Winstar decision increases risk that strategic partners/lenders could be subject to one-year look-back period for preferential payments

Practical Law Legal Update 9-385-9112 (Approx. 4 pages)

Winstar decision increases risk that strategic partners/lenders could be subject to one-year look-back period for preferential payments

by Michael H. Torkin, Solomon J. Noh and Randy Martin, Shearman & Sterling LLP

Facts

Winstar, a large public telecommunications firm, had partnered with Lucent Technologies Inc. to facilitate the build-out of a substantial telecommunications network. Specifically, Winstar contracted with Lucent to procure equipment and services necessary for the network build-out. Lucent also agreed to provide financing for the project (including for the purchase of its own supplies) and entered into two credit agreements to provide Winstar financing for the construction project.

The second credit agreement, which allowed for up to US$2 billion of borrowing availability and supplemented an existing US$1.15 billion revolver from a syndicate of bank lenders, provided, among other things, that both:

Lucent could serve a "refinancing notice" at any time outstanding loans exceeded $500 million.
Any increases in the borrowings available under the revolver facility would be used to repay amounts borrowed under the Lucent facility.

Shortly before it was compelled to file for bankruptcy protection, Winstar was able to negotiate precisely such an increase in the revolver facility by arranging for the addition of Siemens to the lending syndicate. Under that arrangement, Siemens committed to lend an additional $200 million to Winstar and Winstar proceeded to borrow those funds, using the net proceeds of the loan to make an approximately $188 million prepayment of the Lucent loan.

During the course of Winstar's bankruptcy case, the chapter 7 trustee appointed to administer Winstar's estate asserted several legal claims against Lucent, including a claim seeking to characterise the $188 million repayment received by Lucent over four months prior to Winstar's bankruptcy filing as a preferential payment recoverable by the estate. The bankruptcy court found that the payment was indeed a preference and the decision was appealed to the Third Circuit Court of Appeals after having been affirmed by the district court.

Issues

The Bankruptcy Code allows for the "avoidance" (that is, the recovery) by a bankrupt estate of any payment deemed to have been a preference within the meaning of section 547 of the Bankruptcy Code. Assuming no applicable statutory defence applies, section 547 provides that a payment will be treated as a preference if it:

(1) was to or for the benefit of a creditor, (2) was for or on account of an antecedent debt owed by the debtor before such transfer was made, (3) was made while the debtor was insolvent, (4) was made within 90 days before the commencement date or, if the transfer was made to an insider, within one year before the commencement date, and (5) enabled the creditor to receive more than it would have received on its claim if the case was a chapter 7 liquidation (emphasis added).

Accordingly, the issue of whether the recipient of a pre-petition payment is or is not an "insider" within the meaning of the Bankruptcy Code can be critical in determining whether such payment was a preferential transfer. If the recipient is an insider, payments received as far back as a year can be clawed-back by the estate for distribution to other creditors. For non-insiders, the maximum time period for "preference risk" is three months prior to the debtor's bankruptcy filing.

The Bankruptcy Code provides that:

[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.

Many courts have held that the Bankruptcy Code's use of the term "includes" with respect to these six categories clearly indicates that there must be an additional set of so-called "non-statutory insiders".

The court's decision

The Third Circuit Court of Appeals endorsed this interpretation of the statute and further stated that a non-statutory insider need not have actual control over the debtor and that it was sufficient that such entity have "a close relationship… and… anything other than closeness to suggest that any transactions were not conducted at arm's length." Ultimately, the Third Circuit Court of Appeals affirmed the lower courts' decisions that Lucent, by virtue of its close relationship with, and its exertion of commercial dominance over, Winstar, fell within the category of non-statutory insiders and therefore was subject to the extended one-year look-back period for preferential payments.

In determining that Lucent was an insider with respect to Winstar, the Court of Appeals drew upon several factual findings made by the bankruptcy court, focusing in particular on findings:

That Lucent had exerted commercial dominance over Winstar.
With respect to the alleged manipulation by Lucent of the timing of its exercise of rights under the Lucent credit agreement.

With respect to the charge of commercial dominance, the Court of Appeals focused on facts suggesting that Lucent had forced Winstar to make substantial purchases of equipment and software, often on terms designed to favour Lucent at Winstar's expense, and in transactions that could not be characterised as arm's length.

With respect to the charge of improper and opportunistic conduct regarding the Lucent credit agreement, the Court of Appeals focused on the findings by the lower court that Lucent had deliberately delayed issuance of the "refinancing notice" until such time as the Siemens loan had been consummated to avoid creating the appearance that Winstar was financially distressed and with the intent of capturing the benefit of the Siemens loan for itself.

The Third Circuit Court of Appeals affirmed that these facts were sufficient to support the finding that Lucent was an insider and that payments received by Lucent within the one year period prior to the Winstar bankruptcy filing should be returned to the estate.

Comment

Although highly fact-specific, the Winstar ruling could have an immediate and significant impact, not for active bankruptcy cases, but also for parties attempting to quantify and manage their exposure to distressed strategic partners and major customers.

As a result of Winstar, strategies for managing preference risk will be more complicated in situations where close commercial or financial relationships make it uncertain whether a party will be considered an insider if the business partner files for bankruptcy protection. These analytical challenges may be particularly acute and increasingly common in industries characterised by substantial strategic and financial integration, such as the automotive industry where captive supplier relationships similar to those described in Winstar are prevalent and where vendor financing is not uncommon.

The case also may cause some concern among financial lenders given the Third Circuit Court of Appeals' focus on the deliberate and strategically timed exercise of enforcement rights under a credit agreement. But this interpretation of the case may be limited by the Court of Appeals' suggestion that the "exercise of financial control…. incident to the creditor-debtor relationship" is not independently sufficient to make an entity an insider.

The Winstar decision can be helpfully contrasted with the Tenth Circuit Court of Appeals’ recent decision, on essentially the same issue, in Anstine v. Carl Zeiss Meditec AG (In re U.S. Medical, Inc.) 531 F.3d 1272 (10th Cir. 2008). In this case, the Court of Appeals found that a strategic business partner that held a significant equity stake and enjoyed an exclusive supply arrangement was not an insider for purposes of preference analysis. The key distinction in the case appears to have been that the defendant had taken careful steps to ensure fair dealing and arm's length transactions with its business partner prior to its insolvency. Accordingly, ensuring that conduct with business partners is conducted in an arm’s length manner would appear to be an essential best practice for businesses seeking to minimise their credit exposure to distressed partners.

Winstar decision increases risk that strategic partners/lenders could be subject to one-year look-back period for preferential payments | Practical Law