How to Avoid Insider Preference Liability

Code ' 101(31) defines “insider” inclusively so as to cover persons (under ' 101(41) “Person” includes an “individual, partnership, and corporation ' ” who have special relationships and who would not ordinarily deal at arm's length with the debtor. S. Rep. No. 989, 95th Cong., 2d Sess. 25 (1978); In re Newcomb, 744 F.2d 621, 625 n.4 (8th Cir. 1984). (” ' [A] creditor could become so involved in the day-to-day business of a debtor as to become an insider. [But merely because] a large creditor ' can compel payment of a debt ' does not make the creditor an insider. “). Corporate debtors, directors and officers are, because specifically mentioned, statutory insiders per se. Code ' 101(31)(B)(i) and (ii). So, too, are persons who own, control or hold with power to vote 20% or more of the corporate debtor's outstanding voting securities Code 101(31((E); ' 101(2)(A) (affiliates defined as insiders per se). [Note, according to the Tenth Circuit, the creditor was not a director, although it had a designated representative on the debtor's board. U.S. Medical, at *3, n. 3 ("Dr. Seitz was a director on Debtor's board, but the question here is whether Creditor, as a corporation, was an insider, not Dr. Seitz.") (emphasis in original).]

The Code may also deem a person to be an insider even if it is not named in the statutory per se definition. A person in “control” of a corporate debtor is a de facto insider. Code ' 101(31)(B)(vi) (“relative of ' director, officer, or person in control of the debtor”). See, e.g., In re Krehl, 86 F.3d 737, 742-43 (7th Cir. 1996) (” ' insider relationship survived [officer's] resignation and ' subsequent appointment of receiver ' [A] court should look to all of the circumstances to determine whether the relationship between the individual and the corporate entity remains so close that the two could not be dealing at arm's length”; evidence showed that officer remained in control of corporation); In re Kunz, 489 F.3d 1072, 1079-80 (10th Cir. 2007) (” ' other persons may be ' insiders in particular cases, based on the specific facts”; “ director emeritus” held not “per se insider ' as a matter of law”; remanded for trial); In re Fabricators, Inc., 926 F.2d 1458, 1466 (5th Cit. 1991) (finding of “control” justified when creditor's chief executive officer “represent[ed] himself to creditors and other third parties as the chief executive officer and controlling interest holder of [debtor]; ' negotiated ' payment of ' debts and obtained new lines of credit; ' advised [debtor's] bookkeeper with respect to which debts to pay”); In re Holloway, 955 F.2d 1088, 1011 (5th Cir. 1992) (courts focus on two factors ' (1) the closeness of the relationship between the transferee and the debtor; and (2) whether the transactions between [them] were conducted at arm's length.”).

U.S. Medical sheds light on the meaning of “control” in the insider preference context. The debtor's financial dependence, without more, is not “control,” reasoned the court, and will not create insider status.

Facts

The debtor in U.S. Medical served, prior to its commencing a Chapter 7 bankruptcy liquidation, as the defendant creditor's “exclusive distributor in North America and Creditor became Debtor's sole ' manufacturer ' Creditor had the right to appoint a member of Debtor's board of directors ' Creditor acquired a 10.6% equity interest in the company for $2 million in cash and a $2 million inventory-purchase credit.” Id. at *1. “Creditor [also] retained an unexercised warrant for 80,000 additional shares of Debtor.” Id. The parties had a “strategic alliance” because of their “distribution and stock-purchase agreements.” Id. The creditor's CEO had also been “appointed to Debtor's board in accordance with the stock-purchase agreement.” Id. The creditor representative not only “attended every board meeting, either in person or by phone,” but also “had access to all of Debtor's financial information”; still, he never participated “in any vote concerning payment to Creditor.” Id.

The bankruptcy court, after a trial on the trustee's preference claim, “specifically found no evidence that [the] Creditor's representative [on the board], controlled, sought to control, or exercised any undue influence on Debtor.” Id., at *2. (emphasis in original). Moreover, the creditor's representative on the board “was sensitive to 'potential conflicts of interest.'” Id. The Creditor representative and the Debtor's senior management “attended to the kinds of formalities one would expect to see in dealings between third parties at arm's length.” Id. Finally, the bankruptcy court “found no evidence that Creditor's 10% share of Debtor allowed Creditor to control or attempt to exercise any undue influence on Debtor. ” Id.

