Davis Polk & Wardwell Newsflash

Important Third Circuit Decision Finds a Lender and Contractual Counterparty to Be a Non-statutory "Insider"

February 6, 2009

In a decision issued on February 3, 2009, the Third Circuit considered an issue of first impression: when will a creditor be considered a non-statutory insider for purposes of extending the time for recovery of preferential payments.  The Court held that a creditor was a non-statutory insider where it had "an ability to coerce" (and did coerce) the debtor into various transactions, including transactions that were not in the debtor’s best interest.  The creditor was held to be an insider based on "domination," rather than the more typical "actual control" test, and the one-year (rather than ninety-day) lookback period for the avoidance of preferential transfers applied.


Before filing for bankruptcy, Winstar Communications, Inc. ("Winstar") was a publicly traded Delaware corporation that provided local and long distance telecommunications services.  In October 1998, it entered into a "strategic partnership" with Lucent Technologies, Inc. ("Lucent") in connection with its efforts to construct a global broadband network.  Under the strategic partnership, Lucent provided substantial financing to Winstar, and Winstar was obligated to purchase much of its equipment from Lucent.

Winstar’s Chapter 7 trustee (the "Trustee") subsequently brought a number of claims against Lucent, including a claim for the return of a preferential transfer.  Because the transfer was made more than ninety days before Winstar filed for bankruptcy, the transaction was avoidable only if Lucent was an "insider" of Winstar.  See 11 U.S.C. § 547(b)(4)(B).  After a 21-day bench trial, the Delaware bankruptcy court held that Lucent was an insider and that the payment was an avoidable preference.  The district court affirmed.

The Third Circuit's Decision

The Third Circuit upheld the bankruptcy court’s decision that Lucent was an insider and that the transfer was an avoidable preference.  The Bankruptcy Code contains a non-exclusive definition of "insider" (including affiliates, directors, officers and other persons in control of the debtor).  A party found to be an insider that does not fall within the enumerated examples in the definition is sometimes referred to as a "non-statutory insider."  See 11 U.S.C. § 101(31).  The Court stated that the standard for determining whether a creditor is a non-statutory insider is whether (1) "there is a close relationship between the debtor and creditor;" and (2) "anything other than closeness to suggest that any transactions were not conducted at arm's length."  The Court reasoned that "Lucent's ability to coerce Winstar into transactions that were not in Winstar's interest amply demonstrate Lucent's insider status," and that transactions between Winstar and Lucent were not at arm's length. The Court found that Lucent repeatedly (and often at quarter-end) used its power under the strategic partnership agreements – and specifically its threat of not allowing further draws under its line of credit – to force Winstar to purchase equipment from Lucent even when Winstar did not need the equipment and did not have the funds to purchase it.

In one "egregious example," Lucent "applied pressure on Winstar to help Lucent make its end of quarter numbers," even though it was aware that Winstar executives were "vehement that they are out of money and do not want to spend money on products they cannot immediately utilize."  Lucent ultimately "forced Winstar to pay $135 million for software it did not need, did not use, and had a fair market value of substantially less than the contract price."

Clearly troubled by the facts before it, the Court rejected Lucent’s argument that it was "merely driving a hard bargain and exercising its contractual rights."  It agreed with the bankruptcy court that Lucent coerced Winstar to make unnecessary purchases and used Winstar as a "mere instrumentality" to inflate its own revenues.  It also held that while Lucent may not have exercised actual control over Winstar, Lucent had come to dominate the parties' relationship at the time of the preferential transfer and that the "one-sided transactions" refuted Lucent's claims of arm's-length dealings.  Therefore, the Court held that the bankruptcy court's finding that the parties did not deal at arm's length was not clearly erroneous and that Lucent was a non-statutory insider of Winstar.  

Faced with an array of "bad facts," including backdating and improper accounting, the Third Circuit also upheld equitable subordination of Lucent's claims to the claims of Winstar’s other creditors, despite Lucent's arguments that it was exercising rights under a "sole discretion" standard in the relevant agreement.

For a copy of the decision, please see In re Winstar Communications.

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If you have any questions about the matters covered in this newsflash, please contact any of the lawyers listed below or your regular Davis Polk contact.

Laureen F. Bedell, Partner
212-450-4167 | laureen.bedell@dpw.com

Donald S. Bernstein, Partner
212-450-4092 | donald.bernstein@dpw.com

John Fouhey, Partner
212-450-4358 | john.fouhey@dpw.com

Marshall S. Huebner, Partner
212-450-4099 | marshall.huebner@dpw.com

Benjamin S. Kaminetzky, Partner
212-450-4259 | ben.kaminetzky@dpw.com

Karen E. Wagner, Partner
212-450-4404 | karen.wagner@dpw.com

Michael J. Crames, Counsel
212-450-4744 | michael.crames@dpw.com


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