The Third Circuit Court of Appeals[1] recently held in In re Winstar Communications, Inc. (Schubert v. Lucent Technologies, Inc.), 554 F.3d 382 (3rd Cir. 2009) (decided on February 3, 2009) that a creditor could be deemed an “insider” for preference avoidance purposes and thus be subject to the expanded one-year reach back period if the creditor improperly “coerced” its debtor in its business dealings.

Winstar provided telecommunication services to customers and purchased equipment from Lucent.  Later, Winstar became a “strategic partner” with Lucent, who with its vast resources could support Winstar’s desire to build a global broadband network.  Lucent also provided Winstar with a line of credit.  Winstar expanded rapidly and entered into a further credit facility with a consortium of banks.  Winstar entered into a second line of credit with Lucent that contained financial covenants requiring immediate payments if Winstar’s overall debt exceeded a certain amount.  Subsequently, another lender joined the bank facility and advanced an additional $200 million to Winstar.  Since these amounts put Winstar over the debt ceiling, Lucent demanded payment of the full amount of the Siemens’ loan.  Due to Lucent’s relationship and “coercive power” over Winstar, the $200 million was eventually paid over to Lucent.  Four months later, Winstar filed a voluntary Chapter 11 bankruptcy petition that was subsequently converted to a Chapter 7 case.

The claim for preference recovery action depended on whether the defendant, Lucent, was or was not an insider for purposes of section 547(b).  The bankruptcy court held that Lucent was an insider of Winstar both under the “person in control” language of Section 101(31)(B)(ii) and as a non-statutory insider.  Lucent argued that a party could be a “person in control” or non-statutory insider only if that party exercised managerial control over the day-to-day operations of the debtor.  The trustee contended that actual managerial control was only a prerequisite for determination of “person in control” insider, but not for a non-statutory insider.  The court observed that not all categories of insiders enumerated in the Code possess actual control over the debtor.  As such, the court determined that the proper inquiry for non-statutory insider was not whether a the party exercised control over the debtor but whether the party has such a close relationship with the debtor as to suggest that transactions between the party and the debtor were not made at arms’ length.  The court reviewed the extensive evidence submitted and found numerous situations in which Lucent was able to coerce Winstar to enter into various transactions not in Winstar’s interest, thus establishing Lucent’s insider status and the basis for finding that Lucent was subject to the extended one-year (instead of 90 day) preference period. 

Creditors must now have greater awareness of falling into the dreaded non-statutory insider status in their dealings with debtors.  Even if creditors appear to be operating within contractual terms, Schubert now forces creditors to ask an additional and essential question – “have we forced the debtor into a pattern of behavior where the debtor is not acting in its self interest”.  Lucent often used Winstar as a “mere instrumentality” to improve its internal financial position and to otherwise act for the benefit of Lucent.  The decision was probably an appropriate result for the specific case.  But one can now imagine how the Schubert ruling might be expanded to unsuspecting creditors who are driving a hard bargain and have gained some type of unique leverage to force a debtor to act.  Further case law developments will signal just how worrisome Shubert will be and whether bankruptcy trustees and debtors-in-possession have a new arrow in their quiver for the prosecution of avoidance actions. 
Peter C. Califano will be the Conference Co-Chair for the California Bankruptcy Forum’s Annual Conference to be held in Monterey, CA in May 2010.
Barry A. Dubin is the co-editor of the Commercial Finance Guide published by Matthew Bender.

[1] The Third Circuit oversees the Delaware bankruptcy courts, which are among the busiest bankruptcy venues in the nation.  Therefore, court opinions rendered in this court impact significant bankruptcy cases and influence the development of bankruptcy law around the country.

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