In Re: Winstar Comm

Opinions of the United
2009 Decisions States Court of Appeals
for the Third Circuit
2-3-2009
In Re: Winstar Comm
Precedential or Non-Precedential: Precedential
Docket No. 07-2569
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PRECEDENTIAL
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
No. 07-2569
_______
IN RE: WINSTAR COMMUNICATIONS, INC.,
Debtor
CHRISTINE C. SCHUBERT, Chapter 7 Trustee
v.
LUCENT TECHNOLOGIES INC.,
Appellant
On Appeal from the United States District Court
for the District of Delaware
(D.C. No. 06-cv-00147)
District Judge: Honorable Joseph J. Farnan, Jr.
Argued October 27, 2008
Before: SLOVITER, GREENBERG, Circuit Judges,
and IRENAS,* Senior District Judge
(Filed: February 03, 2009)
_____
*
Honorable Joseph E. Irenas, Senior United States District
Judge for the District of New Jersey, sitting by designation.
Craig Goldblatt , Esq. (Argued)
Wilmer Hale
1875 Pennsylvania Avenue, N.W.
Washington, DC 20006
Attorney for Appellant
Andrew C. Gold, Esq.
David R. King, Esq.
Stephen M. Rathkopf, Esq. (Argued)
Herrick Feinstein
2 Park Avenue
New York, NY 10016
Attorneys for Appellee
Robert K. Rasmussen, Esq.
University of Southern California
Gould School of Law
699 Exposition Blvd.
Los Angeles, CA 90089
Attorney for Amicus-Appellant
G. Eric Brunstad, Jr., Esq.
Bingham McCutchen
One State Street
Hartford, CT 06103
Attorney for Amicus-Appellee
____
OPINION OF THE COURT
SLOVITER, Circuit Judge.
This appeal, arising out of the self-described “strategic
partnership” between Winstar Communications, Inc. (the
2
bankrupt corporation) and Lucent Technologies Inc. (one of
Winstar’s primary creditors and suppliers), presents us with an
issue of first impression - when a creditor can be considered a
non-statutory insider for purposes of extending the time for
recovery of preferential payments. Ordinarily, a trustee may
recover transfers made by the debtor within ninety days of the
bankruptcy, but the Bankruptcy Code authorizes a trustee to
recover any transfers made within a year of the bankruptcy if the
creditor was an “insider.” 1 We must determine whether Lucent
may be deemed an “insider” of Winstar for purposes of the
Bankruptcy Code and, if so, whether the Bankruptcy and District
Courts properly held that the Trustee was entitled to recover
approximately $188 million from Lucent as an avoidable
preference payment. We also must determine whether those
courts properly held that Lucent breached its contract with one
of Winstar’s subsidiaries and that Lucent’s claims against
Winstar’s estate should be equitably subordinated to those of
Winstar’s other creditors and certain equity interest holders.
I.
Procedural Background
Winstar Communications, Inc. (“Winstar”) and its
wholly-owned subsidiary Winstar Wireless, Inc. (“Wireless”)
filed voluntary petitions for reorganization pursuant to Chapter
11 of the Bankruptcy Code on April 18, 2001 (the “Petition
1
See 11 U.S.C. § 547(b) (“[T]he trustee may avoid any
transfer of an interest of the debtor in property–(1) to or for the
benefit of a creditor; (2) for or on account of an antecedent debt .
. . ;(3) made while the debtor was insolvent; (4) made . . . between
ninety days and one year before the date of the filing of the
petition, if such creditor at the time of such transfer was an
insider;” and (5) the creditor receives more than otherwise
permissible under Chapter 7); 11 U.S.C. § 550(a) (“[T]o the extent
that a transfer is avoided under section [547] of this title, the trustee
may recover, for the benefit of the estate, the property transferred
. . . .”).
3
Date”). “In January 2002 the cases were converted to Chapter 7
and shortly thereafter Christine C. Shubert (the “Trustee”) was
appointed as the Chapter 7 trustee.” Shubert v. Lucent Techs.,
Inc. (In re Winstar Commc’ns, Inc.), 348 B.R. 234, 244 (Bankr.
D. Del. 2005).
Winstar initially commenced this adversary proceeding
against Lucent Technologies Inc. (“Lucent”) on the Petition
Date, “alleging that [Lucent] breached several of the contracts
between Winstar and Lucent, [thereby] allegedly forcing Winstar
to file its bankruptcy petition.” Shubert v. Lucent Techs., Inc.,
(In re Winstar Commc’ns, Inc.), No. 01-01430, 2004 WL
2713101, at *1 (D. Del. Nov. 16, 2004). In turn, “Lucent filed
several proofs of claim, asserting claims against Winstar that
include secured and unsecured claims for sums alleged due
under agreements between Lucent and Winstar” totaling nearly
one billion dollars.2 Id. Following conversion of the case into a
Chapter Seven liquidation, the Trustee interceded into this
adversary proceeding and filed the Second Amended Complaint
(the controlling complaint in this appeal). Id. After the Trustee
voluntarily dismissed certain claims and the Bankruptcy Court
granted Lucent dismissal of another, the Trustee had three
remaining claims: “Count VII for Breach of the Parties’
Subcontracting Arrangement,” “Count X for Return of
Preferential Transfer,” and “Count XI, a claim seeking to
equitably subordinate Lucent’s claims.” Id.3
2
The Trustee and Lucent have entered into a series of
stipulations that recognize the validity of Lucent’s secured claims
against the Winstar estate and provide that Lucent is entitled to
approximately $21 million subject to the resolution of this
adversary proceeding.
3
The Bankruptcy Court had subject matter jurisdiction over
the initial proceedings pursuant to 28 U.S.C. § 1334(b). The
District Court's jurisdiction for the bankruptcy appeal is found in
28 U.S.C. § 158(a)(1). We have jurisdiction over this appeal under
28 U.S.C. § 158(d). We exercise plenary review over the District
Court’s appellate review of the Bankruptcy Court’s decision and
exercise the same standard of review as the District Court in
4
Lucent made a demand for a jury trial and asserted four
counterclaims for fraud and negligent misrepresentation. Lucent
subsequently requested the District Court to exercise its
discretionary power to withdraw this case from the Bankruptcy
Court under 28 U.S.C. § 157(d) because of its right to a jury trial
on the contract and preference claims. The District Court denied
Lucent’s request, holding that by submitting a proof of claim
against Winstar, Lucent “triggered the process of allowance and
disallowance of those claims,” thereby subjecting Lucent to the
equity power of the Bankruptcy Court. 2004 WL 2713101, at
*3. Finally, the Court declined to exercise its discretion to
withdraw the reference, citing In re Pruitt, 910 F.2d 1160, 1168
(3d. Cir. 1990), and ruled that Lucent violated Local Bankruptcy
Rule 5011-1, which provides that “the movant for withdrawal
shall concurrently file with the Clerk a motion for a
determination by the Bankruptcy Court with respect to whether
the matter . . . is core or non-core.” Id. Thereafter, the
Bankruptcy Court held a trial on the Trustee’s claims and
Lucent’s counterclaims. The Bankruptcy Court found for the
Trustee on all her claims. It rejected all of Lucent’s
counterclaims (which Lucent does not contest on appeal).
