The U.S. Court of Appeals for the Third Circuit held on Feb. 3, 2009, that a debtor’s “strategic partnership” vendor was liable as a non-statutory insider for preferential payments it received approximately four months prior to the debtor’s bankruptcy. In re Winstar Communications, Inc., ___F.3d ___, 2009 U.S. App. LEXIS 1953, at *1 (3d Cir. 2/3/09). The court affirmed the bankruptcy court’s judgment (an 88-page decision with detailed fact findings), rendered after a 21-day bench trial that included 1,400 exhibits and 39 witnesses. The bankruptcy court had awarded Winstar’s Chapter 7 trustee approximately $188 million plus interest for recovery of the debtor’s preferential payment; $55.75 million plus interest for the creditor’s breach of contract; and equitably subordinated the creditor’s claims against the debtor’s estate. In affirming, the Third Circuit slightly modified the lower court’s equitable subordination judgment “such that [the creditor’s claims] are subordinated only to [the debtor’s] other creditors and not [to] any equity interests.” Id., at *81. According to the court, however, the “principal issue presented is the legal standard for [the term] ‘insider.’” Id., at *21.  

Relevance of Decision: Insider; Earmarking; Equitable Subordination

Winstar is critically important to creditors. We summarize here only the three most significant parts of the opinion. First, its preference analysis not only sheds light on when a creditor may become a de facto or “non-statutory” insider, but also when the so-called “earmarking” defense applies. Affirming the bankruptcy court’s finding of “concrete harm” to Winstar’s creditors, Id., at *78, the court further showed what facts are necessary to support an equitable subordination judgment, while defining the limits of the equitable subordination remedy.  

Insider Preferences

A pre-bankruptcy transfer of a debtor’s property (e.g., payment, mortgage, security interest) is ordinarily voidable by a bankruptcy trustee as a preference if made within 90 days of bankruptcy and the other conditions of Bankruptcy Code (“Code”) § 547(b) are satisfied. If a recipient of the transfer was an “insider,” however, the Code extends the preference reach-back period to one year. Code § 547(b)(4)(B). Because Winstar made the $188 million payment to the creditor four months prior to bankruptcy, to prevail on its preference claim, the trustee had to prove that the creditor was an insider.  

The creditor argued that it was not an insider and, therefore, the 90-day limit, rather than the one-year limit, applied. According to the creditor, the “person in control” element of the Code’s definition of “insider” status applied only to those who exercised day-to-day managerial control over the debtor’s operations.  

Code § 101(31) defines “insider” inclusively so as to cover persons who have special relationships with the debtor and who would not ordinarily deal with it at arm’s length. S. Rep. No. 989, 95th Cong., 2d Sess. 25 (1978). Directors and officers of a corporate debtor are, because specifically mentioned, statutory insiders per se. Code § 101(31)(b)(i) – (ii). So, too, are persons who own, control or hold the power to vote 20% or more of a corporate debtor’s outstanding voting securities. Code § 101(31)(E); § 101(2)(A)(affiliates defined as insiders per se). Moreover, “a person in control” of a corporate debtor is an enumerated statutory insider.

Code § 101(31)(B)(vi)(“person in control of the debtor”); In re Krehl, 86 F.3d 737, 742-43 (7th Cir. 1996) (“. . . insider relationship survived [officer’s] resignation and … subsequent appointment of a receiver . . .”; evidence showed that officer remained in control of corporate debtor). “[I]t is important to understand [,however,] that the Code definition [of insider] is not exclusive. [Because] the definition [says] ‘includes,’ and [Code] § 102(3) … provides that the word ‘includes’ is not a word of limitation,” the “litigator’s skills are tested when the defendant [creditor] does not fit conveniently within one of the per se categories of Section 101(31) ….” A.S. Lurey, Bankruptcy Litigation Manual, § 8.02[A] at 85 (2008-09 rev.ed).  

The Third Circuit in Winstar stressed “Congress’s use of the term ‘includes’ in § 101(31),” noting that other courts “have identified a category of creditors, sometimes called ‘non-statutory insiders,’ who fall within the definition outside of any of the enumerated categories.” 2009 U.S. App. LEXIS, at *21, citing In re U.S. Med., Inc., 531 F.3d 1272, 1275 (10th Cir. 2008) (major creditor with designee on debtor’s board of directors and 10.6% equity interest held not to be an insider; creditor had some involvement, but no control over debtor’s business; creditor sensitive to potential conflicts of interest and dealt with debtor at arm’s length). For the Court of Appeals in Winstar, “when a creditor can be considered a non-statutory insider” was “an issue of first impression.” Id., at *1.  

The court rejected the creditor’s assertion that insider status required “actual managerial control over the debtor’s day-to-day operations.” Id., at *24. According to the Third Circuit, “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.” Id., at *26, citing In re U.S. Med., 531 F.3d at 1277.  

