A recent opinion from the U.S. Court of Appeals for the Third Circuit confirms that “actual control” over a debtor is not necessary to qualify as a nonstatutory “insider” for the purpose of extending the period for preference recovery under Section 547 of the Bankruptcy Code. See Schubert v. Lucent Technologies, Inc. (In re Winstar Communications, Inc.), 554 F.3d 382 (3rd Cir. 2009).

In Schubert, the chapter 7 trustee sought to recover more than $188 million from Lucent Technologies, Inc. that was transferred prior to the 90-day statutory period applicable to non-insiders under the Bankruptcy Code. The transfer did take place within the one-year statutory period applicable to insiders of the debtor. See 11 U.S.C. § 547(b)(4)(B).

In support of her claims, the trustee asserted that Lucent was a nonstatutory insider of the debtor as a result of its pre-petition “strategic partnership” with the debtor, pursuant to which Lucent agreed to help finance and construct the debtor’s global broadband telecommunications network.

In response, Lucent argued the strategic partnership was an arm’s-length transaction, and because Lucent did not exercise “actual control” over the debtor, it could not qualify as an insider under the Bankruptcy Code.

Third Circuit Appeal

Affirming the bankruptcy court’s decision in favor of the trustee, the Third Circuit determined that the arrangement between Lucent and the debtor was not an arm’s-length transaction. In support of this holding, the Third Circuit affirmed the bankruptcy court’s findings that Lucent:  

(a) Controlled many of the debtor’s decisions relating to the build-out of the debtor’s telecommunications network;  

(b) Forced the debtor to purchase Lucent’s goods well before equipment was needed and, in many instances, even though the equipment was not needed at all; and  

(c) Treated the debtor as a captive buyer for Lucent’s goods.  

Winstar, 554 F.3d at 397.  

The Third Circuit affirmed the bankruptcy court’s finding that “what began as a ‘strategic partnership’ to benefit both parties quickly degenerated into a relationship in which the much larger company, Lucent, bullied and threatened the smaller Winstar into taking actions that were designed to benefit the larger at the expense of the smaller.” 554 F.3d at 392-93, quoting 348 B.R. 234, 251 (Bankr. D. Del. 2005). Consequently, the Third Circuit determined that the relationship was not an arm’s-length transaction.  

Further, the Third Circuit rejected Lucent’s assertion that it could not be a nonstatutory insider under Section 101 of the Bankruptcy Code because it did not exercise actual control over the debtor’s operations in the same way that a director or officer might. In considering this point, the Third Circuit reviewed the definition of “insider” under the Bankruptcy Code.

The court noted that Section 101(31) of the Bankruptcy Code defines the term “insider” and enunciates several categories of insiders, known as “statutory insiders” because they are expressly included in the language of the statute. See 11 U.S.C. § 101(31).

Still, it is well-settled that Section 101(31) also includes certain parties not expressly defined by the language of the statute, known as nonstatutory insiders.  

Nonstatutory Insiders

In Winstar, the Third Circuit held that actual control (or its close equivalent) is necessary to qualify as a statutory insider under Section 101(31). Winstar, 554 F.3d at 396. In contrast, a demonstration of actual control is not necessary to qualify as a nonstatutory insider. A party can qualify as a non-statutory insider if “there is a close relationship between debtor and creditor and [there is] anything other than closeness to suggest that any transactions were not conducted at arm’s length.” Id.  

The characteristics of the relationship between the debtor and Lucent were indicative of a transaction that was not at arm’s length, the Third Circuit concluded.  

The court further differentiated the relationship between Lucent and the debtor from relationships in which a creditor simply exerts financial pressure over a debtor. The Third Circuit noted that “it is well established that the exercise of financial control incident to the creditor-debtor relationship does not make the creditor an insider.” In the instant case, however, the facts were not limited to Lucent compelling payment of debts or other financial concessions related to its agreements with the debtor.

Instead, the Third Circuit found, among other things, that Lucent had the ability to coerce Winstar to make unnecessary purchases and used Winstar as a mere instrumentality to inflate Lucent’s own revenues. As such, Lucent exercised sufficient control to qualify as a nonstatutory insider, and the Third Circuit affirmed the Bankruptcy Court’s ruling that the longer statutory period applicable under Section 547(b)(4)(B) applied.

Further, given Lucent’s treatment of Winstar, which the Bankruptcy Court determined was “egregious,” the Trustee also prevailed on her breach of contract and equitable subordination claims against Lucent.

This case illustrates that companies entering into a strategic partnership should make sure the partnership is negotiated at arm’s length. The failure to do so could subject an otherwise unaffiliated party to a substantially longer statutory period for preference liability, as well as other longer statutory terms applicable to insiders under the Bankruptcy Code.