The Lower Courts' Rulings

The bankruptcy trustee had sued to recover payments made by the debtor to the creditor “between 90 days and one-year before” the bankruptcy filing, claiming the creditor was an “insider” under Code ' 547(b)(4)(B). Id. at *1. The bankruptcy court found, after trial, that the creditor was liable for the payments as a de facto insider under Code ' 101(31) because of the “extreme closeness” between the debtor and the creditor. Id. at *1. The Bankruptcy Appellate Panel (“BAP”) reversed, however, explaining that “not every creditor-debtor relationship attended by a degree of personal interaction between the parties rises to the level of an insider relationship.” Id. at *2. In other words, reasoned the BAP, “closeness alone does not give rise to insider status ” Id.

Creditor's Conduct Key to 'Control' Finding

The facts here were essentially undisputed. Id. at *2. Affirming the BAP, the Tenth Circuit rejected the trustee's argument that “closeness of the relationship between a creditor and a debtor alone is enough to support a finding” of de facto
insider status. Id. at *3. “A debtor can assert that a statutory per se insider (e.g., officer, director) is an insider” without proving the specific nature of the party's relationship, but de facto insiders are to be found by courts in particular cases, based on the specific facts.'” Id. at *5, quoting In re Kunz, 489 F.3d 1072, 179 (10th Cir. 2007). In other words, “the relationship between a debtor a and a [de facto] insider [must] be not only close, but also at less than arm's length.” Id.

According to the Court of Appeals and the BAP, the bankruptcy court had “erred in holding that Creditor was a [de facto] insider.” Id. at *5. Of key significance to the Tenth Circuit were the creditor's lack of control or undue influence; its sensitivity to “potential conflicts of interest”; and to its arm's-length conduct. Id. at *5-*6.

First, the court reasoned, the creditor was not an insider per se (director, officer, or other person in “control” of the debtor's affairs). “A finding of actual control by the bankruptcy court would make Creditor a statutory insider and would avoid the question whether it was a non-statutory [i.e., de facto] insider altogether.” Id. at 6. Because “actual control is obviously not present here,” the creditor's conduct was critical.

We hold here that a creditor may only be a non-statutory [i.e., de facto] insider of a debtor when the creditor's transaction with the debtor is not at arm's length '
[W]here the bankruptcy court considered a variety of factors and found that all relations between Creditor and Debtor were at arm's length ' a ruling that Creditor is a [de facto] insider does not follow ' Therefore, for a bankruptcy court to hold that a creditor is a [de facto] insider in circumstances like these, a [bankruptcy] trustee must prove that the creditor and debtor did not operate at arm's length at the time of the challenged transaction. Id. at *70.

Nor was the creditor's access to the debtors' financial information significant. “In this case, however, [the creditor's board member] was sensitive to 'potential conflicts of interest' and operated at arm's length with Debtor.” Id. at *8. Moreover, the creditor's board representative “never relied upon any inside information” and never engaged in misconduct. Id. On these particular facts, the court also found “unpersuasive” the creditor's having a representative on the board of directors and the so-called “strategic alliance” between the parties. Id. at *9. According to the court, the trustee's “closeness-alone test” to create de facto insider status “would force corporations to find directors from companies with which they do no business and would impermissibly create a new category of insider not determined within the context of 'particular cases, based on the specific facts.'” Id. at *9, quoting Kunz, 489 F.3d at 1079. Such an approach would be inconsistent “with the intent of Congress [and] the case law ' ” Id.

Facts Govern

The court reached the right result on the facts of this particular case. A creditor's insider status is often contested, but courts generally tend to hold that financial dependence and closeness, without more, will not suffice to establish a “control” relationship between a debtor and an unaffiliated creditor. A trustee will have to prove more than the debtor's financial dependence on the creditor or the creditor's ability to influence the debtor's decision-making.