Relying on the bankruptcy court’s “extensive findings” to support its imposition of insider status, the court stressed the creditor’s ability to coerce Winstar into transactions not in Winstar’s interest, including the following:  

  • The creditor “controlled many of Winstar’s decisions relating to the buildout of the network”;  
  • The creditor “forced the ‘purchase’ of its goods well before the equipment was needed and in many instances … never needed at all”;  
  • The creditor “treated Winstar as a captive buyer for [the creditor’s] goods”;  
  • The creditor used Winstar as a “means for [the creditor] to inflate its own revenue”; and  
  • The creditor “involved Winstar’s employees in [certain improper transactions that benefited the creditor] . . . .” Id., at *27.  

In sum, reasoned the court ,“actual control is unnecessary for an entity to be deemed a non-statutory insider.” Id., at *33. Even if the creditor “was not a ‘person in control’ of Winstar, it was still a non-statutory or de facto insider of Winstar . . . .” Id. It was “both a major creditor and supplier of Winstar.” Id., at *34. As such, it “had the ability to coerce Winstar into a series of transactions that were not in Winstar’s best interests,” thus refuting “any suggestion of arm’s-length dealing. Id., citing In re U.S. Med., 531 F.3d at 1277 n.4 (“[A]n arm’s-length transaction is a transaction in good faith in the ordinary course of business by parties with independent interests. . . [that] each acting in his or her own best interest. . . would carry out . . . .”). Despite the creditor’s argument that it had been “engaging in arm’s-length dealings” with the debtor, the court affirmed the bankruptcy court’s findings that the creditor “had come to dominate the parties’ relationship” when the preferential transfer occurred, and that the parties were not engaged in arms’ length dealings. Id., at *35. Accordingly, it held that the creditor “was a non-statutory insider of Winstar.” Id.  

Earmarking Defense

The court rejected the creditor’s argument that the payment it had received from the debtor “was earmarked and thus was not a transfer of Winstar’s property.” Id., at *36. Essentially, the creditor had argued that it had been repaid with the proceeds from a new loan from another lender, and that there had been no preference “because the debtor had not transferred the property of [its estate]; . . . only the identity of the creditor ha[d] changed.” Coral Petroleum, Inc. v. Banque Paribas - London et al., 797 F.2d 1351, 1356 (5th Cir. 1986).  

The earmarking doctrine applies “whenever a third party provides funds to debtor for the express purpose of enabling the debtor to pay a specified creditor, that is substituting a new creditor for an old creditor.” In re Flanagan 503 F.3d 171, 184 (2d Cir. 2007). According to the Eighth Circuit, three requirements must be met for earmarking to be available as a defense: “(1) the existence of an agreement between the new lender and the debtor that the new funds will be used to pay a specified antecedent debt, (2) performance of that agreement according to its terms, and (3) the transaction viewed as a whole (including the transfer in of the new funds and the transfer out to the old creditor) does not result in any diminution of the [debtor’s] estate.” In re Bohlen Enters., Ltd., 859 F.2d 561, 566 (8th Cir. 1988).  

The Third Circuit agreed with the bankruptcy court that the creditor had failed to show any “agreement between” the new creditor and Winstar as to the use of the new funds. 2009 U.S. App. LEXIS 1953, at *39. In fact, the new lender testified that “Winstar could use that [loan] for whatever its corporate purposes were.” Id., at *40. The relevant language of the loan documents “also provided that the loan was ‘for general corporate purposes’.” Id. Nor was there “evidence to demonstrate that [the new Lender] required Winstar to” repay the loan to the old creditor. Id. at *41, citing Flanagan, 503 F.3d at 185 ([“W]e have been … clear that where a new creditor provides funds to the debtor with no specific requirement as to their use, the funds do become part of the estate.”) Thus, reasoned the Third Circuit in Winstar, “earmarking was inapplicable.” Id. at *42.  

Equitable Subordination

The Court of Appeals affirmed most of the bankruptcy court’s equitable subordination of the creditor’s claims against Winstar. Although the creditor argued that the bankruptcy court had failed to make sufficient findings of inequitable conduct, the Third Circuit stressed the lower court’s “findings [of] concrete harm to Winstar and its creditors and equityholders.” Id. at *78. The creditor’s inequitable conduct substantially damaged Winstar because of its forcing Winstar to “purchase unneeded equipment;” and because of the creditor’s “purposely” [delaying the issuance of] its refinancing notice in order to induce [third party] investments.” Id., at *78-79. The court also stressed “the magnitude of these injuries (e.g. approximately $240 million in unnecessary purchases plus associated interest, storage and insurance costs; the [new] $200 million loan; “and $270 million in private equity investments.”) Id. at *79.  

Code § 510(c), however, “does not permit the subordination of debt to equity.” Accordingly, the court modified the bankruptcy court’s equitable subordination order to the extent of subordinating the creditor’s claims “only to the claims of other creditors.” Id. at *81.