In re Williams: Lenders Should Continue Obtaining Deprizio Waivers

The Deprizio doctrine still may apply to noninsider creditors who receive transfers not constituting payments within the period between 90 days to one year of a bankruptcy filing (the "expanded preference period") as the recent decision Roost v. Associates Home Equity Servs. Inc. (In re Williams), 234 B.R. 801 (Bankr. D. Ore. 1999), demonstrates.

Based on the Williams decision, in order to protect themselves to the greatest extent possible from preference challenges by a trustee with respect to liens perfected within the expanded preference period, lenders should continue to obtain Deprizio waivers.

Preferences Generally

Under Bankruptcy Code § 547, the trustee or the debtor (herein the "trustee") may avoid as preferences certain transfers to creditors. Subject to specified exceptions, § 547(b) allows a trustee to avoid transfers to, or for the benefit of, a creditor that are made within a certain period of time before the filing of a petition for bankruptcy relief. This period, during which such a transfer is considered a preference, is ordinarily 90 days. If the creditor is an "insider," as defined in § 101, however, the period during which the trustee may recover a preference is extended to one year (the "expanded preference period"). The purpose of § 547's avoidance of preferences is generally viewed as facilitating an equal distribution among creditors. 2 Collier Bankr. Man. 6547.01 at 547-3 (Lawrence P. King, ed., 3d ed. 1999).

Prior to the 1994 amendments to the code, § 550 allowed the trustee to recover from a transferee the property or the value of the property that was subject to avoidance under § 547. Recovery could be made from the initial transferee or from the entity for whose benefit the transfer was made, as well as any immediate or mediate transferee of the initial transferee.

Due to the separation of the provisions regarding recovery and avoidance, courts have differed as to whether the avoidance remedy set forth in § 547 exists separately from the recovery remedy contained in § 550. See, e.g., Congress Credit Corp. v. AJC Int'l, 186 B.R. 555 (D.P.R. 1995) (stating that, when property that is the subject of a lien has not yet been transferred, "an action for recovery is unnecessary"); Kepler v. Security Pacific Hous. Servs. (In re McLaughlin), 183 B.R. 171 (Bankr. W.D. Wis. 1995) (indicating that, when a security interest is avoided, § 550 provides the remedy). Further, allowing a trustee to recover an insider preference, or a transfer from either the transferee or the party for whose benefit a transfer is made, opened the door for the court's decision in Deprizio.

In Levit v. Ingersoll Rand Fin. Corp. (In re Deprizio Constr. Co.), 874 F.2d 1186, 1200-1201 (7th Cir. 1989), the trustee sought to avoid certain payments made to outside creditors on loans that had been guaranteed by insiders. The trustee sought to recover these monies from the outside creditors, because the payments had been made during the expanded preference period. Id. at 1188. In Deprizio, the U.S. Court of Appeals for the Seventh Circuit held that, if a transfer made to a noninsider creditor during the expanded preference period was for the benefit of an insider, then that transfer could be avoided under § 547 and recovered under § 550.

Single Rather than Separate Transfers

The Seventh Circuit ruled that each payment made to the outside lenders constituted a single transfer that also benefited the insider guarantors, rather than each payment being construed as separate transfers to each of the lenders and guarantors. Id. at 1196. Because there was only one transfer, the payments could be avoided by the trustee under § 547, and, pursuant to § 550, the amounts paid could be recovered from either the outside creditors or the insider guarantors. Id. at 1200-1201. According to the Seventh Circuit, neither equity nor policy arguments prevented recovery from the guarantors, because lenders would adjust for any inequities that might underlie the court's decision. Id. at 1198.

After Deprizio, many leaders responded by modifying the language of their guarantees, to provide for a waiver of the insider guarantor's right of subrogation and right to repayment by the debtor. See Richard C. Josephson, "The Deprizio Override: Don't Kiss Those Waivers Goodbye Yet," Bus. L. Today, May/June 1995, at 40. These "Deprizio waivers" were premised on the idea that removing the rights of the guarantor against the primary debtor would insulate the lender from avoidance and recovery in respect of payments made during the expanded preference period, because the guarantor would no longer be a creditor of the debtor. The theory was that any payment on the loan would not reduce the guarantor's liability and would therefore not be for the benefit of an insider creditor. Id.