On the Trustee’s preference claim, the Bankruptcy Court
held that Winstar’s payment to Lucent on December 7, 2000, of
the proceeds of a loan Siemens made to Winstar was an
avoidable preference and therefore ordered Lucent to return
those funds to the Trustee. Because that transaction occurred
more than ninety days before Winstar filed for bankruptcy, the
transaction was avoidable only if Lucent was an “insider” of
Winstar. The Bankruptcy Court, after discussing the statutory
definition of an “insider” as including a “person in control of the
debtor,” 11 U.S.C. § 101(31), as well as case law regarding the
non-statutory category of insiders, held that Lucent was an
insider of Winstar. The Bankruptcy Court rejected Lucent’s
argument that Winstar lacked “an interest” (as required by
reviewing the Bankruptcy Court’s determinations. Fellheimer,
Eichen & Braverman, P.C. v. Charter Tech., Inc., 57 F.3d 1215,
1223 (3d Cir. 1995).
5
§547(b)’s prefatory language) in the Siemens loan and rejected
Lucent’s “new value defense” to the preference claim.
Next, the Bankruptcy Court equitably subordinated
Lucent’s claims against the Winstar estate to the claims of all of
Winstar’s other creditors and certain equity interest holders.
Finally, on the Trustee’s breach of contract claim, Lucent
challenged the Bankruptcy Court’s authority to issue a final
judgment with respect to that claim, which Lucent contended
was “non-core.” See 28 U.S.C. § 157(c)(2) (providing that
bankruptcy courts can enter final judgments on non-core matters
only with the consent of the parties). Ultimately, the Bankruptcy
Court rejected Lucent’s challenge to its ability to issue final
orders on several grounds. First, the Bankruptcy Court found
that Lucent “waived its objection to this Court’s entry of final
orders by its conduct,” 348 B.R. at 250, because “[f]rom before
the filing of the withdrawal motion, through the conclusion of
the Trustee’s case-in-chief in this Court when Lucent then
unsuccessfully sought judgment on partial findings pursuant to
Fed. R. Bankr. P. 7052, until after submission of all the
evidence, and indeed, submission of each party’s proposed
findings of fact and conclusions of law[,] . . . Lucent did not
raise the issue that the Bankruptcy Court lacked jurisdiction to
enter final judgment,” id. at 244-45. Indeed, the Court noted that
“Lucent sought a final order in its favor on several occasions
from this Court.” Id. at 245. Second, the Bankruptcy Court
“interpret[ed] the district court’s earlier findings [regarding
Lucent’s motion to withdraw the reference] that the claims and
counterclaims fall within the claims allowance process to
necessitate a finding that these actions are core pursuant to 28
U.S.C. § 157(b)(2)(B).” Id. at 246. See 28 U.S.C. §
157(b)(2)(B) (“Core proceedings include . . . allowance or
disallowance of claims against the estate . . . .”).
Third, the Bankruptcy Court made an “independent
examination of its own jurisdiction” and concluded that the
Trustee’s Subcontract claim was a core claim under §
157(b)(2)(B). Id. Lucent filed a proof of claim that stated that
“Lucent held a secured claim (and to the extent not secured, an
6
unsecured claim) in [a]n amount not less than $138,957,218.90
for goods sold, money loaned, and other.” Id. at 247. “Lucent
described the documents which support its claim as the Supply
Agreement . . . and any and all related documents, agreements
and statements of work.” Id. (emphasis added in original)
(internal quotations omitted). Thus, the Bankruptcy Court
concluded that “[w]hether Lucent may have breached the
Subcontract by refusing to pay [in March 2001] has a direct
bearing upon whether Lucent may recover under its Proof of
Claim and if so, in what amount. Therefore the breach of the
Subcontract claim falls within the core jurisdiction of the Court.”
Id.
On the merits of the Subcontract claim, the Bankruptcy
Court held that Lucent breached the Subcontract by its refusal to
pay Wireless approximately $62 million for services rendered
between January and March 2001.4
Lucent subsequently appealed the Bankruptcy Court’s
decision to the District Court, which affirmed. See Lucent
Technologies, Inc. v. Shubert (In re Winstar Commc’ns, Inc.),
No. 06-147-JJF, 2007 WL 1232185 (D. Del. August 26, 2007).
The parties do not disagree as to the relevant facts. They
vigorously disagree as to the legal effect of these facts and the
conclusions reached by both the Bankruptcy and District Courts.
II.
Facts
Prior to its bankruptcy, Winstar was a publicly traded
Delaware corporation that provided local and long distance
telecommunications services. During the 1990s, Winstar was
also engaged in the construction of a global broadband
4
We express our deep appreciation to Joel B. Rosenthal, the
visiting Bankruptcy Judge from the District of Massachusetts, who
treated this matter with great dedication.
7
telecommunications network. Initially, its subsidiary Wireless
was primarily responsible for the design and construction of this
network. Lucent, which was spun off by AT&T, is a publicly
traded Delaware corporation that “designs and delivers
telecommunications systems, services, and products, including
software.” 348 B.R. at 252.
Before the arrangements at issue here, Winstar and
Lucent had an arm’s-length vendor-creditor relationship in
which Lucent sold goods to Winstar. In October 1998, Winstar
entered into what the parties describe as a “strategic partnership”
with Lucent in order to further Winstar’s network construction.
348 B.R. at 252. As described below, Lucent essentially agreed
to help finance and construct Winstar’s global broadband
telecommunications network.
In October 1998, Lucent and Winstar entered into a
secured credit agreement (the “First Credit Agreement”). Lucent
provided a two billion dollar line of credit “to be used for the
purchase of certain products and services in exchange for a lien
in virtually all of Winstar’s assets.” 348 B.R. at 252.
Simultaneously, Lucent and Winstar entered into the Supply
Agreement, under which “Lucent would build and deliver a
turnkey operation to Winstar, ” i.e. Lucent would take primary
responsibility for the construction of Winstar’s network. 348
B.R. at 253. Lucent was also required to provide “Best of
Breed” equipment. 348 B.R. at 253. Where Lucent could not
provide “Best of Breed” equipment or perform services
necessary for the construction of Winstar’s network, Lucent was
obligated to finance (pursuant to the First Credit Agreement)
such equipment or services provided by third parties. However,
the Supply Agreement provided that 65% of the equipment and
services Winstar purchased during the first year of the contract
would be from Lucent and 70% thereafter. Winstar would face
escalating surcharges of up to three million dollars per year if it
failed to meet these purchase requirements.
In sum, under the October 1998 agreements Winstar
obtained financing for its network construction and Lucent
obtained a major customer for its products and services. Even at
8
that time, Lucent and Winstar “recognized that Lucent did not
have all the core competencies necessary to perform the
[network] buildout.” 348 B.R. at 253. “Therefore the Supply
Agreement provided that Lucent would prepare a transition
agreement that included a schedule of its assumption of various
aspects” of the network construction. 348 B.R. at 253.
However, no transition agreement was ever completed. Instead,
Lucent and Winstar’s subsidiary Wireless entered into an
agreement effective January 4, 1999, (the “Subcontract”) under
which “Wireless agreed to act as Lucent’s subcontractor and
build the network at least until such time as Lucent was willing
and able to assume that role.” 348 B.R. at 253.
In May 2000, Winstar obtained a $1.15 billion revolving
credit and term loan from a consortium of bank lenders (the
“Bank Facility”), which was secured by Winstar’s assets. By
this time, Winstar had also raised almost one billion dollars in
equity and $1.6 billion in public debt. Using funds from the
Bank Facility and these other sources, Winstar paid off the
approximately $1.2 billion it had borrowed from Lucent under
the First Credit Agreement. Lucent then released its lien on
Winstar’s assets.
This transaction did not end Lucent’s financing of
Winstar’s network construction. As the Bankruptcy Court
found: “Lucent desired to keep its good customer relationship
with Winstar and thus in May 2000, simultaneously with the
execution of the Bank Facility and repayment of the $1.2
[billion] owed under the First Credit Agreement, the parties
entered into the Second Credit Agreement whereby Winstar
received from Lucent a $2 billion line of credit with the ability to
borrow up to $1 billion at any one time.” 348 B.R. at 254.
