Recent Expansion in Definition of an “Insider”

By: Crystal H. Thornton-Illar, Esq.

According to a recent Third Circuit case, Schubert v. Lucent Techs., Inc. (In re Winstar Comm’ns, Inc.), if payments were received from a debtor during the one-year period preceding the filing of the debtor’s bankruptcy petition and if a relationship between a debtor and creditor is determined to be too close or not at arm’s length (1), creditors may be at risk of having payments avoided and recovered as preferential payments.

A debtor in possession or a trustee may avoid and recover preferential transfers made by a debtor to a creditor within the 90-day period preceding the filing of the debtor’s bankruptcy petition unless the creditor is an insider. If the creditor is an insider, the Bankruptcy Code authorizes the avoidance and recovery of preferential transfers made during the one-year period preceding the filing of the debtor’s bankruptcy petition (2).

The term insider includes . . . 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 (3).

The list set forth in §101(31) of the Bankruptcy Code is not exhaustive because Congress used the language “includes,” and courts have correspondingly developed the idea of non-statutory insiders that “fall within the definition but outside of any of the enumerated categories.” (4) The Third Circuit held in the Winstar case, that when the relationship between a debtor and a creditor is sufficiently close to suggest that transactions were not conducted at arm’s length, the creditor may be considered a non-statutory insider (5).

The Winstar/Lucent Case

Prior to filing for bankruptcy, Winstar Communications, Inc. (“Winstar”) and its wholly owned subsidiary Winstar Wireless, Inc. (“Wireless”) entered into a “strategic partnership” with Lucent Technologies, Inc. (“Lucent”) whereby Lucent agreed to help finance and construct Windstar’s global broadband telecommunications network in exchange for Winstar’s agreement to become a major purchaser of Lucent products and services (6). Winstar and Lucent entered into a secured credit agreement under which Lucent provided Winstar with a $2 billion line of credit in exchange for a lien on substantially all of Winstar’s assets (the “First Credit Agreement”). Winstar and Lucent also entered into a supply agreement in which Lucent assumed primary responsibility for constructing Winstar’s network and required Winstar to buy a certain percentage of services and equipment from Lucent (7). Since Lucent did not have the ability to provide all of the required services, Lucent and Wireless entered into a subcontracting agreement whereby Wireless acted as Lucent’s subcontractor to build the network (8).

In May 2000, Winstar obtained a $1.15 billion revolving credit line from a group of lenders and used that credit line and other funds on hand to repay the funds borrowed under the First Credit Agreement (9). Shortly thereafter, the parties entered into the Second Credit Agreement whereby Winstar received a $2 billion line of credit from Lucent (the “Second Credit Agreement”) (10). The Second Credit Agreement was not secured by a lien on substantially all of Winstar’s assets but included the following financial covenants:

1) Winstar’s total cash expenditures were limited to $1.3 billion each year;

2) Lucent had the right to serve a refinance notice on Winstar if the outstanding loans exceeded $500 million; and

3) Winstar was obligated to use any increase in the bank senior loan arrangement to repay Lucent. (11)

In November 2000, Siemens, a competitor of Lucent, agreed to join the senior bank facility and lend $200 million to Winstar for general corporate purposes (12). Winstar sought permission from Lucent to keep all or at least some of the Siemens loan proceeds, but Lucent refused and threatened to cease lending under the Second Credit Agreement if Winstar did not pay the proceeds of the Siemens loan to Lucent (13). On December 7, 2000, Winstar paid $188,180,000 of the Siemens loan to Lucent (the total amount of the loan after fees and a refund Lucent owed Winstar) (14).

On April 18, 2001, Winstar and Wireless filed bankruptcy petitions under chapter 11 of the Bankruptcy Code. Those cases were converted to chapter 7 cases in January 2002 (15).  The chapter 7 trustee sought to avoid and recover the $188,180,000 payment asserting that Lucent was an insider and the one-year preference period applied (16). Lucent argued that it was not an insider because it did not have actual managerial control over Winstar’s day-to-day operations.

