Contributed by Yvanna Custodio
Can a waiver of rights ever be beneficial to the person granting the waiver? Yes. In In re Adamson Apparel, the Court of Appeals for the Ninth Circuit held, in a 2-1 opinion, that waiving a right to indemnification on a guaranty may shield an insider guarantor from preference liability, when 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.” Not every court, however, agrees with this conclusion.
When the debtor, Adamson Apparel, Inc., a clothing manufacturer and retailer, obtained a loan from CIT Group Commercial Services, Inc., Arnold H. Simon, the debtor’s president and CEO, guaranteed the debt. Notably, the relevant agreements waived Simon’s right to indemnification from Adamson (i.e., the ability to seek reimbursement or any other form of payment from the debtor).
Nine months later, the debtor sought protection under chapter 11 of the Bankruptcy Code, and the unsecured creditors’ committee filed a preference action against Simon. The committee alleged Simon was a corporate insider who had received a preference on account of his guaranty because amounts paid to CIT prepetition benefited Simon and reduced the debt for which he would be liable as guarantor.
As every bankruptcy practitioner knows, under section 547(b) of the Bankruptcy Code, a preference is a transfer of property to or for the benefit of a creditor, made within 90 days of the filing of the bankruptcy petition by an insolvent debtor on account of an antecedent (i.e., preexisting) debt that allows the transferee to receive more than it would have received in a chapter 7 liquidation. If the transfer involves an insider, the look-back period is one year. The reason for this extended period is, given their close position to the company, insiders are the first to recognize that a company is in distress, and can manipulate the timing of payment on their debt and the bankruptcy filing so that prepetition payments made to them fall outside the typical 90-day period.
In determining whether Simon should be subject to preference liability, the Ninth Circuit agreed with the bankruptcy court’s findings on remand that Simon had unconditionally waived his indemnification rights against the debtor and concluded that Simon could not be subject to preference liability because, due to the indemnification waiver, he was not a creditor of the debtor, as required by the preference statute.
As part of its analysis, the Ninth Circuit discussed the 1989 decision from the Court of Appeals for the Seventh Circuit, In re Deprizio (in which the Seventh Circuit held that a trustee could avoid payments made to the lender within the one-year period when the lender extends a loan to the debtor that is personally guaranteed by an insider), and the 1994 Congressional response to Deprizio – section 550(c) of the Bankruptcy Code (which provides that the trustee can seek recovery only from the insider but not the lender during the extended one-year recovery period). Following the reasoning in Deprizio, a prepetition payment by the debtor on a guaranteed obligation could be a preferential transfer to the guarantor because the transfer is “to or for the benefit of” the guarantor as the debtor’s creditor.
The Ninth Circuit observed that two lines of cases sprang up in the wake of Deprizio – one upholding the validity of bona fide indemnification waivers as a shield against preference liability and one finding that these “Deprizio waivers” are invalid because such waivers could be circumvented when the insider, rather than pursuing payment from the debtor on the guaranty if the debtor does not pay off the debt prepetition, instead purchases the debt from the lender. Under those circumstances, the insider shields itself from preference liability if the debt is paid prepetition, but can still pursue a claim against the debtor if the debt is not paid prepetition. To courts in this camp, the waiver is a sham.
Declining to adopt a “bright-line rule” based on a hypothetical scenario that would invalidate every Deprizio waiver, the Ninth Circuit noted, “courts should instead examine the totality of the facts before them for evidence of ‘sham’ conduct in the circumstances presented.” In finding that Simon’s waiver was not a sham, the Ninth Circuit cited to four factors before it. First, the Ninth Circuit pointed to CIT’s lien over the debtor’s assets, which would have satisfied CIT’s claim in the absence of Simon’s guarantee. Second, the Ninth Circuit emphasized that Simon never filed a proof of claim. Third, Simon did not have a contractual right to purchase the debt from CIT (if he had a right to do so, the Ninth Circuit observed it “would be more concerned about the waiver being a sham”). Finally, there was no evidence that the debt at issue was the only debt that Simon had guaranteed. The Ninth Circuit reasoned that because the debtor was a closely held corporation, there was no reason to assume Simon did not guarantee other debts of the debtor; had he guaranteed other debts, he would not have received any benefit from paying CIT’s debt first over the other debts which he also personally guaranteed.
In disagreeing with the majority, the dissenting opinion noted that the majority’s decision is contrary to every bankruptcy court decision that has addressed the issue, all of which hold that an insider guarantor is necessarily a creditor of the debtor notwithstanding a waiver of indemnification.
As the Ninth Circuit noted, prior to its decision in Adamson Apparel, no district or circuit court had ruled on the validity of Deprizio waivers. The Ninth Circuit decision could pave the way for more courts approving the use of indemnification waivers as shields against preference liability for insider guarantors. As a result, a corporate insider seeking to guarantee a loan or facing potential preference liability on account of its guaranty can look to In re Adamson Apparel in structuring the guarantee and/or crafting possible defenses to preference liability.
Throwback Thursday Bonus
For our loyal readers interested in reading more about Deprizio, stay tuned for our Throwback Thursday post analyzing the decision in greater detail.