The Tenth Circuit carefully distinguished the facts in U.S. Medical from those in another highly publicized case, In re Winstar Communication, Inc., 348 B.R. 234 (Bankr. D. Del. 2005), aff'd, 2007 WL1232185 (D. Del. April 26, 2007). As the Tenth Circuit put it, the trustee in Winstar proved that the creditor had “far more involvement than here.” Id. at *9. In Winstar, the debtor's main vendor with a strategic alliance was held liable for payments eight months prior to bankruptcy. After a 21-day trial, the court found that the vendor had overreached and had exerted excessive control over the debtor, making it a de facto insider. The court stressed the debtor's becoming a “captive buyer” for the vendor's products; its being forced to make purchases of equipment before it was needed; and its being forced to buy software products from the vendor that were never needed. As the bankruptcy court found, the creditor there used the debtor as a “mere instrumentality to inflate [the creditor's] own revenues.” On its particular facts, the Winstar court rejected the defendant vendor's argument that the trustee had to prove a causal connection between the control exerted and the allegedly preferential transfer. Winstar is pending on appeal in the Third Circuit.

Other courts confirm the importance of persuasive evidence in insider preference litigation. In re Radnor Holdings, Corp., 353 B.R. 820 (Bankr. D. Del. 2006). Three investment funds in Radnor held a preferred equity position in the debtor; made loans to the debtor; had a representative on the debtor's board of directors; had the contractual right to increase the representation on the board if the debtor failed to achieve certain income levels; had access to performance reports and other of the debtor's financial information; closely monitored the debtor's business and financial affairs; had an agreement with the debtor's shareholders requiring the appointment of a certain CEO and authorizing board control in the event of a payment default; and had warrants to acquire 15.625% of the debtor's common stock if the debtor failed to generate a certain level of income. Nevertheless, the court held that the investment funds were not insiders either for preference purposes or for the purpose of determining possible equitable subordination of the investment funds' loans. Although the funds had the right to assume control over the debtor, they had not exercised their right and never exercised control over the debtor's daily operations or its board of directors. Id. at 829, 833-835. Accord, In re Optical Techs, Inc., 252 B.R. 531, 539 (M.D. Fla. 2000), aff'd, 246 F.3d 1332 (11th Cir. 2001) (to be person in control, person must “control the company so as to dictate corporate policy and disposition of corporate assets without limits.”); Johnson v. UBD Park Ridge Bank (In re Octagon Roofing), 124 B.R. 522, 530 (Bankr. N.D. Ill. 1991) (“[T]hat a debtor has a weak bargaining position and few choices does not [mean] that the other party is an insider as long as the [creditor] cannot unilaterally implement the transfer in issue”); In re Friedman, 125 B.R. 63, 70-71 (9th Cir. B.A.P. 1991) (creditors “not in control of [debtor's] business affairs at any point ' [N]othing in the record ' suggests that [creditors] functioned on a scale of such unlimited discretion as would invest them with an ability to order, organize or direct [debtor's] operations ' [Loan documents signed] in an adversary atmosphere and at arm's length.”).

Conclusion

In sum, the creditor's conduct, not its title, will drive a court's finding as to whether the creditor is a de facto insider. Counsel for the defendants in U.S. Medical and in Radnor Holdings gave their clients sound advice on how to act, after obtaining strong documents for the clients. Knowing what not to do in those cases was good judgment.

Michael L. Cook, a member of this Newslettter's Board of Editors, is a partner at Schulte Roth & Zabel LLP in New York.

The Tenth Circuit held on July 15, 2008, that a major creditor with a seat on the debtor's board of directors and a 10.6% equity interest was not an insider in a bankruptcy preference suit. In re U.S. Medical, Inc., 2008 WL2736658 (10th Cir. 7/15/08). Affirming the Bankruptcy Appellate Panel's reversal of the bankruptcy court, the Court of Appeals explained that Congress never intended to “subject [to insider status] an entity with 'complex business relationships existing over a period of time, attended by some personal involvement but without control ' over the debtor's business'” ' Id. at *4. As shown below, the decision contains a road map for corporate insiders on how to avoid preference liability.

