Temporary Bankruptcy Solution Helps Lenders

Article excerpt

The Bankruptcy Reform Act of 1994 solved what has come to be known as the "Deprizio" preference problem. But one of the temporary solutions found for the problem may provide a continuing benefit to lenders.

By way of background, the Deprizio problem stemmed from the Bankruptcy Code's definition of preference. Generally speaking, a preference is a transfer of an insolvent debtor's property, to or for the benefit of a creditor, made on account of a pre-existing debt.

If the creditor is not an insider of the debtor, the transfer is a preference if made within 90 days of the debtor's bankruptcy. If the creditor is an insider of the debtor, the transfer is a preference if made within one year of the debtor's bankruptcy.

In 1989, the U.S. Court of Appeals for the Seventh Circuit decided the Deprizio case. It ruled that a lender receiving a payment from a borrower more than 90 days but less than one year before the borrower's bankruptcy had received a preference - one that must be disgorged to the borrower's bankruptcy estate.

The Deprizio ruling was troubling. The lender in that case was not an insider of the borrower, and the 90-day preference period arguably should have applied. Under that view, the payment the lender received should not have been a preference.

The court, however, emphasized that the loan was guaranteed by a shareholder - an "insider" - of the borrower.

In addition, the court found, the guarantor was a creditor of the borrower. If the guarantor had made payments on the guaranty, he would have been able to step into the shoes of the lender - in legal parlance, become "subrogated" to the rights of the lender - with respect to the lender's claims against the borrower.

The court also found that the guarantor benefited from the payment to the lender because the payment reduced his exposure on the guaranty. The court then concluded that because the guarantor was an insider, the one-year preference period, rather than the traditional 90-day period, applied.

Thus, the court found, the payment to the bank was a preference. The lender, by asking for the guaranty, had unwittingly subjected itself to a one-year preference period.

After Deprizio, in an attempt to limit the risk of a one-year preference period, lenders began to ask guarantors to waive their subrogation rights.

The guarantor would thus no longer be a creditor. One of the necessary elements for a preference to occur (the requirement that the transfer be to or for the benefit of a creditor) would be broken.

These waivers quickly became standard language in many guaranty forms.

The Bankruptcy Reform Act inoculated lenders against the risk of having to disgorge a payment received beyond the traditional 90-day period; in other words, it reversed Deprizio. …