Ninth Circuit Holds that Absolute Waiver of Subrogation Rights Insulates Insider-Guarantor from Preference Exposure

In Stahl v. Simon (In re Adamson Apparel, Inc.), 785 F.3d 1285 (9th Cir. 2015), the United States Court of Appeals for the Ninth Circuit considered an unresolved issue of bankruptcy law: whether a corporate insider who personally guaranteed a corporate debtor’s loans is subject to preference liability where the guarantor has previously unconditionally waived his subrogation and indemnification rights (hereafter, Subrogation Rights). Though the opinions of lower courts are split, the Ninth Circuit held, under the specific facts of the case, that a waiver of Subrogation Rights absolved the guarantor of preference liability, as the waiver divests the guarantor of "creditor" status as against the debtor which is a necessary element to a preference claim.

In 2002, Adamson Apparel, Inc. (Debtor), a clothing manufacturer and distributor, received a multi-million dollar loan from CIT Group Commercial Services, Inc. (CIT). As security for the loan, CIT took a security interest in the Debtor’s inventory and accounts receivables. In addition, Arnold Simon (Simon), the Debtor’s President and CEO, guaranteed the repayment of the loan by entering into a Cash Collateral Pledge Agreement (Pledge) and a Limited Guaranty (Guaranty). Both the Pledge and Guaranty contained waivers of Subrogation Rights although in differing degrees. The Pledge contained a postponement of Subrogation Rights until CIT had been paid in full, whereas the waiver in the Guaranty was absolute. In late 2003, BP Clothing, L.L.C purchased a large amount of merchandise from the Debtor and was instructed to transfer the purchase price of $4,989,934.65 (Transfer) directly to CIT in partial satisfaction of the debt that Simon guaranteed. After the Debtor filed for bankruptcy, Simon personally repaid the balance of the loan to CIT which was approximately $3.5 million.

Following the Debtor’s September 28, 2004 Chapter 11 filing, the Committee of Unsecured Creditors (Committee) filed an adversary proceeding against Simon seeking to recover the Transfer from Simon on the theory that the Transfer constituted a preference since it reduced Simon’s exposure under the Pledge and Guaranty. Simon argued that because he waived his Subrogation Rights, he was not a creditor of the Debtor and was not subject to preference liability.

The Bankruptcy Court agreed with Simon, holding that he fully waived his Subrogation Rights, which eliminated his status as creditor for preference liability purposes. On appeal, the United States District Court for the Central District of California reversed and remanded to the Bankruptcy Court for further factual development due to ambiguity between the Pledge and Guaranty. At trial, Simon testified that at all times he believed that he was relinquishing his Subrogation Rights and, based on this belief, never filed a proof of claim against Debtor’s estate even though he satisfied amounts owed to CIT in excess of the Transfer. The Bankruptcy Court again held in Simon’s favor, and the District Court affirmed. An appeal to the Ninth Circuit followed. In a majority opinion, the Ninth Circuit affirmed the holding of the District Court.

The Ninth Circuit began by agreeing that the Pledge and Guaranty were ambiguous as to whether Simon unconditionally waived his Subrogation Rights, and therefore, additional evidence was necessary to determine Simon’s intent. The Ninth Circuit went on to find that the Bankruptcy Court did not err in finding that Simon unconditionally waived his Subrogation Rights based on his oral testimony at trial, and the fact that he did not subsequently file a proof of claim to recoup any amounts paid to CIT in satisfaction of the amount owed.

Turning to the legal issue, the Ninth Circuit analyzed the differing results reached by the lower courts with respect to the effect of waivers of subrogation rights by insiders on preference liability. Case law relied upon by the Chapter 7 trustee¹, who replaced the Committee as Plaintiff upon conversion of the Debtor's case to Chapter 7, utilized an equitable policy based approach to conclude simply that waivers of subrogation rights are sham agreements and are not valid, as they allow for an insider guarantor to escape preference liability but then purchase the debt directly from the lender. The guarantor would then step into the lender’s shoes and assert a claim directly rather than by way of subrogation without fear of suffering later claw-back. In contrast, case law relied upon by Simon applies² the plain language of the Bankruptcy Code to the specific facts of the case and stands for the proposition that bona fide waivers of subrogation and indemnification rights are valid and excuse an insider guarantor from preference liability, as such a waiver eliminates any legally cognizable claim the guarantor may have against the debtor and divests the guarantor of creditor status.

While ultimately finding in favor of Simon, the Ninth Circuit agreed that the policy concerns raised by the Trustee were valid. Specifically, that waivers like the one at issue could allow a savvy guarantor to sidestep preference liability as described above but determined that the better course of action was to examine the facts on a case by case basis and rule according to what actually has happened. In the current instance, the Court noted that the following factors indicated that the waiver of Subrogation Rights by Simon was valid rather than a sham agreement:

CIT held a lien on the Debtor’s inventory and accounts receivable and could have satisfied its claim through liquidation of same rather than through Simon’s guaranty;
Simon never filed a proof of claim against Debtor even though he paid $3.5 million to CIT after application of the Transfer;
Simon had no unilateral right to purchase the debt from CIT, and CIT could have simply refused to sell the Debt and insist on payment; and
There was no evidence that the debt to CIT was the only debt that Simon guaranteed on the Debtor’s behalf, and Simon would receive no benefit by paying off CIT in full over other similar debts.

The Ninth Circuit concluded by noting that it was not at liberty to ignore a clearly drafted statute based on policy concerns. Because Simon waived his Subrogation Rights from the Debtor and was not a creditor, nothing in the Bankruptcy Code could subject Simon to preference liability simply because he received a benefit from the Transfer.

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¹Miller v. Greystone Business Credit II, LLC (In re USA Detergents, Inc.), 418 B.R. 533 (Bankr. D. Del. 2009); Russell v. Jones (In re Pro Page Partners, LLC), 292 B.R. 622 (Bankr. M.D. Tenn. 2003); Telesphere Liquidating Trust v. Galesi (In re Telesphere Comm., Inc.), 229 B.R. 173 (Bankr. N.D. Ill. 1999).
²O’Neil v. Orix Credit Alliance, Inc. (In re N.E. Contracting Co.), 187 B.R. 420 (Bankr. D.Conn. 1995); Hostmann v. First interstate Bank of Or., N.A. (In re XTI Xonix Techs. Inc.), 156 B.R. 821 (Bankr. D.Or. 1993); Hendon v. Assoc. Comm. Corp. (In re Fastrans), 142 B.R. 241 (Bankr. E.D. Tenn. 1992).