Concerns have been expressed that these waivers may not fully insulate lenders from attack, because any payments made might be avoided as fraudulent conveyances or because the grant of the waiver itself could be viewed as a fraudulent conveyance. See Peter L. Borowitz, "Waiving Subrogation Rights and Conjuring Up Demons in Response to Deprizio," 45 Bus. Law. 2151 (August 1990). Courts, however, have enforced Deprizio waivers to protect noninsider creditors. See, e.g., Hostmann v. First Interstate Bank (In re XTI Xonix Techs. Inc.), 156 B.R. 821 (Bankr. D. Ore. 1993); Hendon v. Associates Commercial Corp. (In re Fastrans Inc.), 142 B.R. 241 (Bankr. E.D. Tenn. 1992).

1994 Amendments to the Code

Deprizio was followed widely by courts that faced the issue of extending the one-year preference period to include transfers to noninsider creditors that benefited an insider. See, e.g., Southmark Corp. v. Southmark Personal Storage Inc. (In re Southmark Corp.), 993 F.2d 117, 120 (5th Cir. 1993); Travelers Ins. Co. v. Cambridge Meridian Group Inc. (In re Erin Food Servs. Inc.), 980 F.2d 792, 799 (1st cir. 1992) (assuming, without deciding, that "Deprizio correctly interprets the legislative directives"); Lowrey v. First Nat'l Bank (In re Robinson Bros. Drilling Inc.), 97 B.R. 77, 82 (W.D. Okla. 1988), aff'd, Manufacturers Hanover Leasing Corp. v. Lowrey (In re Robinson Bros. Drilling Inc.), 892 F.2d 850 (10th Cir. 1989).

In the 1994 amendments to the Bankruptcy Code, Congress, however, attempted to override the Deprizio doctrine by altering § 550's recovery provisions. Congress added a new § 550(c), which disallows recovery under § 550(a) from a transferee that is not an insider, when the transfer occurs outside the 90-day limit. Sec. 550(c) provides:

If a transfer made between 90 days and one year before the filing of the petition--

  1. Is avoided under § 547(b) of this 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.

The separation of avoidance and recovery within the Bankruptcy Code has led to some confusion as to what effect the 1994 amendments had on the viability of the Deprizio doctrine. The legislative history to the new § 550(c) provides that "[o]ur legislation overrules the Deprizio line of decisions and clarifies congressional intent that noninsider transferees should not be subject to the preference provisions of the Bankruptcy Code beyond the 90-day statutory period." 140 Cong. Rec. S14461 (Oct. 6, 1994) (statement of Sen. Charles Grassley, R-Iowa). Despite this clear congressional intent, commentators have disagreed as to whether the addition of § 550(c) actually nullified the Deprizio doctrine in all situations. See, e.g., Josephson article, supra, at 40; Margaret Howard, "Avoiding Powers and the 1994 Amendments to the Bankruptcy Code," 69 Am. Bankr. L.J. 259, Summer 1995, at 267; Adam A. Lewis, "Did It or Didn't It? The Deprizio Dilemma," Am. Bankr. Inst. J., Oct. 1995, at 20.

For example, Mr. Josephson noted in his article that lenders should consider carefully whether or not they should continue to obtain Deprizio waivers. Because Congress has not made similar revisions to § 547, a lien that is perfected by an outside lender within the expanded preference period may still be subject to avoidance by the trustee, if the lien is based on a guarantee by an insider. Id. This past June, the Bankruptcy Court for the District of Oregon faced just this issue.

In re Williams

In Roost v. Associates Home Equity Servs. Inc. (In re Williams), 234 B.R. 801, 802 (Bankr. D. Or. 1999), the debtor and his wife purchased and financed a mobile home and real property from the defendant, and they granted the defendant a security interest in the real property and home for the payment of the debt. The perfection of the defendant's security interest in the mobile home took place more than 90 days before, but within one year of, the debtor's Chapter 7 bankruptcy filing. After the commencement of the bankruptcy, the trustee sought to avoid the security interest, based on the fact that the transfer had benefited an insider, namely the debtor's wife.

