After nearly a decade of historically low interest rates, many borrowers will now have to grapple with near-term maturities between 2025 and 2028 on approximately $4.9 trillion of corporate debt.[1]
While some borrowers may be able to refinance their debt, today's higher interest rate environment means that many borrowers may need to restructure their balance sheet. In the lead up to those discussions, there will likely be activity around forbearance agreements or amendments.
In exchange, lenders will often seek concessions related to business operations, such as the appointment of a chief restructuring officer or independent directors, budget compliance measures, or sale milestones, to name a few.
When negotiating and exercising these rights, lenders will need to look around corners, anticipate issues and take proactive steps to minimize risk and uncertainty. In this article, we highlight one of those risks: insider status in a Chapter 11 case.
When a lender is tagged with insider status, that designation can disrupt the restructuring flight path and is sometimes used by out‑of‑the-money stakeholders as a litigation tool to create negotiating leverage.
In this article, we unpack the technical definition of an "insider" and the practical consequences that flow from insider status.
Defining "Insider"
"Insider" is defined in the U.S. Bankruptcy Code differently depending on the debtor's corporate form.
Because an overwhelming majority of private credit borrowers are corporations or limited liability companies, we focus our discussion on those entities. An insider of a corporation and an LLC is defined in Section 101(31) of the Bankruptcy Code with a nonexclusive list of eight relationships with the debtor:[2]
- A director;
- An officer;
- A "person in control of the debtor";
- A partnership in which the debtor is a general partner;
- A relative general partner, director, officer or person in control of the debtor;
- An "affiliate" of the debtor, which in turn is defined to include any entity that "directly or indirectly owns, controls or holds with power to vote, 20% or more of the outstanding voting securities of the debtor";[3]
- An insider of an affiliate as if such affiliate were the debtor; and
- A managing agent of the debtor.
Anyone who fits within this list is a "statutory insider."
The list of statutory insiders is self-explanatory other than "person in control of the debtor." Courts interpret this phrase to capture anyone with actual control over the borrower to "unqualifiably dictate corporate policy and the disposition of corporate assets" or the "legal right or ability to exercise control over a corporate entity," according to the U.S. Court of Appeals for the Tenth Circuit's 2008 ruling in In re: U.S. Medical Inc. and the U.S. Court of Appeals for the Third Circuit's 2009 ruling in In re: Winstar Communications Inc.[4]
A person in control of the debtor must have authority similar to an officer, director or general partner to manage the debtor's day-to-day operations.[5] To satisfy this standard, "there must be day-to-day control, rather than some monitoring or exertion of influence regarding financial transactions in which the creditor has a direct stake," according to the Winstar ruling.[6]
The Bankruptcy Code's insider definition is illustrative and, therefore, not exclusive. Consequently, courts have held that "insiders" also include "any person or entity whose relationship with the debtor is sufficiently close so as to subject the relationship to careful scrutiny," according to the U.S. Bankruptcy Court for the Northern District of Ohio's 1986 ruling in Hunter v. Babcock.[7] This type of insider is referred to as a nonstatutory insider.
Whether someone is a nonstatutory insider is "determined on a case-by-case basis based on the totality of the circumstances, including the degree of an individual's involvement in a debtor's affairs," according to the U.S. Bankruptcy Court for the Southern District of New York's 2011 ruling in In re: Borders Group Inc..[8]
The theme for both statutory and nonstatutory insider status is the degree of control over the borrower.[9] What kind of control is sufficient to render a lender an insider?
Given the highly factual nature of the inquiry, it depends on the context but generally involves the ability to direct corporate actions and asset disposition.[10]
Consequences of Being an Insider
A lender that has been tagged with insider status can expect the following incremental risk exposure in a bankruptcy of the borrower.
Heightened Scrutiny
Courts examine transactions with insiders with heightened scrutiny — generally under an entire fairness standard — as compared to the more deferential "business judgment" standard.
For example, where an insider-lender provides postpetition debtor-in-possession financing or credit bids for collateral in a Section 363 sale, the court will closely review the transaction terms and the process through which the debtor decided to enter the transaction with the insider-lender.
Preference Risk
Section 547 of the Bankruptcy Code provides for the ability to avoid transfers made by the debtor to a creditor on account of existing debt.
The reach-back period is 90 days before the filing of the bankruptcy unless the transferee is an insider, in which case the reach-back period is extended to one year. Thus, prefiling payments to lenders are at greater risk of preference claw-back.
Fraudulent Transfer Risk
Section 548 of the Bankruptcy Code and state law provide the ability to avoid transfers made or obligations incurred either with actual intent to hinder, delay or defraud creditors, or while insolvent or undercapitalized in exchange for less than reasonably equivalent value.
For actual fraudulent transfers, courts typically look at so-called badges of fraud, which include transfers made to or for the benefit of insiders. Thus, prefiling transactions with insiders are subject to, at a minimum, greater scrutiny for avoidance as fraudulent transfer.
Equitable Subordination Risk
Section 510(c) of the Bankruptcy Code recognizes the common law remedy of equitable subordination, which permits the court to subordinate a claim to another claim as a remedy for creditor misconduct.
Equitable subordination is an extraordinary remedy and requires a showing that the lender engaged in some type of inequitable conduct, the misconduct injured a creditor of the debtor or conferred an unfair advantage to the lender and equitable subordination will not conflict with other provisions of the Bankruptcy Code.
