Creditor That Used Debtor As Mere Instrumentality Qualifies As Non-Statutory Insider In Preference Litigation

Transactions between companies and the individuals or entities

that control them, are affiliated with them, or wield considerable

influence over their decisions are examined closely due to a

heightened risk of overreaching caused by the closeness of the

relationship. The degree of scrutiny increases if the company files

for bankruptcy. A debtor's transactions with such

"insiders" will be examined by the bankruptcy trustee,

the chapter 11 debtor-in-possession, official committees, and even

individual creditors or shareholders to determine whether

pre-bankruptcy transfers made by the debtor may be avoided because

they are preferential or fraudulent, whether claims asserted by

insiders may be subject to equitable subordination, and whether the

estate can assert causes of action based upon fiduciary infractions

or other tort or lender liability claims.

Designation as a debtor's "insider" means, among

other things, that the "lookback" period for preference

litigation is expanded from 90 days to one year, claims asserted by

the entity may be subject to greater risk of subordination or

recharacterization as equity, and the entity's vote in favor of

a cram-down chapter 11 plan may not be counted. The Bankruptcy Code

contains a definition of "insider." However, as

demonstrated by a ruling recently handed down by the Third Circuit

Court of Appeals, the statutory definition is not exclusive. In

In re Winstar Communications, Inc., the court of appeals,

in a matter of first impression, ruled that a creditor that used

the debtor as a "mere instrumentality" to inflate its own

revenues was a "non-statutory" insider for purposes of

preference litigation.

Statutory and Non-Statutory Insiders

"Insider" is defined in section 101(31) of the

Bankruptcy Code, which provides that, if the debtor is a

corporation, the term "includes" the following:

(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.

However, because the Bankruptcy Code's definition of the

term is nonexclusive, courts have identified a category of

"non-statutory insiders" consisting generally of those

individuals or entities whose relationship with the debtor is so

close that their conduct should be subject to closer scrutiny than

that of those dealing with the debtor at arm's length. In

determining whether a person or entity qualifies as a non-statutory

insider, some courts consider: (i) the closeness of the

relationship between the debtor and the alleged insider; and (ii)

whether transactions between the debtor and the alleged insider

were conducted at arm's length. As noted by the court in

Friedman v. Sheila Plotsky Brokers, Inc. (In re Friedman),

the relationship must be "close enough to gain an advantage

attributable simply to affinity rather than to the course of

business dealings between the parties." The alleged

insider's degree of control over the debtor is relevant but not

dispositive. Under the Third Circuit's ruling in Winstar

Communications, when a creditor is able to control a

debtor's actions to such an extent that the debtor becomes a

"mere...