The parties agreed that the perfection of the security interest provided a potential benefit to the wife. The defendant/lender, however, argued that, because of § 550(c)'s protection of noninsider transferees, the trustee could not "recover" the security interest, because it was perfected outside the 90-day time period, and, thus, the trustee did not have any claim against the defendant. The defendant argued that § 550(c) barred "recovery," which was not limited only to an actual physical transfer of property, but included the perfection of a lien as well. Thus, the avoidance of the security interest should be construed as a "recovery" that would be subject to § 550(c)'s limitations on the trustee. In response, the trustee contended that, because there was no actual "property" to be recovered from the outside lender, § 550(c) was inapplicable, and the security interest could simply be avoided under § 547 and the Deprizio doctrine.

The bankruptcy court first reviewed the court's split as to whether § 547 provides a remedy that is separate from the recovery remedy under § 550. The bankruptcy court relied heavily on the court in Congress Credit Corp. v. AJC Int'l, 186 B.R. 555 (D.P.R. 1995), which concluded that, when the property subject to a creditor's lien or other interest has not yet been transferred to the third party, no action for "recovery" is necessary. Williams, 234 B.R. at 804. Instead, the trustee simply can avoid the transfer under § 547 and then hold the property for the benefit of the estate, free of the lien or other interest.

No Need to 'Recover'

In its discussion of how the 1994 amendment of § 550 affected the avoidance and recovery rights of the trustee, the courts specifically relied on the analysis presented by the Josephson article. Mr. Josephson reasoned that, where the property itself has not been transferred, the trustee should be able to avoid the security interest without having to "recover" anything under § 550. While Mr. Josephson recognized that a creditor might argue that it is precisely the transfer of the security interest that is being recovered, and thus § 550(c) would apply, he rejected this argument, based on the separation of the recovery and avoidance sections within the Bankruptcy Code. Because only § 550 was amended, the security interest would be avoided under the Deprizio doctrine, without the need for any property to be "recovered." The attempt by Congress to overrule the Deprizio doctrine worked to the extent that a noninsider would not have to disgorge payments received during the expanded preference period, but did not insulate transfers that did not actually have to be "recovered."

The bankruptcy court relegated to a footnote the contrary view of commentators such as Adam A. Lewis, supra, who had argued that Code §§ 547 and 550 should be read together. Under this reasoning, § 547 states the elements of the cause of action, and § 550 provides the remedy. Using Mr. Lewis' approach, § 547 could not be used to alter the rights of a noninsider creditor - including one who perfected a lien - within the expanded preference period.

Although the legislative history indicates that Congress intended to override the Deprizio doctrine in its entirety, the Williams court instead relied on canons of statutory construction and insisted that the plain meaning of a statute must be given effect. 234 B.R. at 805. The court emphasized that Congress chose to amend only § 550, rather than add an exception or defense to § 547 that would have covered "avoidance" as well as "recovery."

Lenders' Continued Concern

Courts following the Williams rationale may allow a trustee to avoid a lien that benefits an insider, if the lien is perfected any time within one year prior to a bankruptcy filing. Although legislative history and policy may support the application of § 550(c) to prevent such action, the Williams court did not find this persuasive.

Until the Supreme Court or Congress addresses this issue, lenders should be concerned that the Deprizio doctrine will apply to the perfection of a security interest that benefits an insider. As a result, lenders should continue to obtain Deprizio waivers in order to protect themselves to the greatest extent possible from the avoidance of a lien where an insider has issued a guarantee in favor of the lender.

Michael J. Sage is a partner with the law firm of Cadwalader, Wickersham & Taft and is resident in the New York office. Ingrid Bagby is an associate with the firm. The authors acknowledge the contributions of Julie Anderson, a summer associate at the firm.

This article is reprinted with permission from the August 1999 edition of Bankruptcy Strategist. © 1999 NLP IP Company. Law News Network