Schubert v. Lucent Technologies, Inc. (In re Winstar Communications, Inc.), 554 F.3d 382 (3d Cir. 2009)

The Court of Appeals for the Third Circuit recently affirmed a ruling that a lender with which Winstar Communications, Inc. (Winstar), the debtor, entered into a strategic relationship was an “insider” and subject to an extended look back period under Bankruptcy Code section 547. The ruling is a cautionary signal for lenders.

As part of the debtor’s strategic partnership with Lucent Technologies. Inc. (Lucent), Lucent loaned Winstar over $2 billion. In return, Lucent received a security interest in all of Winstar’s assets and Winstar agreed to purchase Lucent’s products. In addition, Winstar agreed that any funding it received in the future would go towards repaying its indebtedness to Lucent, and the failure to do so would constitute a default under the Lucent loan agreements. In 2000, Siemens, a Lucent competitor, joined a bank consortium that loaned $200 million to Winstar, which was to be used for “general corporate purposes.” However, Lucent required that all proceeds of the loan be applied to repayment of the Lucent loans, and on December 7, 2000, Winstar paid $188 million of the Siemens loan proceeds to Lucent.

Winstar filed for bankruptcy protection on April 18, 2001. The trustee subsequently sought to recover the $188 million transfer to Lucent in repayment of its loan to Winstar as a preference under Bankruptcy Code section 547. Bankruptcy Code section 547 states that “the trustee may avoid any transfer of an interest of the debtor in property… made… on or within 90 days before the date of the filing of the petition…” This “preference period” is expanded to two years if the debtor’s interest was transferred to an “insider.” The trustee argued that Lucent was an insider of Winstar and that the extended period should apply.

The bankruptcy court held that Lucent was a “statutory insider” of Winstar under Bankruptcy Code section 101(31), which states that an insider “includes,” among other things, a “person in control” of the debtor. The bankruptcy court further stated that the term “includes” in Bankruptcy Code section 101(31) encompasses “non-statutory insiders” whose relationship with the debtor is not specifically enumerated in Bankruptcy Code section 101(31), and that Lucent was also a non-statutory insider.

Lucent appealed, arguing, among other things, that in order to be a statutory or non-statutory insider, the entity in question must have “actual managerial control of the debtor’s day-to-day operations,” and since it did not, it was not an insider of Winstar. The trustee argued on appeal that managerial day-to-day control is not a prerequisite to being a statutory insider. The trustee further argued that “a factual inquiry into the debtor’s relationship with the alleged insider, including whether the debtor and alleged insider dealt [with each other] at arm’s length,” should ultimately determine whether the entity in question is a non-statutory insider and that day-to-day managerial control is not required.

The Third Circuit held that in order to be a statutory insider under Bankruptcy Code section 101(31)(B)(iii) one must indeed posses actual, managerial, day-to-day control of the debtor, however, it rebuffed Lucent’s contention that this level of control is also required for non-statutory insiders. The Third Circuit reasoned that to hold otherwise would render meaningless Congress’s non-exhaustive list of insiders in Bankruptcy Code section 101(31). Under Lucent’s interpretation, the “person in control” category would function as the determinative test for statutory and nonstatutory insiders.

The Third Circuit also stated that Lucent’s position fails to recognize that Bankruptcy Code section 101(31) lists several statutory insiders who do not have any control over debtors (including relatives and general partners of insiders). The Court held that in determining whether an entity is a non statutory insider, a court must analyze whether there is a “close relationship” between the debtor and the alleged insider and whether there was anything other than closeness to suggest that the transaction was not conducted at arm’s length.

In the Winstar case, the Third Circuit found many instances of dealings between the debtor and Lucent that were not at arm’s length. It noted that the bankruptcy court found that Lucent used its position as lender to “bully” Winstar into furthering Lucent’s objectives. Lucent, for example, forced Winstar to purchase unneeded equipment from Lucent prior to Lucent’s financial filings to increase Lucent’s revenues. The Court did not rule on whether the level of control wielded by Lucent was sufficient to make Lucent a statutory insider, but it stated that the bankruptcy

did not clearly err in so holding. The Court further stated that the weight of the evidence suggested that the relationship between Lucent and Winstar was anything but at arm’s length, and that the bankruptcy court did not err in ruling that Lucent was a non-statutory insider.

The Court then addressed several of Lucent’s other defenses, including that the $188 million was “earmarked” for Lucent and therefore could not be avoided. Under the “earmarking doctrine,” when funds are provided by a creditor to a debtor for the sole purpose of paying a debt to an existing creditor, those funds are considered “earmarked” and courts have held that the transfer of such funds are not transfers of “an interest of the debtor in property.” Courts have therefore held that such transfers are not avoidable under Bankruptcy Code section 547(b). The bankruptcy court ruled that the $188 million was not earmarked for Lucent and that, in any event, Lucent waived the defense by failing to raise it as an affirmative defense in its answer.

The Court ruled that contrary to the bankruptcy court’s holding, Lucent did not have to assert the earmarking defense as an affirmative defense in its answer because the burden was on the trustee to prove that a transfer was of “an interest of the debtor in property.” Nevertheless, the Court agreed with the bankruptcy court’s holding that the earmarking defense did not apply in this instance. The Court stated that three elements must be present for the earmarking doctrine to apply: (1) the existence of an agreement between the new lender and the debtor that the new funds will be used to pay a specified antecedent debt, (2) performance of that agreement on its terms, and (3) the transaction viewed as a whole does not result in any diminution of the debtor’s estate. The court stated that that pursuant to the terms of the Siemens loan, Winstar could use the proceeds “for general corporate purposes;” there was no requirement to use the proceeds to repay Lucent. The Court stated that because there was no agreement between Siemens and Winstar to use the loan proceeds to repay Lucent, notwithstanding that failing to do so would result in a default under the Lucent loan agreements, the earmarking doctrine did not apply. In its opinion, the Third Circuit addressed other defenses raised by Lucent and found them to be inapplicable as well.

Lenders (and suppliers) must be aware of the  implications of Winstar. Lenders may not think of themselves as insiders, but under Winstar, a relationship that is anything but arm’s length could lead to being labeled an insider. This could result in the avoidance of two years of loan repayments should the borrower file for bankruptcy.