Relevance of Insider Status

A pre-bankruptcy transfer of a debtor's property (e.g., payment; mortgage; security interest) is ordinarily voidable by the trustee as a preference if made within 90 days of bankruptcy and the other conditions of Bankruptcy Code (“Code”) ' 547(b) are satisfied. If the recipient of the transfer was an “insider,” however, the Code extends the preference reach-back period to one year. Code ' 547(b)(4)(B).

Code ' 101(31) defines “insider” inclusively so as to cover persons (under ' 101(41) “Person” includes an “individual, partnership, and corporation ' ” who have special relationships and who would not ordinarily deal at arm's length with the debtor. S. Rep. No. 989, 95th Cong., 2d Sess. 25 (1978); In re Newcomb, 744 F.2d 621, 625 n.4 (8th Cir. 1984). (” ' [A] creditor could become so involved in the day-to-day business of a debtor as to become an insider. [But merely because] a large creditor ' can compel payment of a debt ' does not make the creditor an insider. “). Corporate debtors, directors and officers are, because specifically mentioned, statutory insiders per se. Code ' 101(31)(B)(i) and (ii). So, too, are persons who own, control or hold with power to vote 20% or more of the corporate debtor's outstanding voting securities Code 101(31((E); ' 101(2)(A) (affiliates defined as insiders per se). [Note, according to the Tenth Circuit, the creditor was not a director, although it had a designated representative on the debtor's board. U.S. Medical, at *3, n. 3 ("Dr. Seitz was a director on Debtor's board, but the question here is whether Creditor, as a corporation, was an insider, not Dr. Seitz.") (emphasis in original).]

The Code may also deem a person to be an insider even if it is not named in the statutory per se definition. A person in “control” of a corporate debtor is a de facto insider. Code ' 101(31)(B)(vi) (“relative of ' director, officer, or person in control of the debtor”). See, e.g., In re Krehl, 86 F.3d 737, 742-43 (7th Cir. 1996) (” ' insider relationship survived [officer's] resignation and ' subsequent appointment of receiver ' [A] court should look to all of the circumstances to determine whether the relationship between the individual and the corporate entity remains so close that the two could not be dealing at arm's length”; evidence showed that officer remained in control of corporation); In re Kunz, 489 F.3d 1072, 1079-80 (10th Cir. 2007) (” ' other persons may be ' insiders in particular cases, based on the specific facts”; “ director emeritus” held not “per se insider ' as a matter of law”; remanded for trial); In re Fabricators, Inc., 926 F.2d 1458, 1466 (5th Cit. 1991) (finding of “control” justified when creditor's chief executive officer “represent[ed] himself to creditors and other third parties as the chief executive officer and controlling interest holder of [debtor]; ' negotiated ' payment of ' debts and obtained new lines of credit; ' advised [debtor's] bookkeeper with respect to which debts to pay”); In re Holloway, 955 F.2d 1088, 1011 (5th Cir. 1992) (courts focus on two factors ' (1) the closeness of the relationship between the transferee and the debtor; and (2) whether the transactions between [them] were conducted at arm's length.”).

U.S. Medical sheds light on the meaning of “control” in the insider preference context. The debtor's financial dependence, without more, is not “control,” reasoned the court, and will not create insider status.

Facts

The debtor in U.S. Medical served, prior to its commencing a Chapter 7 bankruptcy liquidation, as the defendant creditor's “exclusive distributor in North America and Creditor became Debtor's sole ' manufacturer ' Creditor had the right to appoint a member of Debtor's board of directors ' Creditor acquired a 10.6% equity interest in the company for $2 million in cash and a $2 million inventory-purchase credit.” Id. at *1. “Creditor [also] retained an unexercised warrant for 80,000 additional shares of Debtor.” Id. The parties had a “strategic alliance” because of their “distribution and stock-purchase agreements.” Id. The creditor's CEO had also been “appointed to Debtor's board in accordance with the stock-purchase agreement.” Id. The creditor representative not only “attended every board meeting, either in person or by phone,” but also “had access to all of Debtor's financial information”; still, he never participated “in any vote concerning payment to Creditor.” Id.