Winstar created two subsidiaries, WVF-1 LLC (“WVF-1”) and
WVF-LU2 LLC (“WVF-LU2”), to act as borrowers under the
Second Credit Agreement. Lucent received a security interest in
the borrowing subsidiaries’ assets and a security interest senior
to the Bank Facility for equipment financed by Lucent.
However, the Second Credit Facility, unlike the First, was not
secured by a lien on all of Winstar’s assets. Finally, the Second
Credit Agreement also contained the following financial
9
covenants: (1) Winstar would “not permit its total Capital Cash
Expenditures (‘CAPEX’) to exceed $1.3 billion in any year prior
to and including 2001,” (2) Lucent was entitled “to serve a
‘refinance notice’ on Winstar if the outstanding loans exceeded”
$500 million, and (3) Winstar was required to use “any increases
in the Bank senior loan arrangement . . . to repay Lucent.” 348
B.R. at 254-55.
The preceding agreements formed the contractual basis
for the relationship between Winstar and Lucent. The
Bankruptcy Court, which conducted a 21-day bench trial,
reviewed 1,400 exhibits, and heard 39 witnesses, made extensive
factual findings of Lucent’s control over Winstar. In its
overview, the Bankruptcy Court concluded that Lucent used
“Winstar as a mere instrumentality to inflate Lucent’s own
revenues.” 348 B.R. at 284. It noted 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.” 348 B.R. at 251. It stated further,
“taking all the credible evidence as a whole, it is clear that
Lucent used Winstar to inflate Lucent’s own revenues.” 348
B.R. at 251 (emphasis deleted). The opinion continues:
Although Winstar benefitted from some of its dealings
with Lucent and its own actions were, at times, no less
questionable than Lucent’s, the facts point to one
conclusion: Lucent extracted what it needed to prop up its
own revenue from Winstar in the form of purchases by
Winstar of unneeded equipment and manipulated the
timing of a refinancing notice that would have put the
world on notice that Winstar was in dire financial straits
until Lucent could take some more. Lucent used its
position as Winstar’s lender to ensure Winstar’s
cooperation by repeated threats to stop both the funding
of Winstar’s draw requests and the payment of Wireless’s
invoices for services already performed.
Id.
10
The Bankruptcy Court found that Lucent “controlled
many of Winstar’s decisions relating to the buildout of [its]
network;” “forced the ‘purchase’ of its goods well before the
equipment was needed and in many instances . . . never needed
at all;” and “treated Winstar as a captive buyer for Lucent’s
goods.” 348 B.R. at 280. It noted that “Lucent’s ability to
involve Winstar’s employees in Lucent[’s] duplicity is further
evidence of Lucent’s control.” Id.
The Bankruptcy Court also found that “these parties were
not dealing at arms [sic] length” in light of various transactions
between the parties, such as a purchase order “describing as
‘miscellaneous’ a purchase of several million dollars,” the
agreement to purchase unneeded software, other excessive end-
of-quarter deals, and “unneeded equipment paid for by Winstar
but sitting in Lucent’s facilities, duplicate charges, and
difficulty, to say the least, in getting credits correctly to
Winstar’s accounts.” Id. at 266-67. The Bankruptcy Court also
drew an adverse inference against Lucent based on the refusal of
two Lucent employees to answer deposition questions regarding
Lucent’s relationship with Winstar. Id. at 280-82.
As noted above, we must deal with three claims: the
Trustee’s preference claim, the contract claim, and the claim for
equitable subordination.
III.
Discussion
A. The Preference Claim
An understanding of the Trustee’s claims for recovery of
the $188.2 million payment to Lucent requires a detailed
description of the Siemens loan and certain end-of-quarter and
bill-and-hold transactions between Lucent and Winstar deemed
irregular by the lower courts.
In November 2000, Siemens, a competitor of Lucent in
the manufacture of telecommunications equipment, agreed to
11
join the Bank Facility and lend $200 million to Winstar.
According to the Siemens loan documents, the Siemens loan was
to be used for “general corporate purposes.” App. at 2056.
However, the Second Credit Agreement with Lucent obligated
Winstar to pay any such increase in the Bank Facility to Lucent.
Failure to do so would constitute an event of default under the
Second Credit Facility. Moreover, under a cross-default
provision in the Bank Facility, default on the Second Credit
Agreement would constitute default on the Bank Facility.
Winstar sought permission from Lucent to keep all, or
alternatively half, of the Siemens loan proceeds notwithstanding
the above requirements of the Second Credit Agreement. As
found by the Bankruptcy Court, “Lucent refused and responded
with a . . . ‘consent letter’ that was merely a list of demands.”
348 B.R. at 271. Moreover, after “Winstar did not immediately
agree to Lucent’s demands, Lucent put the transition agreement
negotiations on hold.” 348 B.R. at 272. Finally, “[w]hen
Winstar still did not acquiesce, Lucent played its ultimate trump
card: give Lucent all of the Siemens proceeds or there would be
no further draws under the Second Credit Agreement.” 348 B.R.
at 272.
Winstar agreed to pay the proceeds of the Siemens loan to
Lucent and informed the Bank Facility lenders that it would use
the Siemens loan as well as other capital raised at about the same
time to reduce its debt to Lucent. On December 7, 2000,
Winstar “closed on a $200 million increase [in] its syndicated
loan with Bank of New York [the agent of the bank facility],”
and “[o]n the same day Winstar paid, by wire transfer, Lucent
$188,180,000 [the Siemens loan minus certain fees and a refund
owed to Winstar by Lucent] to reduce Winstar’s outstanding
loan with Lucent.” 348 B.R. at 272. It is this payment of almost
$188.2 million that the Trustee characterized as an avoidable
preference.
The Bankruptcy Code provides that “to the extent that a
transfer is avoided under section [547] of this title, the trustee
may recover, for the benefit of the estate, the property
transferred . . . .”. 11 U.S.C. § 550(a). The referenced section,
12
11 U.S.C. § 547(b) provides:
[T]he trustee may avoid any transfer of an interest of the
debtor in property--
(1) to or for the benefit of a creditor;
(2) for or on account of an antecedent debt owed by
the debtor before such transfer was made;
(3) made while the debtor was insolvent;
(4) made--(A) on or within 90 days before the date of
the filing of the petition; or (B) between ninety days
and one year before the date of the filing of the
petition, if such creditor at the time of such transfer
was an insider; and
(5) that enables such creditor to receive more than
such creditor would receive if--(A) the case were a
case under chapter 7 of this title; (B) the transfer had
not been made; and (C) such creditor received
payment of such debt to the extent provided by the
provisions of this title.
Because the Siemens transaction occurred more than
ninety days prior to the Petition Date, § 547(b)(4) can be
satisfied only if Lucent was an insider of Winstar. Lucent
contends that the lower courts erred in so holding. Lucent also
argues that the proceeds of the Siemens loan were “earmarked”
for Lucent such that no “interest of the debtor in property” was
present. Finally, Lucent argues that the lower courts improperly
denied its new value defense pursuant to 11 U.S.C. § 547(c)(4).
Although at least one of our sister Courts of Appeals has
held that the “determination of insider status is a question of fact
. . . subject to the clearly erroneous standard of review,”
Fabricators, Inc. v. Technical Fabricators, Inc. (In re Fabricators,
Inc.), 926 F.2d 1458, 1466 (5th Cir. 1991), we believe that the
issue is best characterized as a mixed question of law and fact.
