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Creditor That Used Debtor as Mere Instrumentality Qualifies As Non-Statutory Insider in Preference Litigation

Transactions between companies and the individuals or entities that control them, are affiliated with them, or wield considerable influence over their decisions are examined closely due to a heightened risk of overreaching caused by the closeness of the relationship. The degree of scrutiny increases if the company files for bankruptcy. A debtor’s transactions with such “insiders” will be examined by the bankruptcy trustee, the chapter 11 debtor-in-possession, official committees, and even individual creditors or shareholders to determine whether pre-bankruptcy transfers made by the debtor may be avoided because they are preferential or fraudulent, whether claims asserted by insiders may be subject to equitable subordination, and whether the estate can assert causes of action based upon fiduciary infractions or other tort or lender liability claims.

Designation as a debtor’s “insider” means, among other things, that the “lookback” period for preference litigation is expanded from 90 days to one year, claims asserted by the entity may be subject to greater risk of subordination or recharacterization as equity, and the entity’s vote in favor of a cram-down chapter 11 plan may not be counted. The Bankruptcy Code contains a definition of “insider.” However, as demonstrated by a ruling recently handed down by the Third Circuit Court of Appeals, the statutory definition is not exclusive. In In re Winstar Communications, Inc., the court of appeals, in a matter of first impression, ruled that a creditor that used the debtor as a “mere instrumentality” to inflate its own revenues was a “non-statutory” insider for purposes of preference litigation.

Statutory and Non-Statutory Insiders

“Insider” is defined in section 101(31) of the Bankruptcy Code, which provides that, if the debtor is a corporation, the term “includes” the following:

(i) director of the debtor;

(ii) officer of the debtor;

(iii) person in control of the debtor;

(iv) partnership in which the debtor is a general partner;

(v) general partner of the debtor; or

(vi) relative of a general partner, director, officer, or person in control of the debtor.

However, because the Bankruptcy Code’s definition of the term is nonexclusive, courts have identified a category of “non-statutory insiders” consisting generally of those individuals or entities whose relationship with the debtor is so close that their conduct should be subject to closer scrutiny than that of those dealing with the debtor at arm’s length. In determining whether a person or entity qualifies as a non-statutory insider, some courts consider: (i) the closeness of the relationship between the debtor and the alleged insider; and (ii) whether transactions between the debtor and the alleged insider were conducted at arm’s length. As noted by the court in Friedman v. Sheila Plotsky Brokers, Inc. (In re Friedman), the relationship must be “close enough to gain an advantage attributable simply to affinity rather than to the course of business dealings between the parties.” The alleged insider’s degree of control over the debtor is relevant but not dispositive. Under the Third Circuit’s ruling in Winstar Communications, when a creditor is able to control a debtor’s actions to such an extent that the debtor becomes a “mere instrumentality,” the creditor qualifies as a non-statutory insider.

Winstar Communications

Prior to filing for chapter 11 protection in April 2001 in Delaware, telecommunications provider Winstar Communications, Inc. (“Winstar”), and its wholly owned subsidiary Winstar Wireless, Inc. (“Wireless”), entered into a “strategic partnership” with Lucent Technologies Inc. (“Lucent”) whereby Lucent essentially agreed to help finance and construct Winstar’s global broadband telecommunications network. The two entered into a secured credit agreement in 1998 under which Lucent provided a $2 billion line of credit to be used for the purchase of certain products and services in exchange for a lien on substantially all of Winstar’s assets. They also entered into a supply agreement under which Lucent assumed primary responsibility for constructing Winstar’s network and which obligated Lucent to provide Winstar with state-of-the-art equipment, failing which Lucent was obligated to finance equipment or services provided by third parties. The supply agreement required that if Winstar did not buy a certain percentage of services and equipment from Lucent, Winstar would incur escalating surcharges of up to $3 million per year.

Because Lucent did not yet have the ability to provide all of the required services, Lucent and Wireless entered into a temporary subcontracting agreement in 1999 under which Wireless acted as Lucent’s subcontractor to build the network until Lucent could transition to assume that role. In 2000, certain banks provided Winstar with a secured $1.15 billion revolving credit and term loan. At the time, Winstar had raised nearly $1 billion in equity and floated $1.6 billion in public debt. Winstar used the bank loan proceeds to pay off the $1.2 billion it had borrowed from Lucent.

Lucent, however, continued its lending relationship with Winstar, providing the company in May 2000 with a $2 billion line of credit. Lucent’s second credit facility was not secured by a lien on all of Winstar’s assets but included covenants that limited Winstar’s total cash expenditures, gave Lucent the right to serve a refinance notice on Winstar if its outstanding loans exceeded $500 million, and obligated Winstar to use any increase in the senior bank debt to repay Lucent.

