Bankruptcy Court Affirms Constitutionality of BAPCPA's Deprizio Amendment

While I've spent quite of bit of time bashing BAPCPA, it's not all bad. One change, for example, that was long overdue was an amendment to the Bankruptcy Code that addressed the so-called "Deprizio problem," a problem the drafters of the Code's amendments in 1994 thought they had resolved once and for all.

In In re ABC-Naco, (2005 WL 2649305) (Bankr. N.D. Ill., 10/13/05), Judge Wedoff, Chief Judge of the Bankruptcy Court for the Northern District of Illinois, in addressing a challenge to the constitutionality of BAPCPA's Deprizio amendment, first succinctly summarized the purpose of the amendment, and then affirmed its constitutionality.

For those contemplating constitutional challenges to BAPCPA based on violations of the Takings and Due Process Clauses of the US Constitution, this case is worth reading as it well demonstrates the challenges facing the litigant who contests garden variety amendments to BAPCPA like the "Deprizio amendment." (See also, Erwin Chemerinsky, Constitutional Issues Posed in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, 79 Am. Bankr. L. J. 571 (2005) ("identify[ing] the constitutional issues most likely raised by BAPCPA")).

Excerpts from the Court's opinion follow:

A. Section 547, In re Deprizio, and § 1213 of BAPCPA

The underlying legal issue in this case is the applicable preference period: how long before the filing of a bankruptcy case is a transfer of the debtor's property on account of an antecedent debt subject to avoidance as a preference? Section 547(b) generally makes transfers voidable as preferences if they occurred "on or within 90 days" of the bankruptcy filing, but it provides an extended preference period of one year for a transfer made "to or for the benefit of a creditor" if "such creditor at the time of such transfer was an insider."


In Levit v. Ingersoll Rand Fin. Corp. (In re Deprizio), 874 F .2d 1186, 1200-01 (7th Cir.1989) ("Deprizio"), the Seventh Circuit construed § 547(b) to allow avoidance of a loan payment made within the extended preference period, even though the payment was made to a non-insider lender, because an insider had guaranteed the loan. The court reasoned (1) that for purposes of § 547(b), the payment to the lender resulted in a "benefit" to the insider-guarantor by reducing the guarantor's liability, and (2) that the guarantor was a "creditor" because it held a contingent claim against the debtor--the subrogation right that would come into existence if the guarantor was required to pay on the guarantee. Id. at 1190 (citing 11 U.S.C. § 101(4)(A), (9)). Deprizio also held that pursuant to § 550(a) the trustee could recover either the transferred property or its value from the "initial transferee"--the lender--as well as from the guarantor, the "entity for whose benefit such transfer was made." Id. Thus, the trustee had the option to collect from the lender, guarantor, or both, "subject only to the proviso in § 550(c) that there can be but one satisfaction." Id. at 1194.

In 1994, Congress added to the Code a new § 550(c), intended to overrule Deprizio. However, the amendment to § 550 failed to address another possible remedy--where the property interest transferred was a lien, the preference plaintiff might merely seek to avoid the transfer under § 547(b) and preserve the value of the lien for the bankruptcy estate under § 551. In this situation, no return of the transferred property or its value under § 550 would be necessary.

Section 1213 of BAPCPA adds a new subsection to § 547 that addresses this remaining ground of recovery under Deprizio:

If the trustee avoids under subsection (b) a transfer made between 90 days and 1 year before the date of the 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(j) (emphasis added).

The House Report emphasizes that the intent of this new provision is a more complete elimination of what it calls "the Deprizio problem". ... Furthermore, Congress determined that this "perfecting amendment" should have immediate effect....

Accordingly, by its terms, § 1213 of BAPCPA eliminates the Committee's pending avoidance action against the Bank, and the Committee does not contend to the contrary. Rather, the Committee argues that retroactive application of § 1213 to this proceeding is unconstitutional.