Cf. Anstine v. Carl Zeiss Meditec AG (In re U.S. Med., Inc.),
531 F.3d 1272, 1275 (10th Cir. 2008) (characterizing insider
status as a mixed question where “the facts are undisputed and
the issue revolves around the legal conclusion drawn from the
facts against the backdrop of a statute”). Thus, we will review
13
the Bankruptcy Court’s findings for clear error but exercise
“plenary review of the lower court’s interpretation and
application of those facts to legal precepts.” Schlumberger Res.
Mgmt. Servs., Inc. v. Cellnet Data Sys., Inc. (In re Cellnet Data
Sys., Inc.), 327 F.3d 242, 244 (3d Cir. 2003).
Under the statute, “[t]he term ‘insider’ includes . . . (B) 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.” 11 U.S.C. §
101(31)(B). Additionally, in light of Congress’s use of the term
“includes” in § 101(31), courts have identified a category of
creditors, sometimes called “non-statutory insiders,” who fall
within the definition but outside of any of the enumerated
categories. See In re U.S. Med., 531 F.3d at 1276.
The Bankruptcy Court held that Lucent was an insider of
Winstar under § 101(31)(B)(iii)’s “person in control” language
and as a non-statutory insider. Lucent argues that the lower
courts applied the incorrect legal standard under § 101(31) and,
further, that the evidence was insufficient to support a finding of
insider status.
The principal issue presented is the legal standard for
“insider.” Lucent asserts that, in order for a creditor to constitute
an “insider” as either a “person in control” or a non-statutory
insider, that creditor must exercise “actual managerial control
over the debtor’s day-to-day operations.” Appellant’s Br. at 32-
33. According to Lucent, the term “person in control” and the
scope of the non-statutory insider category both “should be
interpreted in light of the other statutorily enumerated ‘insiders’”
such that “the evidence would have to demonstrate that Lucent
exercised the type of authority over Winstar that an officer,
director, or general partner exercises–actual managerial control
over the debtor’s day-to-day operations.” Appellant’s Br. at 32.
In support of that argument, Lucent cites to only one decision by
an Article III court, Butler v. David Shaw, Inc., 72 F.3d 437, 443
(4th Cir. 1996) (holding, apparently under the non-statutory
14
category, that to constitute an insider, an entity “must exercise
sufficient authority over the debtor so as to unqualifiably dictate
corporate policy and the disposition of corporate assets”)
(quoting Hunter v. Babcock (In re Babcock Dairy Co.), 70 B.R.
662, 666 (Bankr. N.D. Ohio 1986)). However, Butler relied
entirely on In re Babcock Dairy for this proposition and the
quoted language interpreted the “person in control” statutory
insider category, not the non-statutory insider category. 70 B.R.
at 666 (holding, in the context of the “person in control”
category, that although no “standard has been established for
determining the degree to which a person must control a debtor
before he is considered . . . an insider . . . it does appear that the
person . . . must exercise sufficient authority over the debtor so
as to unqualifiably dictate corporate policy and the disposition of
corporate assets”). Butler is unpersuasive.
The Trustee contends that the “person in control” and
non-statutory insider categories are subject to different legal
standards. As to “person in control” insider status, the Trustee
argues that managerial control is sufficient but not necessary.
As to non-statutory insiders, the Trustee argues that “actual
control is not required.” Appellee’s Br. at 33. See In re U.S.
Med., 531 F.3d at 1277 n.5 (“The ‘control’ to which [non-
statutory insider] cases refer can only correctly be interpreted as
something short of actual, legal control over the debtor’s
business because ‘actual control’ would subject the creditor to
the statutory category of ‘person in control of the debtor’ under
[§ 101(31).] Any interpretation of ‘control’ within the non-
statutory-insider context as anything like the ability to ‘order,
organize or direct’ the debtor’s operations is simply incorrect.”)
(citations omitted). Instead, the Trustee argues that, in
considering non-statutory insiders, courts conduct “a factual
inquiry into the debtor’s relationship with the alleged insider,
including whether the debtor and the alleged insider dealt at
arms [sic] length.” Appellee’s Br. at 34 (quoting In re Craig Sys.
Corp., 244 B.R. 529, 539 (Bankr. D. Mass. 2000)). See
generally 5 Alan N. Resnick & Henry J. Sommer, Collier on
Bankruptcy, § 547.03[6] (15th rev. ed. 2008) (“The
consideration of insider status focuses on two factors: (1) the
closeness of the relationship between the parties; and (2)
15
whether the transaction was negotiated at arm's length.”).
We agree with Lucent that 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.5
However, a finding of such control is not necessary for an entity
to be a non-statutory insider. See In re U.S. Med., 531 F.3d at
1279 (“A finding of actual control by the bankruptcy court
would make Creditor a statutory insider and would avoid the
question of whether it was a non-statutory insider altogether.
Obviously, then, a bankruptcy court does not have to find actual
control of the debtor by the creditor before ruling that the
creditor is a non-statutory insider of the debtor.”). To hold
otherwise would render meaningless Congress’s decision to
provide a non-exhaustive list of insiders in 11 U.S.C. §
101(31)(B) because the “person in control” category would
function as a determinative test. Lucent persuasively argues that
“to avoid turning the catch-all ‘non-statutory’ category into an
end-run around Congress’s intent–making superfluous the
specific, narrow categories Congress identified–that catch-all
category must be reserved for persons and entities that are
functionally equivalent to the types of insider enumerated in the
statute.” Appellant’s Reply Br. at 11.
However, Lucent glosses over the fact that not all of the
enumerated insiders possess actual control over the debtor. For
example, a “relative of a general partner, director, officer, or
person in control of the debtor” is an insider. 11 U.S.C. §
101(31)(B)(vi). Similarly, a “partnership in which the debtor is
a general partner” is an insider–even though the direction of
control is reversed, i.e. the debtor as general partner controls the
partnership. 11 U.S.C. § 101(31)(B)(iv). Cf. 11 U.S.C. §
101(31)(E) (providing that an “affiliate” of the debtor is an
5
Indeed, the Bankruptcy Court applied this standard: “There
must be day-to-day control, rather than some monitoring or
exertion of influence regarding financial transactions in which the
creditor has a direct stake.” 348 B.R. at 279 (quoting In re
Armstrong, 231 B.R. 746, 749-50 (Bankr. E.D. Ark. 1999)).
16
insider, even though an affiliate under § 101(2)(B) includes a
corporation “20 percent or more of whose outstanding voting
securities are directly or indirectly owned . . . by the debtor”). In
light of these enumerated categories, we hold that it is not
necessary that a non-statutory insider have actual control; rather,
the question “is whether there is a close relationship [between
debtor and creditor] and . . . anything other than closeness to
suggest that any transactions were not conducted at arm’s
length.” In re U.S. Med., 531 F.3d at 1277. See also S. Rep.
No. 95-989, at 25 (1978), as reprinted in 1978 U.S.C.C.A.N.
5787, 5810 (“An insider is one who has a sufficiently close
relationship with the debtor that his conduct is made subject to
closer scrutiny than those dealing at [arm’s] length with the
debtor.”).
The Bankruptcy Court’s extensive findings regarding
Lucent’s ability to coerce Winstar into transactions not in
Winstar’s interest amply demonstrate Lucent’s insider status.
For example, the Bankruptcy Court found that 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.” 348 B.R. at 280. The Bankruptcy Court also
found that “Lucent’s ability to involve Winstar’s employees in
[certain improper transactions that benefitted Lucent] is further
evidence of Lucent’s control.” Id.
