In a case of first impression for any district or appellate court, the Court of Appeals for the Ninth Circuit (the “Court”) held that “when an 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, he is absolved of any preference liability to which he might otherwise have been subjected.” As discussed below, the case provides a list of factors for courts to consider in determining whether an indemnification waiver should be considered valid for purposes of exempting an insider guarantor’s preference liability.

In Stahl v. Simon (In re Adamson Apparel, Inc.), the Court decided whether a personal guarantor of corporate debt may be liable for preferences where that guarantor is an insider of the debtor but validly waived his rights to indemnification against the debtor. The debtor Adamson Apparel, Inc. (the “Company”) was the borrower under a multi-million dollar loan. The Company’s President and CEO Arnold H. Simon (“Simon”) personally guaranteed the Company’s obligations under the loan. At the same time, Simon waived his rights against the Company for indemnification, for reimbursement of any amounts Simon paid against the loan.

Prior to filing bankruptcy, the Company executed a large sale of its merchandise to a third party for approximately $5 million. The Company instructed the merchandise purchaser to transfer the purchase price directly to the Company’s lender, in partial satisfaction of the debt. A few months thereafter, Simon personally paid the balance of the loan, equal to approximately $3.5 million.

Six months after Simon paid off the loan, the Company filed for Chapter 11 bankruptcy, and the Committee of Unsecured Creditors (“Committee”) filed a lawsuit against Simon claiming he was liable for preferential payments. The Committee’s lawsuit theorized that the $5 million debt payment by the Company (via the merchandise sale) amounted to a preference in favor of Simon, because it reduced Simon’s debt under the loan by the same amount.

The key question was whether Simon was a “creditor” of the Company. Bankruptcy Code Section 547(b) sets the parameters of preference liability, and those parameters state that a preference exists only if, among other things, the debtor transfers property “to or for the benefit of a creditor.” Bankruptcy Code Section 101(10) defines “creditor” as an “entity that has a claim against the debtor that arose at the time of or before the order for relief,” and a “claim” includes a contingent right to payment. The plaintiff carries the burden of proof to establish that the defendant is, in fact, a creditor.

Under Levitt v. Ingersoll Rand Fin. Corp. (In re Deprizio), 874 F.2d 1186 (7th Cir. 1989) and Section 547(b), insider guarantors may be liable for transfers made by the debtor on the guaranteed debt up to one year before the petition date.   In the wake of Deprizio, an increasing number of guarantors executed indemnification waivers like the one executed by Simon. The bankruptcy courts have been split on whether such waivers are valid. One line of bankruptcy cases concludes that such waivers are valid and excuse the guarantor from preference liability. E.g., O’Neil v. Orix Credit Alliance, Inc. (In re Ne. Contracting Co.), 187 B.R. 420 (Bankr. D. Conn. 1995). However, another line of bankruptcy cases, most notably In re Telesphere Commc’ns, Inc., 229 B.R. 173 (Bankr. N.D. Ill. 1993), concludes that such waivers are invalid, because they lack economic impact—

if the principal debtor pays the note, the insider guarantor would escape preference liability, but if the principal debtor does not pay the note, the insider could still obtain a claim against the debtor, simply by purchasing the lender’s note rather than paying on the guarantee. . . . The attempted waiver of subordination rights was thus held to be a sham provision, unenforceable as a matter of public policy.

Telesphere, 229 B.R. at 176 n.3.

At a bench trial before the bankruptcy court, Simon argued that he had fully waived his indemnification rights against the Company and did not file a proof of claim against the Company, and therefore he was not a “creditor” of the Company and not subject to preference liability. The bankruptcy court agreed and entered judgment in favor of Simon. The district court affirmed the bankruptcy court’s judgment, and the lawsuit was then appealed up to the Ninth Circuit, which reviewed the bankruptcy court’s findings of fact for clear error and its conclusions of law de novo.

After concluding that the bankruptcy court did not make clear error in finding that Simon fully waived his indemnification rights, the Court addressed Telesphere’s concern regarding “sham” waivers. The Court stated that, rather than negating a waiver because it hypothetically could be a sham, “courts should instead examine the totality of the facts before them for evidence of ‘sham’ conduct.” In this case, the Court considered four factors to be relevant to the examination:

  1. Available Collateral—The loan in question was secured by a lien on the Company inventory and accounts receivable and, therefore, the loan could have been satisfied by those assets, without Simon’s guarantee.
  2. No Act as Creditor—Simon never filed a proof of claim against the Company and did not purchase the loan from the lender.
  3. No Unilateral Right to Purchase Loan—Simon did not have a unilateral right to purchase the loan.
  4. Other Guaranteed Debts—The plaintiff presented no evidence that the loan in question was the only Company debt that Simon guaranteed. If the loan was the only Company debt that Simon guaranteed, then perhaps Simon would have an incentive to satisfy this lender’s debt instead the Company’s other debts. But plaintiff presented no such evidence to support its burden.

All of these facts led the Court to conclude that Simon’s indemnification waiver was valid and not a sham, and therefore Simon was not a “creditor” of the Company under the Bankruptcy Code.

As the only appellate or district court decision to decide the issue, Adamson presents the strongest case to date that, in the event a borrower files bankruptcy, any insider guarantors who have truly waived their indemnification rights will not be liable for preferences related to the borrower’s pre-petition payoff of the debt.