Deprizio: A Lesson in the Dangers of Strict Construction
December 30, 2005
Lisa Johnson - Chicago
By adding section 547(i) to the United States Bankruptcy Code through its enactment of the Bankruptcy Abuse Prevention & Consumer Protection Act of 2005, Congress finally abolished the “Deprizio doctrine.” This laid to rest once and for all the issue of whether a non-insider creditor can be held liable for the return of a preferential transfer received prior to the 90-day preference period if such transfer benefits an insider. A brief look at the history of the Deprizio doctrine, its creation, progeny and demise, teaches us, in a nutshell, an important lesson in construing the Bankruptcy Code. Specifically, Deprizio represents a lesson in the dangers of overly strict construction and the absurdity of attempting to evaluate the literal meaning of portions of the Bankruptcy Code in isolation from the general context and operation of the Bankruptcy Code as a whole. As a complex body of interconnected concepts, terms and phrases, specific portions of the Bankruptcy Code must be considered and understood in connection with and as a part of the whole.
In 1989, the Seventh Circuit’s landmark decision in Levitt v. Ingersoll Rand Financial Corp. (In re V.N. Deprizio Constr. Co.), 874 F.2d 1186 (7th Cir. 1989) established the so-called Deprizio doctrine, wreaking havoc on the business of lenders and small and start-up businesses whose financing arrangements included individual guarantees. In Deprizio, the Seventh Circuit addressed the question of whether payments to creditors who dealt at arms’ length with a debtor and which would otherwise be subject to the non-insider 90-day preference period would be subject to the year-long preference period applicable to transfers to insiders when the payments made to that creditor benefited an insider. Id. at 1187. Among other types of payments, the appellate court specifically considered the applicable preference period for payments to non-insider lenders on loans guaranteed by an insider. See id. at 1192-1200. The Seventh Circuit concluded that payments to non-insiders during the one-year preference period applicable to insiders, but outside the 90-day preference period, were nonetheless recoverable by a bankruptcy trustee from the non-insider lenders because such payments, though not paid directly to the insider guarantor, reduced the guarantor’s obligations under the guarantees, thereby benefiting an insider who was also a creditor of the debtor due to the guarantor’s contingent claims for reimbursement. Id. at 1200-1201.
In examining the issue, the Seventh Circuit first construed the requirement of section 547(b)(1) that in order to be a preference a payment had to be “to or for the benefit of a creditor.” The appellate court concluded that the debtor’s payments to the lenders on loans guaranteed by an insider were “for the benefit” of the insider because every payment on the loans correspondingly reduced the extent to which the insider was exposed on his guarantees. This relationship, however, only shows that a benefit was received by the insider, not that the payment was made “for” the benefit of the insider. Indeed, any benefit received by an insider guarantor from the debtor’s payment to the principal outside creditor is arguably of an entirely incidental and collateral nature. To be clear, the Deprizio court made a policy decision to presume that in such circumstances any payment made beyond the 90-day period but within one year of the petition date was made for the insider’s benefit, or more specifically, for the improper purpose of giving a preference to the insider guarantor’s liabilities. Id. at 1195 (“While concealing the firm’s true financial state, [insider guarantors] would pay off … the debts they had guaranteed, while neglecting others.”). Congress, by operation of the provisions of section 547(b), did not require such a conclusion.
After determining that such payments were avoided under section 547(b), the Seventh Circuit then moved to the issue of whether the bankruptcy trustee could recover the preferential transfers which benefited an insider guarantor from the non-insider creditors under section 550 of the Bankruptcy Code. Having already construed the phrase “for the benefit of a creditor” to include any creditor benefiting from a transfer made to another creditor, it was not difficult for the Seventh Circuit to conclude that such transfers were recoverable from the outside creditor under section 550(a) as the insider guarantor would necessarily be an “entity for whose benefit such transfer was made.” Id. at 1194.