In November 2000, Siemens, a competitor of Lucent in the manufacture of equipment, agreed to join the senior bank facility and lend $200 million to Winstar for “general corporate purposes.” Winstar sought permission from Lucent to keep at least some of the Siemens loan proceeds, notwithstanding the requirements of the second credit agreement. Lucent refused and, among other things, threatened to cease lending under the second credit agreement absent surrender of the Siemens loan proceeds. Winstar acquiesced and wired net proceeds of the loan amounting to approximately $188 million to Lucent in December 2000, four months prior to Winstar’s bankruptcy filing.

The Winstar bankruptcy cases were converted to chapter 7 liquidations in January 2002. Prior to the conversion, Winstar sued Lucent, alleging that by breaching its pre-petition contracts with Winstar, Lucent forced Winstar into bankruptcy. Lucent asserted secured and unsecured claims against Winstar aggregating $1 billion based upon the contracts. Post-conversion, the chapter 7 trustee filed an amended complaint in which she asserted various causes of action against Lucent, including claims for breach of subcontract, avoidance of the $188 million payment as a preference, and equitable subordination of Lucent’s claims.

The bankruptcy court ruled that Lucent used Winstar as a mere instrumentality to inflate Lucent’s own revenues, concluding that what began as a “strategic partnership” to benefit both parties quickly degenerated into a relationship in which the much larger company, Lucent, bullied and threatened the smaller Winstar into taking actions that were designed to benefit Lucent. The court found that Lucent controlled many of Winstar’s decisions relating to the buildout of its network, forced the “purchase” of its goods well before the equipment was needed (if needed at all), treated Winstar as a captive buyer for Lucent’s goods, and controlled many of Winstar’s employees. The bankruptcy court held that the $188 million payment was preferential, despite having been made more than 90 days before Winstar filed for bankruptcy, because Lucent was an “insider” as “a person in control” of Winstar and qualified as a “non-statutory insider.” The court also directed that Lucent’s claims against Winstar be equitably subordinated under section 510(c) of the Bankruptcy Code to the claims of other creditors as well as stockholder interests.

The Third Circuit’s Ruling: Actual Control of Debtor Unnecessary

The district court and the Third Circuit, in a matter of first impression, affirmed the ruling in part on appeal. According to the court of appeals, a person may be an insider of a debtor either as: (i) a “person in control” of the debtor, or (ii) a non-statutory insider. To be an insider under category (i), actual control (or its close equivalent) is necessary. Actual control of the debtor is not necessary, however, to establish that a creditor is a non-statutory insider. A creditor’s ability to coerce a debtor into transactions not in the debtor’s interest can establish the creditor as a non-statutory insider. While mere aggressive enforcement of a debt does not ordinarily establish insider status, when a creditor is able to dominate a debtor and require the debtor to affirmatively engage in new, non-arm’s length transactions that benefit the creditor and not the debtor, insider status can be established.

To hold otherwise, the Third Circuit emphasized, would render meaningless Congress’s decision to provide a nonexhaustive list of insiders in section 101(31)(B) because the “person in control” category would function as a determinative test. The court agreed with Lucent’s assertion that “to avoid turning the catch-all ‘non-statutory’ category into an end-run around Congress’s intent—making superfluous the specific, narrow categories Congress identified—that catch-all category must be reserved for persons and entities that are functionally equivalent to the types of insider enumerated in the statute.” Concluding, however, that it is not necessary for a non-statutory insider to have actual control, the Third Circuit explained that the question is whether there is a close relationship between the debtor and the creditor and “anything other than closeness to suggest that any transactions were not conducted at arm’s length.” Finding no fault with the bankruptcy court’s factual findings concerning Lucent’s control of Winstar and Lucent’s abusive conduct, the court of appeals affirmed the court’s ruling with respect to Lucent’s insider status. However, it modified the bankruptcy court’s ruling insofar as it directed subordination of Lucent’s claims to shareholder interests, holding that “§ 510(c)’s language plainly provides that a creditor’s claim can be subordinated only to the claims of other creditors, not equity interests.”

Outlook

Winstar Communications is a significant development and a warning to creditors that have close relationships with financially troubled companies. Even in the absence of actual control, a significant degree of influence over a prospective debtor’s affairs and conduct, coupled with non-arm’s length dealings, can lead to an “insider” designation for a creditor in connection with preference litigation or estate causes of action challenging the priority or validity of a creditor’s claims.

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Schubert v. Lucent Technologies Inc. (In re Winstar Communications, Inc.), 554 F.3d 382 (3d Cir. 2009).

Hirsch v. Va. Tarricone (In re A. Tarricone, Inc.), 286 B.R. 256 (S.D.N.Y. 2002).

Friedman v. Sheila Plotsky Brokers, Inc. (In re Friedman), 126 B.R. 63 (Bankr. 9th Cir. 1991).

Wilson v. Huffman (In re Missionary Baptist Foundation, Inc.), 712 F.2d 206 (5th Cir. 1983).

In re South Beach Securities, Inc., 376 B.R. 881 (Bankr. N.D. Ill. 2007).

In re Eccles, 393 B.R. 845 (Bankr. W.D. Mo. 2008).

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