Throughout this period, Lucent was interested in ensuring
that its financial records show a rosy picture. To this end, it
focused on the quarterly reports that it reported publicly and to
the financial authorities. The Bankruptcy Court found that
“Winstar repeatedly and knowingly helped Lucent by making
massive, last minute, allegedly unneeded purchases that were
arranged by Lucent as the ends of quarters approached.” 348
B.R. at 255. These deals “enabled Lucent to report more
revenue and appear more profitable in its quarterly public reports
than it really was.” Id. Indeed, “Winstar’s purchases of Lucent
equipment in end of quarter sales [were] on average eight times
17
as high as . . . Winstar purchases of Lucent equipment in months
in which a quarter did not end.” Id. The Bankruptcy Court also
found that “Winstar helped Lucent record revenue through
alleged accounting schemes such as improper bill and hold deals,
whereby Winstar would pay for goods that it did not need, often
were not identified with any kind of particularity, and frequently
never even left the Lucent warehouse.” Id. The Bankruptcy
Court concluded that “Winstar was and remained Lucent’s
captive purchaser of unneeded and sometimes unidentified
goods to permit Lucent to inflate its own revenue.” 348 B.R. at
267.
One of the egregious examples of Lucent’s power to
coerce Winstar is demonstrated by the transaction termed the
Software Pool Agreement by the Bankruptcy Court. In
September 2000, Lucent applied “pressure on Winstar to help
Lucent make its end of quarter numbers.” 348 B.R. at 259.
Although Lucent was aware that Winstar executives were
“vehement that they are out of money and do not want to spend
money on products that they can not immediately utilize,” there
were high-level discussions between Lucent and Winstar
executives, during which Winstar’s President and Chief
Operating Officer Nate Kantor offered to “help whenever
possible” on end of quarter deals and instructed another Winstar
executive, David Ackerman, to make a deal. Id. at 260. In light
of the CAPEX provision in the Second Credit Agreement that
limited Winstar’s capital expenditures, Ackerman expressed
discomfort in reaching the $110-115 million target that Lucent
sought but told Kantor that “[t]here is not much I can give them
that we really need, but there are some creative things I can do
that can get us close to their number without being totally
stupid.” Id. at 260-61. Ultimately, Lucent forced Winstar to pay
it $135 million “for software it did not need, did not use, and had
a fair market value of substantially less than the contract price.”
348 B.R. at 255.
The Bankruptcy Court found several irregularities in the
Software Pool Agreement. First, “Lucent’s [i]nitial software
proposal was for a much smaller amount–$25 million–but in less
than nine days . . . the pool expanded approximately five-fold . . .
18
without the numerous internal studies” typically prepared by
Winstar. 348 B.R. at 263. Second, Winstar agreed to pay the
list price for the software, even though it was contractually
entitled to a lower price. Third, the Bankruptcy Court found that
“less than $20 million [of the software purchase] was of value to
Winstar.” Id. Fourth, “[t]o enable Winstar to make the required
cash payment for the software, the companies agreed to enter
into contracts for credits postdated after September 29, 2000 and
payable in the fourth quarter of 2000 (i.e., before Winstar was
obligated to actually make the software payments to Lucent).”
Id. This postdating enabled “Lucent to book almost the entire
amount of the software deal as revenue in [the] final fiscal
quarter of 2000,” meaning that “Lucent funded Winstar’s
purchase of the unnecessary software in advance, to obtain
Lucent’s September 2000 revenue and profit infusion.” Id. As
Lucent concedes, its accounting treatment of this transaction was
improper. It conducted an internal investigation, revised its
projected revenue announcement, reported the matter to the
SEC, and ultimately paid “a substantial fine.” Appellant’s Br. at
17.
These purchases “forced Winstar out of compliance with
the CAPEX covenant and over the $500 million refinancing
threshold” under the Second Credit Agreement, thereby entitling
Lucent to issue a refinancing notice. 348 B.R. at 262-63. The
Bankruptcy Court found that Lucent subsequently “deliberately
held up” the issuance of a refinancing notice under the Second
Credit Agreement, which the Bankruptcy Court characterized as
“the equivalent of a financial death knell,” in order “to ensure
that the [Siemens loan and certain private equity investments]
occurred and new equity was infused into the dying Winstar.”
Id. at 284. In sum, given this course of conduct, the Bankruptcy
Court found that the “parties were not dealing at arms [sic]
length.” Id. at 266.6
6
Lucent objects to the adverse inference the Bankruptcy
Court drew against Lucent based on the refusal under the Fifth
Amendment of two Lucent executives to answer deposition
questions about the relationship between Lucent and Winstar.
19
Lucent contests the sufficiency of these findings to
support the conclusion that it was an insider. It argues that
rather than exercising actual control over Winstar, it simply used
its superior bargaining position “to push Winstar to purchase as
much Lucent equipment as Winstar was willing to take.”
Appellant’s Br. at 39. It contends that Winstar’s management
“determined that it was in Winstar’s best interests to maintain a
good relationship with their principal supplier, Lucent.”
Appellant’s Br. at 40. As to the Siemens loan transaction,
Lucent argues that, given its contractual right to those proceeds
under the Second Credit Agreement, “the preference statute
[cannot] penalize Lucent for conduct that was wholly
permissible under the parties’ freely entered agreements.”
Appellant’s Br. at 41.
Lucent’s contention that it was merely driving a hard
bargain and exercising its contractual rights is not persuasive.
The decision of the bankruptcy court in Johnson v. NBD Park
Ridge Bank (In re Octagon Roofing), 124 B.R. 522, 530 (Bankr.
N.D. Ill. 1991), provides an instructive contrast. There, the
alleged insider creditor required the debtor to provide a
mortgage on certain property in order to secure a previously
unsecured debt; if the debtor refused, the creditor “could have,
and would have, effectively shut down Debtor’s operations.”
124 B.R. at 530. The bankruptcy court held that the creditor was
not a “person in control of the debtor” because these facts
“merely demonstrate that the [creditor] could compel payment of
its debt” and “it is well established that the exercise of financial
control . . . incident to the creditor-debtor relationship[] does not
make the creditor an insider.” Id. Here, however, the
Bankruptcy Court’s findings are not limited to Lucent
compelling payment of debts or other financial concessions
“incidental” to the Credit Agreements. Instead, the Bankruptcy
Court found, among other things, that Lucent had the ability to
Because we believe that the Bankruptcy Court’s factual findings
are more than sufficient to demonstrate that Lucent was an insider
of Winstar even without considering the Bankruptcy Court’s
adverse inference, we do not consider the adverse inference issue.
20
coerce Winstar to make unnecessary purchases and used
“Winstar as a mere instrumentality to inflate Lucent’s own
revenues.” 348 B.R. at 284.
Moreover, given our conclusion that actual control is
unnecessary for an entity to be deemed a non-statutory insider,
even if Lucent was not a “person in control” of Winstar, it was a
non-statutory insider of Winstar based on the Bankruptcy
Court’s findings. Not only was Lucent both a major creditor and
supplier of Winstar, but, according to the Bankruptcy Court, it
had the ability to coerce Winstar into a series of transactions that
were not in Winstar’s best interests, such as the Software Pool
transaction, the improper bill-and-hold transactions, and other
purchases of unneeded equipment. Such one-sided transactions
refute any suggestion of arm’s-length dealings. See In re U.S.
Med., 531 F.3d at 1277 n.4 (“An arm’s-length transaction is a
transaction in good faith in the ordinary course of business by
parties with independent interests . . . [that] each acting in his or
her own best interest[ ]would carry out . . . .”) (quotation
omitted).
