What Is Your Preference?

In this time of economic hardship, there are many entities that file for bankruptcy protection. If you have been a creditor of a debtor in a bankruptcy court, then you have probably run into the preference rules.

And, depending on whether that required you to pay the money back to the bankruptcy trustee or someone else had to do that so that your payout from the bankruptcy estate was increased, you may have a different impression of the relative fairness of the preference concept.

Generally speaking, the Bankruptcy Code presumes that a debtor is insolvent 90 days prior to its filing. The bankruptcy trustee may require certain payments received from a debtor during that 90 day period to be paid back to the trustee unless the payment fits within specified exceptions in the Bankruptcy Code. Payments that must be returned to the trustee because they do not fit within an exception are called preferences.

The 90 day period may be extended to a period of up to 1 year if, at the time of the transfer, the creditor was an “insider.” The term “insider” is defined in the Bankruptcy Code to include people in actual control of the debtor (officers, directors, general partners, and so on) and those who are not in actual control (relatives of the foregoing). In addition, the courts have expanded the definition to include a category sometimes called “non-statutory insiders.”

In In Re: Winstar Communications, Inc., 554 F.3d 382 (D.C. Bankr. Ct. 2009), the bankruptcy trustee contended that a $188,000,000 payment that had been made by Winstar, the Debtor, more than 90 days prior to the filing of the bankruptcy complaint should be required to be repaid as a preference because the creditor was a non-statutory insider.

In this case, Lucent Technologies entered into a “strategic partnership” with the Debtor. As a part of this strategic partnership, Lucent provided the Debtor with a $2,000,000,000 line of credit that the Debtor was to use to construct a global broadband telecommunications network. Lucent was to take primary responsibility for the construction of the network and provide the equipment to the Debtor (to be financed under the facility) that was the best in the industry. Where Lucent’s equipment was not the best, then Debtor could use the credit facility to purchase the equipment from a third party (but the agreement required that the significant majority of the equipment and services purchased would be from Lucent in a given year.)

Debtor also had a senior credit facility with lenders other than Lucent. Siemens joined the senior facility and made available $200,000,000 to Debtor. Under the terms of the Lucent facility, however, Lucent could, and did, require Debtor to draw down the increase in the senior facility and pay it to Lucent to reduce the Lucent debt. As a result, Debtor paid approximately $188,000,000 of the $200,000,000 from Siemens to Lucent for that purpose.

More than 90 days after the payment by Winstar of the Siemen’s money to Lucent, but within a year, Debtor filed for bankruptcy. The Trustee sought to recover the $188,000,000 as a preference. Since the payment was more than 90 days prior, however, the Trustee had to show that Lucent was an insider of Debtor.

Clearly, Lucent did not meet the statutory definition of insider as it was not an owner or even a relative of an owner of Winstar. In order to recover the payment as a preference, the Trustee would have to show that Lucent should be considered a “non-statutory insider” of Winstar. In order to be considered a “non-statutory insider” the court agreed that the Trustee would have to show that Lucent had “day-to-day control,” rather than merely monitoring or exerting influence over financial transactions in which the creditor has a direct interest.

The facts in this case are extraordinarily egregious. The lower court found that Lucent used “Winstar as a mere instrumentality to inflate Lucent’s own earnings” and 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 the larger at the expense of the smaller.” “Winstar repeatedly and knowingly helped Lucent by making massive, last minute, allegedly unneeded purchases that were arranged by Lucent as the ends of quarters approached. [citations omitted.] These deals ‘enabled Lucent to report more revenue and appear more profitable in its quarterly public reports than it really was.’ ”

The appellate court found that the Bankruptcy Court’s extensive findings clearly indicated that Lucent was able to control Winstar and to “coerce” it into transactions that were not in Winstar’s interest. This, the court concluded, amply demonstrated Lucent’s insider status.” As a result of these findings, the court required Lucent to return the $188,000,000 to the bankruptcy trustee as a preferential payment.

The moral of the story, of course, is that even if you are not an owner of the debtor, if you exert sufficient control over the debtor, you may find yourself as a non-statutory insider having to disgorge payments received from the debtor for a period of up to 1 year.

Posted by: Kimberly K. Mauer

Categories: Bankruptcy & Banking Law