When is an “Outsider” Really an “Insider?” And When Does It Matter?

06 Feb When is an “Outsider” Really an “Insider?” And When Does It Matter?

Conventional wisdom has it that Chapter 11 cases in this economic downturn will be far more fractious than those in the prior cycle.

In an era of extensive de-leveraging, various constituencies are expected to wrangle fiercely over their relative positions within a debtor’s complicated capital structure.  Likewise, the growing trend toward more bankruptcy sales means creditors will likely to pursue litigation against third parties in an attempt to recover value beyond the sale proceeds.

On Wednesday, the influential Third Circuit Court of Appeals (whose juridsiction includes bankruptcy venues in Pennsylvania and Delaware) upheld an earlier bankruptcy court decision that may widen this already-growing field of battle.

The decision – which, ironically, arises from a 2001 case commenced during the last bankruptcy cycle – holds (among other things) that Lucent Technologies, a primary creditor, supplier, and “strategic partner” of bankrupt Winstar Communications, was an “insider” of Wintsar.  As a result, Lucent was liable to Winstar’s creditors for the return of a $188 million payment made by Winstar to Lucent prior to Winstar’s bankruptcy filing.

The payment grew out of a relationship in which Lucent agreed to both finance and build out Winstar’s global broadband network.  Over the course of that relationship, Lucent coerced Winstar to make unnecessary purchases and used Winstar “as a mere instrumentality to inflate Lucent’s revenues.”

Winstar’s trustee ultimately sought to recover the $188 million payment from Lucent as a “preferential transfer” – i.e., as a payment to Lucent on account of prior obligations, made while Winstar was insolvent and that provided more to Lucent than it otherwise would have received without the payment, under Winstar’s Chapter 7 liquidation.

The US Bankruptcy Code would make any such payment recoverable for Winstar’s creditors only if it was made within the 90-day period immediately preceding Winstar’s bankruptcy case . . . with one exception: If Lucent was an “insider” of Winstar, it could be liable to Winstar’s creditors for payments made up to one year prior to Winstar’s bankruptcy.

In this case, the $188 million payment was made outside the normal, 90-day preference period, but within one year of Winstar’s bankruptcy.  To recover it, therefore, Winstar’s trustee had to show that Lucent was an “insider.”

Following a 21-day trial in which the bankruptcy court heard from 39 witnesses and reviewed over 1,400 trial exhibits, the court ruled in the trustee’s favor – Lucent was an “insider,” and Winstar’s prior $188 million payment was a recoverable preference.

To reach this conclusion, the bankruptcy court – and, ultimately, the Third Circuit – had to define the term “insider.”  The US Bankruptcy Code lists several types of entities that qualify, and further defines “insider” to “include[] . . . [a] person in control of the debtor.”  Because it employs the word “include,” various courts have treated the definition as an expansive one, and have included parties other than those specifically enumerated in the Code.  In Winstar’s case, the Third Circuit took this approach and held that the question of who is an “insider” is fact-intensive, requiring “an inquiry into [Lucent’s] relationship with [Winstar], including whether [Lucent] dealt at arm’s length” with Winstar.

Based on this definition, and on the extensive factual findings at trial, the Third Circuit agreed with the bankruptcy court: Lucent and Winstar were separated by far less than an arm’s length.

In an age of widespread business collaboration, the Winstar decision may be a potential warning signal for “strategic partners” who have credit and business relationships on multiple levels with troubled companies.  But for those prepared to heed the warning, how close is too close?  When does an “outsider” become an “insider?”

Given the Third Circuit’s fact-based approach, a “bright-line” threshhold is difficult to draw.  The Third Circuit appeared to focus on Lucent’s willingness to require Winstar, at its own expense and to its own detriment, to make purchases from Lucent for no apparent purpose other than to pump up Lucent’s bottom line.  The Third Circuit also left some further clues to its view of “arm’s length” in its distinction between the Lucent-Winstar relationship and a more general business relationship in which a strongly-positioned creditor can compel payment of its debt or other financial concessions that may be incidential to a credit agreement or loan.

The Third Circuit’s decision looms large as a fresh wave of bankruptcies sparks renewed interest in “unwinding” the business transactions of bankrupt debtors and recovering the greatest amount possible for creditors.

Hat-tip to the Wall Street Journal’s Jacqueline Palank for offering up a concise post spotlighting this important case.