B. The Committee's Constitutional Challenges to § 1213 of BAPCPA

There is nothing inherently unconstitutional about retroactive legislation. Absent a specific constitutional impediment, the intent of Congress to apply a statute retroactively must be honored. See Landgraf v. USI Film Prods., 511 U.S. 244, 267 (1994). The specific constitutional provisions under which the Committee seeks to prevent retroactive application of § 1213 are the Takings and Due Process clauses of the Fifth Amendment. Neither clause, however, is offended by § 1213....

1. Unconstitutional Taking of Property

The likely reason for the Committee's failure to claim an unconstitutional taking in this respect is a well-established principle that an interest in a cause of action does not vest, for purposes of the Takings Clause, until judgment is entered. McCullough v. Virginia, 172 U.S. 102 (1898).

The Committee does not directly dispute the McCollough principle that there is no unconstitutional taking in retroactively abrogating a cause of action that has not resulted in a final judgment. Rather, the Committee argues that two other property interests were unconstitutionally taken from ABC-NACO by § 1213 of BAPCPA. First, the Committee argues that § 1213 deprived ABC-NACO of an interest that it held in the mortgaged real estate. Before the enactment of § 1213, the argument asserts, ABC-NACO's ownership interest in the mortgaged properties was "that of an absolute owner of unencumbered real estate" (Committee's Response [Docket No. 159] at 2); as absolute owner, ABC-NACO's rights "would include the right of possession and alienation (and all the value from the exercise of such rights)" (id. at 3); and § 1213 took these rights away from ABC-NACO by giving the Bank a lien it otherwise would not have (id.).

This argument misconstrues the effect of the Bankruptcy Code's avoidance provisions. These provisions alter property interests established under non-bankruptcy law--but only through a judgment based on the provisions. There is no "automatic" reversal of avoidable transfers. Under applicable non-bankruptcy law, ABC-NACO held its real estate, prior to its bankruptcy filing, subject to the liens that it had granted to the Bank; after the filing, those liens, though subject to possible avoidance under § 547, remained valid. Thus, § 1213 of BABCPA did not remove a property interest enjoyed by ABC-NACO. It removed a cause of action that might have resulted in ABC-NACO recovering a property interest.

This understanding of avoidance in bankruptcy is illustrated by In re Colonial Realty Co., 980 F.2d 125 (2d Cir.1992). In Colonial Realty, the Second Circuit rejected an argument by a bankruptcy trustee much like the one made by the Committee here--that the debtor's estate included property that had been transferred to a third party in a transaction subject to avoidance. The court held that transferred property subject to recovery in an avoidance action is not property of the estate until it is actually recovered by the bankruptcy trustee. Id. at 131.

Colonial Realty relied on the definition of "property of the estate" set out in § 541 of the Bankruptcy Code. It adopted the reasoning of the Saunders court that "if property that has been fraudulently transferred is included in the § 541(a)(1) definition of property of the estate, then § 541(a)(3)"--which provides that property of the bankruptcy estate includes "[a]ny interest in property that the trustee recovers" under certain Code provisions, including § 550--"is rendered meaningless with respect to property recovered pursuant to fraudulent transfer actions." Colonial Realty, 980 F.2d at 131 (internal quotation omitted). As the Saunders court explained, "The inclusion of property recovered by the trustee pursuant to his avoidance powers in a separate definitional subparagraph clearly reflects the congressional intent that such property is not to be considered property of the estate until it is recovered." 101 B.R. at 305. Thus, "[u]ntil a judicial determination has been made that the property was, in fact, fraudulently transferred, it is not property of the estate." Id. Otherwise, "allowing the debtor to retain an interest, legal or equitable, in fraudulently transferred property conceivably places a cloud on the title of any property transferred by the debtor until there is a judicial determination that the transfer is not avoidable ... [a] result [that] was clearly not contemplated by Congress." Id.