Though arguably true to the literal meaning of the plain language of the statute when analyzed in a narrow and piecemeal fashion, the Seventh Circuit’s construction of sections 547 and 550 in Deprizio was admittedly contrary to historical bankruptcy practice. This construction fostered various internal inconsistencies in the Bankruptcy Code that Congress would have trouble fixing over the following decade.
The Deprizio court’s conclusion that the reference in section 550(a) to “the entity for whose benefit [a transfer avoided under §547] was made” referred to any creditor other than that creditor possessing the antecedent debt owed by the debtor before such transfer was made as required by section 547 was not just novel, as the Seventh Circuit marveled, it was perverse. As a result of the Deprizio court’s construction of the Bankruptcy Code, a trustee could recover a preference from the non-insider creditor to whom the payment was made even if the recovered transfer was not a preference to that creditor, but to an insider guarantor. As acknowledged by the appellate court, the general practice under the Bankruptcy Act of 1898 permitted recovery of payments only from those to whom the transfer represented a preference. Id. at 1196. Viewed as a disparate set of instructions and in isolation from prior bankruptcy practice historically, the logic of Deprizio’s strict literal construction of the Bankruptcy Code might have made sense. However, read together, the provisions of sections 547 and 550 could hardly be construed to subject outside creditors to any preference liability for transfers made beyond 90 days prior to the debtor’s petition date.
The Seventh Circuit in Deprizio was the first circuit court to rule on the issue. Prior to Deprizio, most lower courts addressing the issue held that an outside creditor could not be held liable for payments made to it beyond the 90-day preference period on loans guaranteed by insiders. Deprizio, however, was widely followed by circuit courts considering the issue. See Galloway v. First Alabama Bank (In re Wesley Indus., Inc.), 30 F.3d 1438 (11th Cir. 1994); Official Unsecured Creditors Comm. v. U. S. Nat’l Bank (In re Suffola Inc.), 2 F.3d 977 (9th Cir. 1993); Southmark Corp. v. Southmark Personal Storage Inc. (In the Matter of Southmark Corp.), 993 F.2d 117 (5th Cir. 1993); The Travelers Ins. Co. v. Cambridge Meridian Group, Inc. (In re Erin Food Servs., Inc.), 980 F.2d 792 (1st Cir. 1992); Ray v. City Bank and Trust Co. (In re C-L Cartage Co., Inc., 899 F.2d 1490 (6th Cir. 1990); Manufacturers Hanover Leasing Corp. v. Lowrey (In re Robinson Bros. Drilling Inc.), 892 F.2d 850 (10th Cir. 1989).
After Deprizio, unwary but otherwise sophisticated lenders found themselves in a potentially worse position for having taken what they presumed was a credit-enhancing guarantee than the position that they would have occupied had they not obtained the guarantee. Most of these lenders soon devised a solution to the problem and, as a short run response, included provisions in their insider guarantees whereby directors, officers and other insider guarantors waived any right to subrogation, payment or contribution against the borrower. Having waived such rights, insider guarantors would no longer be creditors under section 547(b)(1) so that transfers made to or for their benefit would not be avoidable.
The brunt of the Deprizio problem and its immediate solution fell upon the unsophisticated lender and upon small and/or new businesses for which securing a loan at a reasonable rate depended on the assurance of an individual guarantor. Moreover, the immediate solution to the Deprizio problem was not a panacea, because at least one court was of the view that the insider’s creditor status did not have to arise in connection with the debtor’s obligation to the non-insider creditor in order for Deprizio to apply. See Tidwell v. AmSouth Bank, N.A. (In the Matter of Cavalier Homes of Georgia, Inc.), 102 B.R. 878, 884-86 (Bankr. M.D. Ga. 1989) (payment made by the debtor-guarantor reduced the insider obligors’ liability to the lender at a time when the debtor owed money to insiders under a lease agreement). Under such a view, an insider’s waiver of claims against the debtor in connection with the payments to the lender would not preclude recovery from the lender under the Deprizio doctrine.