Lucent counters that the totality of the parties’
relationship suggests that both were able to obtain concessions
from the other–and therefore, they were engaged in arm’s-
length dealings. Lucent points to certain of the Bankruptcy
Court’s findings in support of this argument: Lucent engaged in
the “pass-through” transactions as an accommodation to
Winstar, which obtained favorable accounting benefits from the
practice; Lucent funded more non-Lucent equipment than called
for under the Supply Agreement and did not impose
contractually-authorized penalties based on those purchases; and
Winstar sought out a strategic partnership with Siemens, one of
Lucent’s competitors. These findings may suggest that Lucent
did not exercise actual control over Winstar. But cf. In re S.
Beach Sec., Inc., 376 B.R. 881, 889 (Bankr. N.D. Ill. 2007) (“To
be an insider of the debtor [as a person in control], a person need
not have legal or absolute control of the debtor.”) (quotation
omitted). However, the Bankruptcy Court’s findings
demonstrate that Lucent had come to dominate the parties’
relationship by December 7, 2000 (the date on which the alleged
21
preferential transfer occurred).7 Therefore, we cannot conclude
that the Bankruptcy Court’s finding that the parties did not deal
at arm’s length was clearly erroneous and we hold that Lucent
was a non-statutory insider of Winstar. Therefore, the Trustee
was not limited to the ninety-day look back but could recover
Winstar’s payment of $188.2 million to Lucent which occurred
within the year prior to the bankruptcy.
Lucent interposed several defenses to the Trustee’s
preference claim. In addition to its contention that the
Bankruptcy Court’s factual findings do not establish actual
control, it argued that the payment to Lucent was earmarked and
thus was not a transfer of Winstar’s property. “The earmarking
doctrine is entirely a court-made interpretation of the statutory
requirement that a voidable preference must involve a ‘transfer
of an interest of the debtor in property.’” McCuskey v. Nat’l
Bank of Waterloo (In re Bohlen Enters., LTD.), 859 F.2d 561,
565 (8th Cir. 1988) (quoting 11 U.S.C. § 547(b)). Under this
doctrine, “[w]hen . . . funds are provided by [a] new creditor to
or for the benefit of the debtor for the purpose of paying the
obligation owed to [an existing] creditor, the funds are said to be
‘earmarked’ and the payment is held not to be a voidable
7
Indeed, none of the facts cited by Lucent undermine the
Bankruptcy Court’s finding that the parties were not engaged in
arm’s length dealings. For example, as to the Siemens loan, the
Bankruptcy Court found that “Lucent deliberately held up the
refinancing notice [permitted under the Second Credit Agreement]
to ensure that the Siemans [sic] refinancing occurred and new
equity was infused into the dying Winstar” for Lucent’s benefit.
348 B.R. at 284. Similarly, the Bankruptcy Court found that
Lucent never “developed the core competencies needed for it to
assume the buildout” of Winstar’s network, id. at 259–suggesting
that Lucent simply could not supply the equipment contemplated
by the Supply Agreement. Finally, Lucent pushed back against the
pass-through transaction structure under the Subcontract in
September 2000, and used those objections to force Winstar into
approximately $200 million worth of end-of-quarter transactions
that largely involved unneeded equipment.
22
preference.” Id.
The following are requirements for the earmarking
doctrine: “(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
according to its terms, and (3) the transaction viewed as a whole
. . . does not result in any diminution of the [debtor’s] estate.”
Id. at 566. We review the Bankruptcy Court’s findings for clear
error and its legal conclusions de novo. Cf. In re Cellnet Data
Sys., 327 F.3d at 244.
Although the Bankruptcy Court ultimately reached the
merits of Lucent’s earmarking defense, it held in the alternative
that Lucent waived earmarking because Lucent (1) stipulated
that 11 U.S.C. § 547(b)(1) was satisfied and (2) failed to plead
earmarking as an affirmative defense. 348 B.R. at 272-73. We
agree with Lucent that these conclusions were erroneous. As to
the stipulation, the statutory language underlying earmarking
(“an interest of the debtor in property”) is not contained in §
547(b)(1), but rather precedes the enumerated subsections of §
547(b). Therefore, Lucent’s stipulation did not cover
earmarking.
As to the affirmative defense conclusion, as the Ninth
Circuit has held, “the earmarking doctrine is not an affirmative
defense under [Fed. R. Civ. P.] 8, but rather a challenge to the
trustee’s claim that particular funds are part of the bankruptcy
estate.” Metcalf v. Golden (In re Adbox, Inc.), 488 F.3d 836,
842 (9th Cir. 2007). Because the trustee has the burden of
proving the avoidability of a transfer under subsection (b) of this
section, “the trustee has the burden of establishing [under §
547(b)] that property is part of the bankruptcy estate.” In re
Adbox, 488 F.3d at 842; see 11 U.S.C. § 547(g). Where, as
here, “the trustee establishes that the transfer of the disputed
funds was from one of the debtor's accounts over which the
debtor ordinarily exercised total control . . . the trustee makes a
preliminary showing of an avoidable transfer ‘of an interest of
the debtor’ under § 547(b). The burden then shifts to the
defendant in the preference action to show that the funds were
23
earmarked.” Id.
Turning to the merits, the Bankruptcy Court held that
earmarking was inapplicable because there was no agreement
between Winstar and Siemens that the proceeds of the Siemens
loan would be used to repay Lucent. 348 B.R. at 273. Lucent
argues that the Bankruptcy Court was “clearly wrong” in finding
no agreement between Siemens and Winstar because the Second
Credit Agreement required Winstar to use the proceeds of any
additional debt incurred under the Bank Facility to pay down its
debt to Lucent, and the Bank Facility listed the “fail[ure] to pay
any Indebtedness . . . in an amount of $25.0 million or more
when due” as an event of default. App. at 1997. Thus, Lucent
concludes that the bank agreement “required Winstar to use the
Siemens loan proceeds to pay Lucent,” Appellant’s Br. at 51,
and Siemens was aware of this requirement because Winstar sent
a memorandum to all lenders under the Bank Facility (including
Siemens) notifying them that Winstar intended to utilize “up to
$200 million of proceeds from the Additional Capital,” which
included the Siemens loan, “to repay outstandings under the
credit agreement with Lucent,” App. at 2052.
Notwithstanding the vigor with which Lucent presents its
earmarking contention, it has not shown that the Bankruptcy
Court’s finding that there was no agreement between Siemens
and Winstar was clearly erroneous. Siemens’ corporate
representative testified that “Winstar could use that [loan] for
whatever its corporate purposes were,” App. at 2849, and
language in the amendment to the Bank Facility which added
Siemens to that lending group also provided that the loan was
“for general corporate purposes,” App. at 2056. Cf. Reigle v.
Mahajan (In re Kumar Bavishi & Assocs.), 906 F.2d 942, 944
(3d Cir. 1990) (rejecting earmarking where “record does not
reflect the existence of an agreement [between the new creditor
and debtor] that the funds be used to pay a specified antecedent
debt”); In re AmeriServe Food Distrib., Inc., 315 B.R. 24, 30-31
(Bankr. D. Del. 2004) (finding no agreement and thus no
earmarking where new creditor provided loan “for general
corporate purposes”).
24
Moreover, Winstar’s memorandum to the Bank Facility
lenders did not clearly indicate that Winstar intended to use the
Siemens loan specifically to repay Lucent. That document stated
that Winstar would use “Additional Capital” to repay Lucent and
defined “Additional Capital” to include significant funds other
than the Siemens loan (such as $270 million in a private equity
investment and $500 million in an equipment leasing facility).
