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Two Recent Bankruptcy Cases Threaten Secured Lenders’ Position

Expert Witness: Fulcrum Inquiry
Secured lenders should be concerned about two recent rulings in which the bankruptcy court used its discretion in performing its role as a court of equity. The cases (i) expand the definition of an “insider” to include a creditor with a “close relationship” to a debtor, and (ii) under what circumstances a lender can be equitably subordinated.

The Third Circuit expanded the definition of an “insider” to include a creditor with a “close relationship” to a debtor. Because the lender was found to have overstepped and abused its relationship with the debtor, (i) the time for potential bankruptcy preference actions was lengthened so a large preference payment needed to be returned, and (ii) the entire creditor claim was given a lower payment priority, which made the entire claim worthless.

The case is Winstar Communications Inc.; Schubert v. Lucent Technologies Inc., No. 07-2569, 2009 (3d Cir. Feb. 3, 2009). Winstar was a provider of local and long-distance
telecommunications services, filed for Chapter 11 protection in 2001. The case has since been converted to a Chapter 7 liquidation.

Lender Ruled to be an Insider for Preference Actions

Under federal bankruptcy law, a trustee may recover preferential payments made by the debtor within 90 days of the filing of its bankruptcy petition. However, §547(b) of the Bankruptcy Code extends this recovery period to one year one year of the bankruptcy filing if the creditor meets the definition of an “insider.” The Third Circuit reviewed the definition of insider and the issue before it as follows:

“Under the statute, “[t]he term ‘insider’ includes . . . (B) if the debtor is a corporation - (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.” 11 U.S.C. §101(31)(B). Additionally, in light of Congress’s use of the term “includes” in §101(31), courts have identified a category of creditors, sometimes called “non-statutory insiders,” who fall within the definition but outside of any of the enumerated categories. See In re U.S. Med., 531 F.3d at 1276….

The principal issue presented is the legal standard for “insider.” Lucent asserts that, in order for a creditor to constitute an “insider” as either a “person in control” or a non-statutory insider, that creditor must exercise “actual managerial control over the debtor’s day-to-day operations.” According to Lucent, the term “person in control” and the scope of the non-statutory insider category both “should be interpreted in light of the other statutorily enumerated ‘insiders’” such that “the evidence would have to demonstrate that Lucent exercised the type of authority over Winstar that an officer, director, or general partner exercises – actual managerial control over the debtor’s day-to-day operations.” [some citations omitted]

Lucent was a vendor/supplier who granted credit as a secured lender. The trial court described the lending and supply relationship between Lucent and Winstar as follows:

“Although Winstar benefitted from some of its dealings with Lucent and its own actions were, at times, no less questionable than Lucent’s, the facts point to one conclusion: Lucent extracted what it needed to prop up its own revenue from Winstar in the form of purchases by Winstar of unneeded equipment and manipulated the timing of a refinancing notice that would have put the world on notice that Winstar was in dire financial straits until Lucent could take some more. Lucent used its position as Winstar’s lender to ensure Winstar’s cooperation by repeated threats to stop both the funding of Winstar’s draw requests and the payment of Wireless’s invoices for services already performed.”

The Third Circuit elaborated on the relationship as follows:

“Lucent’s contention that it was merely driving a hard bargain and exercising its contractual rights is not persuasive…. Here, however, the Bankruptcy Court’s findings are not limited to Lucent compelling payment of debts or other financial concessions “incidental” to the Credit Agreements. Instead, the Bankruptcy Court found, among other things, that Lucent had the ability to coerce Winstar to make unnecessary purchases and used “Winstar as a mere instrumentality to inflate Lucent’s own revenues.’”

With these factual determinations behind it, the Third Circuit Court adopted a broad interpretation of “insider” status for purposes of bankruptcy avoidance claims. It ruled that Lucent must return to Winstar’s bankruptcy estate $188 million in loan payments it received from Winstar within the year before Winstar’s bankruptcy filing. Absent this finding, the normal 90-day preference period would have been applicable, and Lucent could have kept its loan repayments. The Third Circuit’s rationale follows:

“We hold that it is not necessary that a non-statutory insider have actual control; rather, the question “is whether there is a close relationship [between debtor and creditor] and . . . anything other than closeness to suggest that any transactions were not conducted at arm’s length.” In re U.S. Med., 531 F.3d at 1277. See also S. Rep. No. 95-989, at 25 (1978)’… The Bankruptcy Court’s extensive findings regarding Lucent’s ability to coerce Winstar into transactions not in Winstar’s interest amply demonstrate Lucent’s insider status.”

Equitable Subordination Expanded

To add insult to injury, Lucent’s secured and unsecured claims were then subordinated to the claims of other unsecured creditors. §510(c) of The Bankruptcy Code provides that a

“court may (1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest; or (2) order that any lien securing such a subordinated claim be transferred to the estate.”

Effectively, equitable subordination moves a claim lower on the ladder of priority than would otherwise exist. This frees up assets to be paid to other creditors who have not been so subordinated.

Repeating the trail court’s finding that gave rise to the conclusion that Lucent was an insider, the Third Circuit affirmed the trial court’s finding that Lucent’s claims should be equitably subordinated. Normally, the amount of equitable subordination must not exceed the damages that the wrongful conduct caused to the other creditors, yet the trial court mad no such damages finding. The Third Circuit found that there was no requirement for the damage to be specifically monetized, thus allowing the entire claim to be subordinated without specific damage quantification.

Equitable subordination other than for insiders is rare. In Lucent’s case, equitable subordination followed a finding that Lucent was an insider. But this need not be the case. Earlier this year, in re: Yellowstone Mountain Club, the District of Montana Bankruptcy Court (case No. 09-00014) issued an order subordinating the Credit Suisse’s secured $232 million claim below the (i) post-petition debtor-in-possession financing, (ii) administrative fees, and (iii) all other unsecured claims. The Bankruptcy Court was shocked at the lender’s conduct when issuing a syndicated loan (i) with little financial due diligence and (ii) far in excess of the borrower’s ability to repay.

Impact on Other Restructurings

Secured lenders should obviously be concerned about these rulings. They illustrate the bankruptcy court’s discretion in performing its role as a court of equity. The Winstar and Yellowstone Mountain Club decisions will likely encourage trustees and debtors to delve deeper into creditor-debtor dealings to show more than an ordinary, prudent, arm’s length business relationship.

At times, a secured lender appropriately requires its borrower to retain a consultant as a condition to further lending under a forbearance agreement. When dealing with asset monitoring and troubled loan workouts, these outside consultants provide a layer of insulation between a secured lender and management control that might cause the problems noted in the Lucent and Yellowstone cases. More importantly, a competent outside financial advisor provides a fresh perspective that usually provides savings that more than pays for the consultant’s cost.

Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.

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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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