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.
However, the subrogation waiver developed to limit Deprizio risk serves a separate, perhaps equally important, purpose, and should be retained in many instances.
Suppose, for example, that a lender makes an unsecured $10 million loan to a somewhat financially weak corporate borrower, and that the credit is supported by an unsecured guaranty of the borrower's stronger corporate parent.
Suppose further that eight months before the borrower enters bankruptcy, the borrower pays the lender $4 million. After the borrower enters bankruptcy, the lender will be able to keep the $4 million payment; that is the change wrought by the Bankruptcy Reform Act.
Now assume that to be paid the balance of the loan, the lender has to call on its guaranty. The problem is that the guarantor has received a $4 million preference; that part of the preference rule was not changed by the Bankruptcy Reform Act.
Consequently, the guarantor - but not the lender - remains obligated to return to the borrower, for the benefit of all of the borrower's creditors, the $4 million preference it received when the lender received its pre- bankruptcy payment.
If the guarantor does not have sufficient assets to pay both the amount owing to the lender on the guaranty as well as the $4 million it owes to the borrower on the preference claim, the guarantor may enter bankruptcy and its available assets will be allocated among all of its creditors.
In that process, the lender will find its guaranty claim competing against the borrower's preference claim. The lender may very well come up short.
Suppose, though, that the guarantor had waived its subrogation rights. As analyzed in Deprizio, the guarantor is no longer a creditor of the borrower.
Thus, the borrower's $4 million payment would not be for the benefit of an insider that is a creditor and hence would not be a preference that the guarantor has to return to the borrower's bankruptcy estate.
Therefore, the lender will not find itself in the position of having to compete with the borrower's bankruptcy estate for the guarantor's assets to obtain payment of the balance of its loan.
To be sure, the Bankruptcy Reform Act certainly alleviated the principal difficulty raised for lenders by Deprizio.
However, at least in circumstances where a lender takes a guaranty from an insider that provides real credit support to the loan, the subrogation waiver should be retained. It may be the only way to avoid the lender finding itself in competition with its borrower for the guarantor's assets.
Mr. Wight is a partner in the banking and institutional investment group of Milbank, Tweed, Hadley & McCloy law firm in New York.