In this Throwback Thursday piece, we revisit the Seventh Circuit’s landmark decision Levit v. Ingersoll Rand Financial Corp. (In re Deprizio), better known as Deprizio.  This decision was a contender for best quote in a case in Weil’s 2014 March Madness competition.  As we noted then, “Mr. Deprizio … found out the hard way that the automatic stay does not extend to mob justice” after Richard N. Deprizio, president of V.N. Deprizio Construction Corporation, placed his company into bankruptcy.  Judge Easterbrook summed up the situation as follows:  

As the investigation continued and Deprizio’s indictment was imminent, word circulated that he might “sing.”  So in January 1986 Deprizio was lured to a vacant parking lot, where an assassin’s gun and the obligations of a lifetime were discharged together.  Corporations are not so easily liquidated.

With such lurid facts, who would have thought that Mr. Deprizio’s financial predicament would generate a decision that would send shockwaves through the otherwise staid commercial lending community?

In the chapter 7 case of Deprizio’s company, the trustee sought to avoid certain payments as preferential transfers, including payments made on account of loans to outside creditors that were guaranteed by insiders, including Mr. Deprizio. The Seventh Circuit held that, under section 547(b) of the Bankruptcy Code, the preference recovery period of one year applies to allow a trustee to avoid a transfer to an outside creditor (lender), where the transfer benefited an insider creditor (guarantor).  Moreover, under section 550(a)(1) of the Bankruptcy Code, such transfers may be recovered from both the outside and inside creditor.

A quick refresh of the following section of the Bankruptcy Code is critical in understanding the court’s reasoning: 547(b) (preferences)101(4) (definition of claim)101(9) (definition of creditor)101(30) (definition of insider)101(50) (definition of transfer), and 550 (specifies who is liable for a transfer avoided under section 547).

Transfers Made Within the One-Year Preference Period for the Benefit of Insider Guarantors May Be Avoided Under Section 547(b)

In holding that the preference recovery period for insider guarantors is one year, the court reasoned that “[a] guarantor has a contingent right to payment from the debtor:  if the Lender collects from Guarantor, Guarantor succeeds to Lender’s entitlements and can collect from Firm.  So Guarantor is a ‘creditor’ in Firm’s bankruptcy.”  Moreover, a payment by the firm to the lender is “for the benefit of” the guarantor under section 547(b)(1) because every reduction in debt to the lender reduces the guarantor’s exposure and, thus, benefits the guarantor.  Accordingly, each reduction is avoidable under section 547(b)(4)(B) unless one of the exemptions in section 547(c) applies.

The court went on to note that, although Congress concluded that 90 days is sufficient time for careful creditors to protect themselves, insiders “pose special problems.”  Insiders “will be the first to recognize that the firm is in a downward spiral.”  Thus, if insiders and outsiders had the same preference recovery period, insiders that lent money to the troubled company would use their knowledge to protect themselves by paying their loans preferentially, then putting off bankruptcy until the 90 day period has passed.  This, in turn, could create costly consequences, such as causing outside creditors to more closely monitor the troubled company, grab assets themselves, and precipitate bankruptcy at the smallest sign of trouble, hoping to catch inside preferences before it is too late.  The solution?  Make the preference recovery period for insiders longer than that for outsiders.

But what about transfers to pay off loans guaranteed by insiders as opposed to transfers to pay off loans made by insiders?  According to the Seventh Circuit, they create similar problems.  Insiders who want to serve their own interests could induce the troubled company to pay the guaranteed loans preferentially.  If the preference recovery period for such payments were identical to the one for outside debts, this would create an attractive device for insiders.  Moreover, to the extent the insiders could use inside information to induce payment more than 90 days before the company files for bankruptcy, “they would make out like bandits.”  Even though it is possible to recover from the insider the value of the released guarantee, the court explained that it is hard to determine the value of a released guarantee, and insiders might think that it would be easier to fight off the claims of a trustee rather than outside creditors.  Thus, the Seventh Circuit viewed extending the preference recovery period to one year for insider guarantees was a necessary solution.

Avoidable Transfers May Be Recovered from Both Outside (Lender) and Inside (Guarantor) Creditors under Section 550

After determining that the aforementioned transfers to outside creditors (lenders) that benefit inside creditors (guarantors) may be avoided if made during the one-year preference recovery period, the Seventh Circuit went on to discuss from whom such transfers may be recovered.  In doing so, the court held that while section 547(b)(4) distinguishes between insiders and outsiders, section 550 (which provides the trustee with authority to recover preferential payments) does not.  Indeed, section 550 provides that the transfer may be recovered from either the initial transferee or the “entity for whose benefit such transfer was made.”  The court held that the initial transferee is the outside creditor (lender), and the “entity for whose benefit such transfer was made” is the insider creditor (guarantor).  Thus, the trustee could recover the preferential transfer from either of the creditors.

Deprizio’s Aftermath

Immediately following Deprizio, lenders changed their guaranty forms to include a waiver of the guarantor’s right to reimbursement from the borrower if the guarantor was required to pay on the guaranty.  The reasoning behind these waivers was that, because the guarantor had no right to reimbursement from the borrower/debtor, a payment on the guaranteed loan outside the 90-day preference period was not a payment “for the benefit of a creditor” within the meaning of section 547(b)(1) of the Bankruptcy Code.   This was precisely the type of language used in Adamson Apparel, a recent Ninth Circuit decision on which we previously reported.

Such waiver language itself, though, is a throwback to the early post-Deprizio years.  AfterDeprizio, Congress remedied the perceived inequity to third party lenders created byDeprizio and its progeny in a 1994 amendment to section 550(c) of the Bankruptcy Code.  Under that amendment, which is still in effect, the extended recovery period applies to payments made on loans guaranteed by insiders, but the trustee or debtor in possession may seek recovery only from the insider and not from the lender.

Even so, several courts still found a way to apply Deprizio.  For example, some courts held that a security interest, which need not be recovered, may nevertheless be avoided under the Deprizio doctrine.  To resolve this issue, as part of the Bankruptcy Abuse Prevention & Consumer Protection Act of 2005, Congress added an exception to section 547 similar to the amendment made to section 550(c) in 1994.  Section 547(i) prohibits the trustee or debtor in possession from avoiding a preferential transfer made during the insider preference period with respect to anyone other than an insider — seemingly putting the final nail in the proverbial Deprizio coffin.

So is Deprizio still relevant?  Two lines of cases developed since Deprizio wreaked its havoc — cases that hold that bona fide indemnification waivers are valid and excuse an insider guarantor from preference liability and cases that hold that such waivers are simply invalid.  As we reported, the Ninth Circuit recently held that waiving a right to indemnification on a guaranty may shield an insider guarantor from preference liability so long as the 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.”  It appears that Congress finally put Deprizio to rest.