The bankruptcy court, after a trial on the trustee's preference claim, “specifically found no evidence that [the] Creditor's representative [on the board], controlled, sought to control, or exercised any undue influence on Debtor.” Id., at *2. (emphasis in original). Moreover, the creditor's representative on the board “was sensitive to 'potential conflicts of interest.'” Id. The Creditor representative and the Debtor's senior management “attended to the kinds of formalities one would expect to see in dealings between third parties at arm's length.” Id. Finally, the bankruptcy court “found no evidence that Creditor's 10% share of Debtor allowed Creditor to control or attempt to exercise any undue influence on Debtor. ” Id.

The Lower Courts' Rulings

The bankruptcy trustee had sued to recover payments made by the debtor to the creditor “between 90 days and one-year before” the bankruptcy filing, claiming the creditor was an “insider” under Code ' 547(b)(4)(B). Id. at *1. The bankruptcy court found, after trial, that the creditor was liable for the payments as a de facto insider under Code ' 101(31) because of the “extreme closeness” between the debtor and the creditor. Id. at *1. The Bankruptcy Appellate Panel (“BAP”) reversed, however, explaining that “not every creditor-debtor relationship attended by a degree of personal interaction between the parties rises to the level of an insider relationship.” Id. at *2. In other words, reasoned the BAP, “closeness alone does not give rise to insider status ” Id.

Creditor's Conduct Key to 'Control' Finding

The facts here were essentially undisputed. Id. at *2. Affirming the BAP, the Tenth Circuit rejected the trustee's argument that “closeness of the relationship between a creditor and a debtor alone is enough to support a finding” of de facto
insider status. Id. at *3. “A debtor can assert that a statutory per se insider (e.g., officer, director) is an insider” without proving the specific nature of the party's relationship, but de facto insiders are to be found by courts in particular cases, based on the specific facts.'” Id. at *5, quoting In re Kunz, 489 F.3d 1072, 179 (10th Cir. 2007). In other words, “the relationship between a debtor a and a [de facto] insider [must] be not only close, but also at less than arm's length.” Id.

According to the Court of Appeals and the BAP, the bankruptcy court had “erred in holding that Creditor was a [de facto] insider.” Id. at *5. Of key significance to the Tenth Circuit were the creditor's lack of control or undue influence; its sensitivity to “potential conflicts of interest”; and to its arm's-length conduct. Id. at *5-*6.

First, the court reasoned, the creditor was not an insider per se (director, officer, or other person in “control” of the debtor's affairs). “A finding of actual control by the bankruptcy court would make Creditor a statutory insider and would avoid the question whether it was a non-statutory [i.e., de facto] insider altogether.” Id. at 6. Because “actual control is obviously not present here,” the creditor's conduct was critical.

We hold here that a creditor may only be a non-statutory [i.e., de facto] insider of a debtor when the creditor's transaction with the debtor is not at arm's length '
[W]here the bankruptcy court considered a variety of factors and found that all relations between Creditor and Debtor were at arm's length ' a ruling that Creditor is a [de facto] insider does not follow ' Therefore, for a bankruptcy court to hold that a creditor is a [de facto] insider in circumstances like these, a [bankruptcy] trustee must prove that the creditor and debtor did not operate at arm's length at the time of the challenged transaction. Id. at *70.

Nor was the creditor's access to the debtors' financial information significant. “In this case, however, [the creditor's board member] was sensitive to 'potential conflicts of interest' and operated at arm's length with Debtor.” Id. at *8. Moreover, the creditor's board representative “never relied upon any inside information” and never engaged in misconduct. Id. On these particular facts, the court also found “unpersuasive” the creditor's having a representative on the board of directors and the so-called “strategic alliance” between the parties. Id. at *9. According to the court, the trustee's “closeness-alone test” to create de facto insider status “would force corporations to find directors from companies with which they do no business and would impermissibly create a new category of insider not determined within the context of 'particular cases, based on the specific facts.'” Id. at *9, quoting Kunz, 489 F.3d at 1079. Such an approach would be inconsistent “with the intent of Congress [and] the case law ' ” Id.