Most importantly, even if Siemens knew that Winstar would use
the loan to repay Lucent, there is no evidence to demonstrate that
Siemens required Winstar to do so. Indeed, as noted above, the
clear language of the Siemens loan documents did not require
Winstar to use the loan to repay its antecedent debt to Lucent.
Cf. Cadle Co. v. Mangan (In re Flanagan), 503 F.3d 171, 185
(2d. Cir. 2007) (“[W]e have been . . . clear that where a new
creditor provides funds to the debtor with no specific
requirement as to their use, the funds do become part of the
estate . . . . This result does not change even where the new
creditor knows, but does not require, that the new loan funds will
be used to pay off a preexisting debt.”) (internal citations
omitted).
In sum, Siemens was (at most) aware that the Second
Credit Agreement between Lucent and Winstar required Winstar
to pay the proceeds of the Siemens loan to Lucent and that
Winstar intended to do so. Although Lucent is correct that a
failure to do so would have ultimately led to an event of default
under the Bank Facility, that merely implies that the Bank
Facility lenders (including Siemens) could have brought breach
of contract claims against Winstar–not that Siemens conditioned
its loan on Winstar’s payment to Lucent. Thus, the Bankruptcy
Court properly held that earmarking was inapplicable.
Apparently recognizing that its earmarking contention
may not defeat the Trustee’s $188.2 million claim in its entirety,
Lucent next argues that it is entitled to a $90.7 million new value
defense. Under the Bankruptcy Code, a trustee may not avoid a
transfer
to or for the benefit of a creditor, to the extent that, after
such transfer, such creditor gave new value to or for the
25
benefit of the debtor--(A) not secured by an otherwise
unavoidable security interest; and (B) on account of
which new value the debtor did not make an otherwise
unavoidable transfer to or for the benefit of such creditor.
11 U.S.C. § 547(c)(4). New value includes “money or money's
worth in goods, services, or new credit.” 11 U.S.C. § 547(a)(2).
Lucent bears the burden of proving its new value defense. 11
U.S.C. § 547(g).
This court has held that § 547(c)(4) imposes three
requirements: (1) “the creditor must have received a transfer that
is otherwise voidable as a preference under § 547(b);” (2) “after
receiving the preferential transfer, the preferred creditor must
advance ‘new value’ to the debtor on an unsecured basis;” and
(3) “the debtor must not have fully compensated the creditor for
the ‘new value’ as of the date that it filed its bankruptcy
petition.” New York City Shoes, Inc. v. Bentley Int’l, Inc. (In re
New York City Shoes, Inc.), 880 F.2d 679, 680 (3d Cir. 1989)
(emphasis in original). As explained by one treatise, “[a]lthough
there is no requirement that the [new value] be extended as a
result of the previously received preference, the rationale of this
section treats the [new value] as if it were, in effect, a return of
the preference, restoring the previous depletion of the estate.” 4
William J. Norton Jr., Norton Bankruptcy Law and Practice §
66:36 (3d ed. 2008). We defer to the Bankruptcy Court’s factual
findings regarding Lucent’s new value defense unless they were
clearly erroneous. In re New York City Shoes, 880 F.2d at 682.
Lucent contends that it “provided Winstar with $90.7
million of unsecured new value after December 7, 2000 [the date
of the Siemens transaction], in the form of: (1) $28.4 million in
equipment and related services for which Winstar never paid;
and (2) a $62.3 million loan that Winstar drew from Lucent
under the Second Credit Agreement on December 29, 2000, and
did not repay.” Appellant’s Br. at 55. The Bankruptcy Court
rejected Lucent’s new value defense because Lucent provided
any such new value “on a secured basis, as is evidenced by the
Security Agreements dated May 9, 2000, and December 22,
2000, and as admitted by Lucent in its . . . secured proof of claim
26
and the escrow fund stipulations.” 348 B.R. at 283 (internal
citations omitted). Indeed, the Trustee and Lucent entered into
stipulations “which recognize the validity of Lucent’s security
interests and provide for distribution to Lucent of the proceeds
of the sale of Winstar assets that were subject to Lucent’s lien.”
Id. Moreover, the Bankruptcy Court found that “Lucent . . .
failed to show that [the new value] was provided after the receipt
by Lucent of the preferential transfer.” Id. (emphasis in
original).
We agree with Lucent that it has demonstrated that the
equipment and services underlying the $28.4 million were
delivered after the date of the Siemens transaction (December 7,
2000). Lucent employee Vernon Terrell testified that this
equipment was shipped between December 8, 2000, and April
18, 2001, App. at 2662-63, and invoices for the equipment at
issue show that the “ship date” for all of the equipment was
December 8, 2000, or later. Indeed, the Trustee does not even
address this issue in her brief and appears to concede the point.
Thus, the Bankruptcy Court’s contrary finding was clearly
erroneous.
On the other hand, the Bankruptcy Court found that this
new value was secured, a finding Lucent contends was
erroneous. Of course, if the equipment was the subject of a prior
security interest possessed by Lucent, it could not be part of new
value purportedly provided by Lucent. As noted above, it was
Lucent’s burden to prove its new value defense, and we
conclude that it has failed to satisfy its burden of proof to show
that the $28.4 million was unsecured. When Lucent filed its
secured claim, it listed certain equipment that was covered by the
security agreements dated May 9, 2000 and December 22, 2000
that was owned by Winstar’s subsidiaries WVF-1 and WVF-
LU2. In fact, the record shows that Lucent included almost all
of the equipment claimed as new value as part of its secured
claim against Winstar. Compare App. 1216-17 (invoice
numbers for equipment underlying secured claims) with App.
2210-2332 (invoices underlying $28.4 million in alleged new
value). Moreover, the Trustee and Lucent entered into three
related settlements that recognize the validity of Lucent’s
27
security interests for purposes of the bankruptcy proceedings and
expressly provide that “all of Lucent’s secured claims against the
Debtors’ estates [i.e. Winstar and its subsidiaries] have been
resolved” in exchange for approximately $21 million. App. at
1412. That is, for purposes of these bankruptcy proceedings, the
combined effect of Lucent’s security agreements, proof of claim
and the parties’ stipulations is that Lucent failed to show that the
equipment underlying its $28.4 million new value defense was
unsecured. Cf. Norton Bankruptcy Law and Practice at § 66:36
(noting that § 547(c)(4) “requires a . . . determination of whether
the security interest is valid in bankruptcy. If it is not, the
creditor will lose the benefit of the security interest, but will be
able to use the entire [new value] to protect a prior preference.”).
Thus, we cannot conclude that the Bankruptcy Court clearly
erred in concluding that Lucent provided the $28.4 million in
alleged new value on a secured basis. Consequently, Lucent
cannot claim a new value defense as to the $28.4 million in
equipment and related services.
Lucent also failed to meet its burden of proof with respect
to its new value defense as to the payment on December 29,
2000 of $62.3 million. This payment was part of a “pass-
through” transaction between Winstar, Lucent, and Wireless that
involved three steps: (1) Winstar borrowed funds from Lucent
under the Second Credit Agreement (2) in order to pay Lucent
for services under the Supply Agreement, (3) which in turn paid
Wireless for its services pursuant to a subcontract between
Lucent and Wireless. As to the first step in the transaction,
Lucent has failed to show that this loan was unsecured. Indeed,
Lucent had a security interest in the equipment and services
financed pursuant to the $62.3 million loan payment under the
Second Credit Agreement and related security agreements, and
does not appear to argue otherwise.
Instead, Lucent contends that, even if the $62.3 million
alleged new value was subject to a security interest, Lucent was
undersecured at the time it provided such new value. Thus,
Lucent argues that it is entitled to a setoff to the extent that any
new value exceeds the value of its security interests.