The bankruptcy court held that Lucent was an insider under section 101(31)(B)(iii)’s ‘person in control’ language and a non-statutory insider because Lucent “controlled many of Winstar’s decisions relating to the buildout of the network; forced the purchase of its goods well before the equipment was needed and in many instances never needed at all; treated Winstar as a captive buyer for Lucent’s goods; and used Winstar as a means for Lucent to inflate its own revenue.” (17) In other words, the parties “were not dealing at arms [sic] length.” (18)

The Third Circuit affirmed the bankruptcy court’s determination that Lucent was a non-statutory insider but rejected the bankruptcy court’s finding that Lucent was an insider under the statute. In doing so, the Third Circuit stated, “actual control (or its close equivalent) is necessary for a person or entity to constitute an insider under § 101(31)’s person in control language. However, a finding of such control is not necessary to be a non-statutory insider.” The Third Circuit went on to state that “to hold otherwise would render meaningless Congress’s decision to provide a non-exhaustive list of insiders in §101(31)(B) because the person in control category would function as a determinative test.” (19) Instead, the Third Circuit explained that “the question is whether there is a close relationship between the debtor and creditor and anything other than closeness to suggest that any transactions were not conducted at arm’s length.” (20) To answer this question, a court must conduct a fact intensive inquiry and closely review the creditor-debtor relationship.

The Third Circuit rejected Lucent’s contention that it was merely driving a hard bargain and exercising its contractual rights and instead concluded that based on the bankruptcy court’s extensive factual findings, Lucent had the power to coerce Winstar into one-sided transactions not in Winstar’s interest, which “refute[d] any suggestion of arm’s-length dealings.” For example, Lucent forced Winstar to purchase unnecessary equipment at non-competitive prices from Lucent just prior to Lucent’s financial filings to inflate Lucent’s revenues, including goods that often remained at Lucent’s warehouse. Lucent also forced Winstar to pay $135 million for software it did not need, did not use, and was worth less than the contract price (21). Therefore, the Third Circuit concluded Lucent was an insider and that the $188,180,000 payment was avoidable as a preference. The Third Circuit also found that Lucent’s secured and unsecured claims should be subordinated to the claims of other unsecured creditors under the principles of equitable subordination.

Conclusion

Winstar expands the definition of insider, and consequently, bankruptcy courts in the Third Circuit will scrutinize the creditor-debtor relationship for any appearance of coercion or for dealings closer than arm’s length. While the actions taken by Lucent in Winstar were egregious, creditors that maintain close relationships with financially distressed companies should proceed with caution as it is not entirely clear where the line is between a creditor with a close relationship and an insider. Even without actual day-to-day control, a significant degree of influence and potentially non-arm’s length transactions could lead to an insider designation in connection with preference litigation or even under other statutes, which may could lead to a challenge in the priority or validity of a creditor’s claim.

Crystal H. Thornton-Illar is an Associate and practices in Leech Tishman’s Bankruptcy & Creditors’ Rights Practice Group. She can be reached at 412.261.1600 x 231 or cthornton-illar@leechtishman.com. Recognition is extended to Justin Stark for his assistance and research in preparing this article. Please feel free to contact Crystal if you have any questions about this information or other bankruptcy & creditors’ rights issues. For more information on the Bankruptcy & Creditors’ Rights Practice Group, please click here.

Leech Tishman is a firm dedicated to providing full-service commercial legal services to individuals, businesses, and institutions. We combine a deep understanding of our clients’ and their businesses with skilled legal counsel to find solutions. We offer legal services in alternative dispute resolution, bankruptcy & creditors’ rights, construction, corporate, employment, energy, environmental, safety & toxic torts, estates & trusts, government relations, insurance coverage & corporate risk mitigation, litigation, real estate, and taxation. For more information call 412.261.1600 or visit www.leechtishman.com.

(1) 554 F.3d 382 (3d Circuit 2009).
(2) 11 U.S.C. §547(b).
(3) 11 U.S.C. § 101(a)(31)
(4) In re Winstar Comm’ns, Inc., 554 F.3d at 395.
(5) See id.
(6) Id. at 391.
(7) Id. at 391-92.
(8) Id. at 392.
(9) Id.
(10) Id.
(11) Id.
(12) Id. at 393.
(13) Id. at 394.
(14) Id.
(15) Id. at 389.
(16) Id. at 394.
(17) Id. at 393.
(18) Id. at 395.
(19) Id. at 396 (citations omitted).
(20) Id. at 396-97.
(21) Id. at 397.