This reasoning is consistent with the McCullough principle. A bankruptcy estate does not possess a property interest in transferred property, even though the transfer is subject to avoidance, until the estate obtains a judgment actually avoiding the transfer. Until that time, the estate holds only an unvested interest in a cause of action. Because no judgment avoiding the Bank's mortgages was entered prior to its enactment, § 1213 did not deprive ABC-NACO of any interest in real property.

In addition to the asserted real property interest, the Committee contends that the Takings Clause protected one other property interest of ABC-NACO--a contractual right, arising under its mortgages, to have preferential transfers avoided. Specifically, the Committee argues that under Illinois law the mortgage agreements contained an implied provision incorporating the Bankruptcy Code's avoidance provisions as they existed at the time the mortgages were granted. The Committee cites no specific authority for this proposition. It simply notes the general principle that "statutes and laws in existence at the time a contract is executed are considered part of the contract." ...

This argument has several flaws. First, any implied contractual term would deal with the rights and obligations of the parties to the contract. The cases cited by the Committee provide examples of such implied terms. ... Second, even if Illinois law would find that a mortgage contract includes by implication existing law granting rights to the creditors of a bankruptcy estate, the contract would also include, by implication, Congress's constitutional power to "enact uniform Laws on the subject of Bankruptcies," a power that plainly encompasses the avoidance of preferences. U.S. Const., art. I, cl. 8; see In re Dehon, Inc., 327 B.R. 38, 62-64 (Bankr.D.Mass.2005) (discussing the history of preference law in bankruptcy). ... Finally, even if ABC-NACO and Bank had expressly provided in their mortgages that only existing preference law would be applicable, that provision would have been unenforceable. See Connolly v. PBGC, 475 U.S. 211, 223-24 (1986) ("'Contracts, however express, cannot fetter the constitutional authority of Congress.... Parties cannot remove their transactions from the reach of dominant constitutional power by making contracts about them.'").

2. Violation of Due Process

© Steve Jakubowski 2005

As an alternative to its Taking Clause argument, the Committee asserts that retroactive application of § 1213 would be a denial of substantive due process, violating the Fifth Amendment's provision that "[n]o person shall ... be deprived of life, liberty, or property without due process of law." Like any other legislative provision, a retroactive congressional amendment is consistent with substantive due process if the legislation is "rationally related to a legitimate legislative purpose." PBGC v. R.A. Gray & Co., 467 U.S. 717, 729 (1984). A party challenging legislation as a denial of substantive due process has the burden of showing that Congress acted irrationally in enacting the legislation. ...

The Committee argues that Congress' purpose in enacting § 1213 of BAPCPA is only sufficient to support prospective, not retroactive application. And indeed, one of the rationales supporting the abrogation of Deprizio-type preference actions, set out in H.R.Rep. No. 109-31, at 144 (2005), is that limiting to 90-days the preference liability of lenders with insider guarantees may encourage lending supported by insider guarantees. This rationale, the Committee asserts, does not support retroactive application, since loans already made need no encouragement.

But Congress had at least two other reasons for enacting § 1213. The first was simply that lenders were never intended to have been subject to an extended preference period based on insider guarantees--that the relevant Code provisions were misconstrued by Deprizio, and the 1994 amendments inadvertently failed to overturn the decision completely. Thus, the House Report on BAPCPA, cited above, refers to § 1213 as "a perfecting amendment" to address the "Deprizio problem." Correcting legislative errors is a "benign and legitimate" rationale for retroactive application of a statute. See Landgraf, 511 U.S. at 267-68.

The second reason is related to the first. If, as a matter of fairness, loans by non-insiders should not be subject to an extended preference period based on an insider guarantee, then retroactive application rationally promotes the purpose of preventing an inappropriate transfer of property from the lender to other creditors of the debtor's estate.

Since retroactive application of § 1213 has not been shown irrational, the Committee has failed to establish a denial of substantive due process under the Fifth Amendment.


Steven Jakubowski