Restructuring

Contributed by Rich Mullen
As “they” say, good friends are hard to find.  Whether you happen to be in a scuffle at the (bankruptcy) bar or are a debtor in a chapter 11 case, it sure helps to have someone on your side.  A supportive friend, however, will not always be able to save the day, especially if he or she is conspiring with the debtor to skirt around the Bankruptcy Code.  A debtor in the Bankruptcy Court for the Eastern District of North Carolina recently learned this lesson when the bankruptcy court found that a creditor that purchased claims at the behest of the debtor’s principal was a non-statutory insider whose vote would be designated and not counted in the section 1126(c) ballot computation.  The ruling was significant as the purchased claims were in a class that constituted the only impaired class to accept the debtor’s plan.
The debtor in In re Lichtin/Wade, LLC was in the real estate business and owned two office buildings and approximately twelve acres of vacant land on which it planned to build three additional office buildings.  Just two months after the maturity of approximately $40 million of notes secured by substantially all of the debtor’s real and personal property, the debtor filed a voluntary chapter 11 petition.
The debtor filed a chapter 11 plan and solicited votes on the plan.  Before the filing of the plan, however, the debtor’s principal arranged for a friend to purchase a certain secured claim based on equipment leases of two back-up generators located in the debtor’s office buildings.  The friend’s private aircraft company acquired the claims and filed a proof of claim in the amount of $11,601.10 ($7,569.44 of which was allegedly secured).  When the plan was filed, the claims belonging to the friend’s company were separately classified as an impaired class that would receive payment in full over a period of three years with interest accruing on the unpaid balance at a rate of 5%. 
The holder of the $40 million in secured notes filed a motion seeking to designate the vote of the friend’s company, arguing that the friend’s company acquired the equipment claims in bad faith at the direction of the debtor’s principal and was an insider for purposes of section 1129(a)(10) of the Bankruptcy Code.  The debtor countered by arguing that the friend’s company was not an alter ego of the debtor and was not in any way controlled by the debtor.  Further, the debtor argued that the actions of the friend’s company did not rise to the kind of bad faith contemplated by section 1126(e) of the Bankruptcy Code. 
The court first discussed insider status and found that the friend’s company was not an insider under section 101(31) of the Bankruptcy Code.  As the court stated, however, this definition is “illustrative rather than exhaustive,” and the term also encompasses anyone with a “sufficiently close relationship with the debtor that his conduct is made subject to closer scrutiny than those dealing at arm’s length with the debtor.”  The court based its “non-statutory insider” definition on the body of cases coming from Schubert v. Lucent Tech. Inc. (In re Winstar Commc’n) and In re Krehl. 
Ultimately, the court concluded that the friend’s company was a non-statutory insider and its vote would not count for the section 1126(c) ballot computation.  The court found the friend’s testimony particular damaging and concluded that the friend’s company purchased the claims at the request of the debtor’s principal.  Indeed, the friend testified that he did not conduct any diligence before purchasing the claims, “did not have any hesitation in purchasing the claims” because the debtor’s principal “was a friend,” and did not even read the proposed chapter 11 plan before casting his company’s vote.  In reaching its conclusion, the court also noted that the friend’s company had provided services to the debtor’s management company without being compensated for a period of eighteen months. 
Having reached its conclusion regarding the non-statutory insider status of the friend’s company, the court did not go on to address the arguments concerning bad faith. 
Not many appellate courts have addressed the issue of non-statutory insiders, but the issue seems to be well-established.  The leading cases are Winstar, Krehl, and In re U.S. Medical Inc..  While the precedent is sparse, these cases all agree that “actual control” is not necessary to render a party a non-statutory insider.  Instead, the threshold inquiry focuses on (1) the closeness of the relationship between the parties and (2) whether the transaction at question was negotiated at arm’s length.