Facts Govern

The court reached the right result on the facts of this particular case. A creditor's insider status is often contested, but courts generally tend to hold that financial dependence and closeness, without more, will not suffice to establish a “control” relationship between a debtor and an unaffiliated creditor. A trustee will have to prove more than the debtor's financial dependence on the creditor or the creditor's ability to influence the debtor's decision-making.

The Tenth Circuit carefully distinguished the facts in U.S. Medical from those in another highly publicized case, In re Winstar Communication, Inc., 348 B.R. 234 (Bankr. D. Del. 2005), aff'd, 2007 WL1232185 (D. Del. April 26, 2007). As the Tenth Circuit put it, the trustee in Winstar proved that the creditor had “far more involvement than here.” Id. at *9. In Winstar, the debtor's main vendor with a strategic alliance was held liable for payments eight months prior to bankruptcy. After a 21-day trial, the court found that the vendor had overreached and had exerted excessive control over the debtor, making it a de facto insider. The court stressed the debtor's becoming a “captive buyer” for the vendor's products; its being forced to make purchases of equipment before it was needed; and its being forced to buy software products from the vendor that were never needed. As the bankruptcy court found, the creditor there used the debtor as a “mere instrumentality to inflate [the creditor's] own revenues.” On its particular facts, the Winstar court rejected the defendant vendor's argument that the trustee had to prove a causal connection between the control exerted and the allegedly preferential transfer. Winstar is pending on appeal in the Third Circuit.

Other courts confirm the importance of persuasive evidence in insider preference litigation. In re Radnor Holdings, Corp., 353 B.R. 820 (Bankr. D. Del. 2006). Three investment funds in Radnor held a preferred equity position in the debtor; made loans to the debtor; had a representative on the debtor's board of directors; had the contractual right to increase the representation on the board if the debtor failed to achieve certain income levels; had access to performance reports and other of the debtor's financial information; closely monitored the debtor's business and financial affairs; had an agreement with the debtor's shareholders requiring the appointment of a certain CEO and authorizing board control in the event of a payment default; and had warrants to acquire 15.625% of the debtor's common stock if the debtor failed to generate a certain level of income. Nevertheless, the court held that the investment funds were not insiders either for preference purposes or for the purpose of determining possible equitable subordination of the investment funds' loans. Although the funds had the right to assume control over the debtor, they had not exercised their right and never exercised control over the debtor's daily operations or its board of directors. Id. at 829, 833-835. Accord, In re Optical Techs, Inc., 252 B.R. 531, 539 (M.D. Fla. 2000), aff'd, 246 F.3d 1332 (11th Cir. 2001) (to be person in control, person must “control the company so as to dictate corporate policy and disposition of corporate assets without limits.”); Johnson v. UBD Park Ridge Bank (In re Octagon Roofing), 124 B.R. 522, 530 (Bankr. N.D. Ill. 1991) (“[T]hat a debtor has a weak bargaining position and few choices does not [mean] that the other party is an insider as long as the [creditor] cannot unilaterally implement the transfer in issue”); In re Friedman, 125 B.R. 63, 70-71 (9th Cir. B.A.P. 1991) (creditors “not in control of [debtor's] business affairs at any point ' [N]othing in the record ' suggests that [creditors] functioned on a scale of such unlimited discretion as would invest them with an ability to order, organize or direct [debtor's] operations ' [Loan documents signed] in an adversary atmosphere and at arm's length.”).

Conclusion

In sum, the creditor's conduct, not its title, will drive a court's finding as to whether the creditor is a de facto insider. Counsel for the defendants in U.S. Medical and in Radnor Holdings gave their clients sound advice on how to act, after obtaining strong documents for the clients. Knowing what not to do in those cases was good judgment.

Michael L. Cook, a member of this Newslettter's Board of Editors, is a partner at Schulte Roth & Zabel LLP in New York.