Courts will review an insider's actions with rigorous scrutiny, and less egregious conduct — as compared to noninsiders — may support a claim for equitable subordination. Inequitable conduct includes: fraud, illegality and breach of fiduciary duties; undercapitalization of the debtor; and the creditor's use of the debtor as an alter ego.
Recharacterization Risk
Recharacterization is a remedy that allows a court to treat debt as if it were equity and is most often applied to insider loan transactions that are disguised equity contributions.
Thus, when a lender is tagged as an insider, the insider-lender's loan will be more susceptible to recharacterization risk.
Plan Voting
Confirmation of a Chapter 11 plan requires, among other things, the acceptance of at least one impaired class of creditors.
For purposes of determining whether an impaired class has accepted the plan, Section 1129(a)(10) of the Bankruptcy Code provides that insider votes are disregarded. This means that if a lender is an insider, its vote will be disregarded for determining compliance with Section 1129(a)(10).
Recommendations
Here are 10 tips to mitigate lender liability and the risk of being tagged with insider status.
1. In any restructuring, a lender will not know from the onset of the borrower's distress whether it has a situation that will be resolved consensually or whether it will be heavily litigious. Thus, prepare for the worst and hope for the best.
2. Act like a lender and not an owner. Do not control the borrower.
3. Lenders do not determine whom to hire or fire, or whom to pay. That does not mean a lender cannot impose discipline after a default where funding is discretionary pursuant to an agreed-upon budget, or otherwise insist on conditions for an amendment, waiver or forbearance — e.g., commencement of a sale process, retention of an investment banker or appointment of a chief restructuring officer.
4. Make recommendations as opposed to directives.
5. Consider downshifting lender-affiliated directors to observers and hardwiring a requirement to share board packages with lenders in the forbearance agreement.
6. When appointing independent directors, avoid appointing lender-affiliated directors. Recognize that all material connections will be explored, and potentially exploited, to evaluate, or create noise, about undue control or bias.
7. Avoid excessive internal and external emails — especially those with overheated rhetoric. Assume every email will be read by the court. When in doubt, do not say it or send it.
8. Assume communications will be distorted and twisted to fit an adversary's narrative. Recognize that a settlement discussion — often with the protection of Rule 408 of the Federal Rules of Evidence — is not blanket immunity.
9. Include counsel and avoid internal email discussion. That said, not every communication with counsel will be protected from disclosure — generally, only communications seeking legal advice are protected.
10. Be prepared. Litigation is a tool for out-of-the-money constituents to use to create value by being obstructionist. There is a significant difference between a material risk of liability and the risk of being sued.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of their employer, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] Credit Trends: Global Refinancing Update Q3 2024: Near-Term Risk Eases | S&P Global Ratings (spglobal.com).
[2] Courts have held that a corporation under the definition of "insider" includes LLCs. See In re Brooke Corp. , 506 B.R. 560, 566-67 (Bankr. D. Kan. 2014); In re Longview Aluminum LLC , 657 F.3d 507, 509 n.1 (7th Cir. 2011).
[3] 11 U.S.C. § 101(2).
[4] In re U.S. Med. Inc. , 531 F.3d 1272, 1277 n.5, 1279 (10th Cir. 2008) (internal quotations and citations omitted); In re Winstar Commc'ns. Inc. , 544 F.3d 382, 396 (3d Cir. 2009).
[5] See Winstar, 544 F.3d at 395-96 n.5 ("There must be day-to-day control, rather than some monitoring or exertion of influence regarding financial transactions in which the creditor has a direct stake." (citing In re Winstar Commc'ns Inc. , 348 B.R. 234, 279 (Bankr. D. Del. 2005)).
[6] Id.
[7] Hunter v. Babcock (In re Babcock Dairy Co. of Ohio Inc. ), 70 B.R. 657, 660 (Bankr. N.D. Ohio 1986); see also Matter of Krehl , 86 F.3d 737, 741 (7th Cir. 1996) (noting the definition of "insider" is "intended to be illustrative rather than exhaustive"); Winstar, 554 F.3d at 395.
[8] In re Borders Grp. Inc. , 453 B.R. 459, 469 (Bankr. S.D.N.Y. 2011). Some courts apply a two-prong test that looks at whether (1) there is a close relationship between the debtor and creditor, and (2) the transactions between them were conducted at arm's length. In re RayTrans Holdings Inc. , 573 B.R. 121, 132 (Bankr. D. Del. 2017) (citing U.S. v. State St. Bank & Trust Co. , 520 B.R. 29, 81 (Bankr. D. Del. 2014)).
[9] However, some courts may look to factors outside of control to determine insider status. See In re Vill. at Lakeridge LLC , 814 F.3d 993, 1001 (9th Cir. 2016) ("[S]ome degree of control is one of many indications that a creditor may be a non-statutory insider, but actual control is not required to find non-statutory insider status.... Likewise, access to the debtor's inside information may — but not shall — warrant a finding of non-statutory insider status." (citations omitted)).
[10] See Lynn v. Cont'l Bank, N.A. , 154 B.R. 909, 913 (Bankr. N.D. Tex. 1993).
Reproduced with permission. Originally published October 21, 2024, "What Being An 'Insider' Means In Ch. 11, And Why It Matters,” Law360.