In response to Deprizio and its progeny, Congress passed section 202 of the Bankruptcy Reform Act of 1994 with an amendment to section 550 prohibiting the trustee from recovering a preferential transfer made during the insider preference period from anyone other than an insider:
(c) If a transfer made between 90 days and one year before the filing of the petition –
(1) is avoided under section 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.
11 U.S.C. § 550(c). By so amending section 550, Congress intended to overrule Deprizio. The legislative history to section 550(c) indicates that Congress expressly added section 550(c) to “overrule the Deprizio line of cases and clarify that non-insider transferees should not be subject to the insider preference provisions of the Bankruptcy Code beyond the 90-day statutory period.” Legislative History to section 550; 140 Cong. Rec. H:10, 752-01, H:10,767 (daily ed. Oct. 4, 1994).
Even so, after Congress’ attempt to resolve the issues giving rise to the Deprizio decision, several courts found a way to apply Deprizio in disregard of the express intent of Congress. Most notably, in Roost v. Associates Home Equity Servs., Inc. (In re Williams), 234 B.R. 801 (Bankr. D. Or. 1999), the court acknowledged that the 1994 Reform Act expressly precluded recovery of a preference made for the benefit of an insider from an outsider under section 550(a), as amended, but held that such a preference was not precluded from avoidance under section 547(b). With an appeal to canons of statutory construction and bankruptcy decisions recognizing avoidance and recovery as distinct concepts, the court in Williams held that a security interest, which need not be “recovered” in the literal sense of the word as such an interest becomes property of the debtor’s estate upon the commencement of the bankruptcy case, was avoidable under the Deprizio doctrine even though recovery of a payment would not be recoverable under section 550(c). Id. at 805.
To resolve the problem once and for all, in April 2005 Congress closed the loophole identified in Williams and added an exception to section 547 mirroring its 1994 amendment to section 550(c), prohibiting the bankruptcy trustee from avoiding a preferential transfer made during the insider preference period with respect to anyone other than an insider:
If the trustee avoids under subsection (b) a transfer made between 90 days and 1 year before the date of filing of the petition, by the debtor to an entity that is not an insider for the benefit of a creditor that is an insider, such transfer shall be considered to be avoided under this section only with respect to the creditor that is an insider.
11 U.S.C. §547(i).
The Deprizio problem created by the Seventh Circuit’s misguided construction of the Bankruptcy Code would appear to be finally resolved. The message from Congress to the courts would seem to have been made crystal clear and unavoidable. Preferential transfers made between 90 days and one year and avoided as transfers to or for the benefit of an insider are not recoverable from anyone other than the insider. Preferential transfers made between 90 days and one year are not avoidable with respect to any entity other than an insider. But what have we learned and could we find ourselves once again entangled in the web of misguided statutory construction?
Is it certain that Congress’ abolishing the remedy available under the Deprizio doctrine is sufficient to avoid the effects of the right established therein? For example, section 502(d) states that the court shall disallow “any claim” of “any entity” “that is a transferee of a transfer avoidable” under section 547 unless such entity or transferee “has paid the amount, or turned over any such property, for which such entity or transferee is liable under section 522(i), 542, 543 or 553.” Taken literally, an outsider securing a lien between 90 days and one year before the debtor’s petition is filed is a transferee of an avoidable transfer. Should Congress be required to add an amendment to section 502(d) to clarify that this outsider, a recipient of a “transfer” as that term is broadly defined in section 101(54), is not a transferee for purposes of section 502(d) because the transfer was not avoidable with respect to him? Without doubt, the better route would be for courts to be wary of disrupting the careful balance struck by Congress in weaving together the Bankruptcy Code and construe the Bankruptcy Code as a whole without emphasizing a rigidly literal interpretation of provisions of the statute in piecemeal fashion. Such an emphasis, as the follow-up from Deprizio attests, will almost certainly create ambiguity in derogation of the statute’s practical import.
For more information, e-mail Lisa Johnson at lisa.johnson@hklaw.com or call toll free, 1-888-688-8500.
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