The Effect of the Bankruptcy Reform Act of 1994 on Commercial Lenders

By Donahue, Bonnie Kay; Edwards, W. David | Journal of Commercial Lending, January 1995 | Go to article overview

The Effect of the Bankruptcy Reform Act of 1994 on Commercial Lenders


Donahue, Bonnie Kay, Edwards, W. David, Journal of Commercial Lending


On October 22, 1994, President Bill Clinton signed into law the Bankruptcy Reform Act of 1994. The reform act makes important changes to the Bankruptcy Code, and without question, it is the most ambitious legislation affecting bankruptcy cases in a decade. Rather than reforming the Bankruptcy Code in a comprehensive manner, the reform act makes changes to a number of different sections of the code. The reform act amendments are effective, with minor exceptions, in bankruptcy cases filed on or after October 22, 1994.

No single article could address all of the nuances of this complex legislation. Therefore, the goal of this article is to alert readers to major changes affecting commercial lending brought about by the reform act.

Bankruptcy Review Commission

One of the most significant features of the reform act is the creation of the Bankruptcy Review Commission charged with undertaking a global evaluation of the bankruptcy system. This will be the first bankruptcy commission in 25 years, and the commission's recommendations may set the agenda for future bankruptcy reform. The duties of the Bankruptcy Review Commission, which consists of nine members, are as follows:

* To investigate and study issues and problems relating to the Bankruptcy Code.

* To prepare and submit a report to Congress, the president, and the chief justice of the Supreme Court within two years of the commission's first meeting.

* To solicit divergent views on the bankruptcy system.

In fulfilling these duties, the commission will hold hearings, take testimony, and receive evidence.

The broad latitude of the commission presents commercial lenders with the opportunity to express their concerns regarding the operation of the bankruptcy system and the treatment of commercial creditors. Commercial lenders and their representatives should begin preparing for the commission's hearings, which will be held in 1995. An added incentive for commercial lenders to participate in the process is the directive for the commission to seek comments from those with divergent viewpoints. Commercial entities and, perhaps more significantly, attorneys representing commercial debtors will undoubtedly make their views known to the commission.

Deprizio Overruled

Perhaps the most widely reported amendment in the reform act is the immunity of noninsiders from preference avoidance actions for transfers made after the 90-day preference period. The intent of the amendment is to reverse the much criticized Deprizio ruling.(1) After Deprizio, many courts extended the preference period to one year - the period applicable to insiders of the debtor. The one-year period was applied in situations in which the transfer was considered to benefit an insider. A classic example of the application of the Deprizio rule is a payment made to a lender that benefited an insider guarantor by reducing the guarantor's liability. To minimize the application of Deprizio, many lenders eliminated, among other things, subrogation provisions in loan documents.

The demise of Deprizio should encourage lenders to review and revise loan documents that were modified because of Deprizio-related concerns. Lenders may also want to consider revising their workout strategies, particularly in cases in which the strategies were developed with Deprizio preference actions in mind. In the past, debtors often filed bankruptcy to take advantage of significant avoidable preferences against noninsiders. The reform act may discourage such bankruptcy filings.

The demise of Deprizio, although a welcome reprieve, is not a panacea for lenders. Before Deprizio, many bankruptcy trustees pursued preferences up to one year before the bankruptcy by alleging that the lender was an insider. The reform act provides relief only to noninsider transferees. Thus, there may be a resurgence of litigation in which trustees allege that the lender was an insider of the debtor and, consequently, subject to the one-year preference period.

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