be enforceable. For example, many transactions contain a guarantor’s waiver of reimbursement against the affiliated obligor until the related lender is paid in full. If a guarantor’s waiver is limited or conditional, such as waiving a reimbursement claim only until the related lender is paid in full, the waiver likely will be insufficient to establish that the guarantor holds no “creditor status” against the affiliated obligor.
In addition, instead of invalidating Deprizio waivers as a whole, the Ninth Circuit’s decision in Adamson permits such a waiver so long as related facts and circumstances support a “bona fide basis” for the waiver and show the guarantor has taken “no subsequent actions that would negate the economic impact of that waiver.” Id. at *9. Thus, based on the Adamson decision, the evidentiary record that either provides support for, or that is contrary to, the waiver will be important. Given the need for a guarantor’s actions to be consistent with a waiver for the waiver to be upheld, the relevant evidentiary record will include not only the facts at the time of the waiver, but also a guarantor’s actions subsequent to delivering the waiver. Because the related facts and circumstances can be used to either support or discredit a Deprizio waiver, it is likely that additional litigation will ensue on factors that are alleged as supporting, or as discrediting, a waiver.
Moreover, the court noted that the debtor (or bankruptcy trustee) has the burden to establish a guarantor’s “creditor status” and “each of the other preference-liability requirements.” Id. at *1-2. See also 11 U.S.C. § 547(g). The burden of the debtor, creditor’s committee or bankruptcy trustee to establish a guarantor’s “creditor status” and each other element of a preference under Section 547(b) may also be important in determining the validity of Deprizio waivers in future cases.
It is also possible that the Ninth Circuit could, upon the request of a party, rehear the Adamson case en banc. The issuance of a dissenting opinion could increase the possibility of such a rehearing.
Additional Information
For more information on this and other bankruptcy issues, please contact Bruce A. Wilson or your Kutak Rock attorney.
[1] The Deprizio case and its progeny also extended the preference or “look back” period on obligations that were guaranteed by an insider of the debtor to one year, rather than 90 days, under Section 547(b) based on the presence of an insider guarantor who benefitted from the debtor’s pre-petition transfers. The one-year preference period was designed to apply to instances in which insiders with greater knowledge or control over a debtor and its declining financial condition because they could receive preferential payments over a longer period of time. However, based on the language of the Bankruptcy Code as it existed at that time, Deprizio and its progeny also applied the one-year preference period to non-insider lenders based solely on the presence of an insider guarantor who benefitted from pre-petition payments. This issue was subsequently resolved in amendments to the Bankruptcy Code to generally clarify that the one-year preference period applies to insider creditors who themselves receive pre-petition payments (or otherwise receive a preference) from a debtor.
[2] Of course, assuming the Deprizio waiver is effective, the guarantor also cannot look to the debtor or assert a claim in the debtor’s bankruptcy case for reimbursement of any payments made to the debtor’s lender under the guaranty.