28
Although the authorities disagree as to whether an
undersecured creditor is entitled to a new value defense,8 we
need not decide the issue because Lucent has failed to
demonstrate that it was undersecured at the time of the $62.3
million loan at issue. Indeed, Lucent’s evidence before the
Bankruptcy Court suggested that Winstar was solvent at and
about the time of the alleged new value transfer, and therefore
Lucent could not have been undersecured at that time. Although
the Bankruptcy Court rejected that evidence and found that
Winstar was insolvent (a finding not at issue on appeal), the
Trustee notes that the Bankruptcy Court’s findings suggest that
Winstar had assets of approximately $3 billion in December
2000. 348 B.R. at 277-78. Moreover, Lucent’s reliance on the
value of the assets underlying its secured claim at the time that
Winstar liquidated its holdings is unpersuasive because a
liquidation sales price does not represent the value of the assets
at the time Lucent provided the alleged new value.
As to the second step of the transaction, the payment
flowed from Winstar to Lucent for services under the Supply
Agreement, not from Lucent.
Finally, as to the third step of the transaction, Lucent’s
payment to Wireless was simply a payment on an antecedent
debt for services provided by Wireless to Lucent. New value in
services is deemed to be provided when the services are
performed. See In re U.S. Interactive, Inc., 321 B.R. 388, 394
(Bankr. D. Del. 2005) (“Value is deemed given on the date the
services are performed.”). Here, Lucent failed to offer any
8
Compare Collier on Bankruptcy at § 547.04[4] n.46 (“If
the creditor extending the credit is partially secured by a valid
security interest, then the exception only applies to the extent that
the creditor's collateral is less than the total claim against the debtor
resulting from the extension of credit.”), with Norton Bankruptcy
Law and Practice at § 66:36 (“[T]he emerging view is that [the]
plain meaning of the statute does not distinguish between fully and
partially secured advances and that § 547(c)(4)(A) simply
disqualifies any new value that is secured.”) (quotations omitted).
29
evidence to demonstrate that these services were provided after
December 7, 2000 (the preference date), and therefore Lucent
failed to satisfy its burden of proof as to its new value defense on
this basis as well.
In sum, we conclude that the Bankruptcy Court properly
denied Lucent its new value defense under § 547(c)(4) because
Lucent failed to carry its burden of proof as to both components
of its new value theory. We therefore will affirm the Bankruptcy
Court’s decision, approved by the District Court, that the Trustee
may recover the $188.2 million paid to Lucent.
B. The Contract Claim
We turn next to the Trustee’s claim that Lucent breached
its subcontract with Wireless, a claim that the Bankruptcy Court
accepted and for which it awarded the Trustee more than $62
million. Before we discuss this claim, we must first consider
Lucent’s challenge to the Bankruptcy Court’s jurisdiction to
enter final judgment on this claim.
A bankruptcy court may enter final judgments only to
“core proceedings” absent consent of the parties. 28 U.S.C. §
157(b)-(c). This court has adopted a two step process to
determine whether a claim is a core proceeding. See Halper v.
Halper, 164 F.3d 830, 836 (3d Cir. 1999). First, “a court must
consult § 157(b)” to determine if the claim at issue fits within
that provision’s “illustrative list of proceedings that may be
considered ‘core.’” Id. If so, “a proceeding is core [1] if it
invokes a substantive right provided by title 11 or [2] if it is a
proceeding, that by its nature, could arise only in the context of a
bankruptcy case.” Id. (quotation omitted).
Even if a claim is not a core proceeding, a bankruptcy
court may still have jurisdiction over the claim if the claim is
“related to a case under title 11,” i.e. the Bankruptcy Code. 28
U.S.C. § 157(c)(1). However, the bankruptcy court (absent
consent of the parties not present here) may only submit
“proposed findings of fact and conclusions of law” that are
subject to de novo review by the district court. 28 U.S.C. §
30
157(c)(1). We have held that a claim falls within the bankruptcy
court’s “related to” jurisdiction if “the outcome of that
proceeding could conceivably have any effect on the estate being
administered in bankruptcy.” Halper, 164 F.3d at 837 (quotation
omitted).
The Bankruptcy Court held that the Trustee’s breach of
contract claim was “core” because that claim had a “direct
bearing upon whether Lucent may recover under its Proof of
Claim and if so, in what amount.” 348 B.R. at 247. See 28
U.S.C. § 157(b)(2) (“Core proceedings include . . . allowance or
disallowance of claims against the estate . . . .”).9 Lucent
contends that, under N. Pipeline Constr. Co. v. Marathon Pipe
Line Co., 458 U.S. 50 (1982), “it would violate Article III to
permit an Article I bankruptcy court to enter final judgment . . .
in a contract action by the estate that arises solely under state law
and implicates no federal statutory or regulatory regime.”
Appellant’s Br. at 74.
We need not adopt the conclusion of the Bankruptcy
Court that the Trustee’s breach of contract claim is a core
proceeding because in our view that claim was within the
Bankruptcy Court’s jurisdiction as “related to” the Trustee’s case
under Title 11. Lucent filed proofs of claim against Winstar and
its subsidiaries. Moreover, as noted by the Bankruptcy Court,
Lucent’s proofs of claim “described the documents which
support its claims as the Supply Agreement, any amendments
thereto and any and all related documents, agreements and
statements of work. The Subcontract is certainly an agreement
related to the Supply Agreement; it is the means by which
9
The Bankruptcy Court also held that Lucent, by its
conduct, consented to the issuance of a final order by the
Bankruptcy Court on the breach of contract claim. However,
Lucent persuasively distinguishes the authority on which the
Bankruptcy Court relied for that alternative holding because, unlike
the cases cited by the Bankruptcy Court, Lucent objected in its
Answer to the issuance of a final order on the breach of contract
claim.
31
Lucent was to fulfill its obligation to perform the network
buildout.” 348 B.R. at 247. (quotations omitted). That is, in
order to determine whether Lucent is entitled to recover on its
proofs of claim, and if so, in what amount, the Bankruptcy Court
had to determine whether Lucent breached its obligations under
the Subcontract. Any amount that Lucent was entitled to recover
against Winstar would, in essence, be offset by any amount that
Lucent failed to pay under the Subcontract.10 Thus, the Trustee’s
breach of contract claim falls within § 157(c)(1) because
resolution of that claim “could conceivably have [an] effect on
the estate being administered in bankruptcy.” Halper, 164 F.3d
at 837. Although the Bankruptcy Court could not enter a final
judgment on the claim if supported only by its “related to”
jurisdiction, the Bankruptcy Court expressly stated that “to the
extent that . . . this Court may only enter proposed findings and
rulings . . . the following constitutes the Court’s proposed
findings and rulings.” 348 B.R. at 243. Thereafter, the District
Court upheld the Bankruptcy Court’s resolution of the Trustee’s
breach of contract claim after “reviewing the decision of the
Bankruptcy Court under a plenary standard of review.” 2007
WL 1232185, at *6 (emphasis added). Thus, even assuming that
the Bankruptcy Court could not enter a final judgment as to the
breach of contract claim, the lower courts complied with the
necessary procedures for cases based on a bankruptcy court’s
“related to” jurisdiction. See 28 U.S.C. § 157(c)(1).11
10
We also note that Lucent’s course of conduct under the
Subcontract (e.g. its repeated threats to refuse payment in order to
coerce Winstar’s purchase of unneeded equipment) was also
relevant to the hierarchical ordering of creditors because it helped
form the basis for the Bankruptcy Court’s conclusions that Lucent
was an insider and consequently that the Trustee was entitled to
recover on her preference claim and that equitable subordination
was appropriate.
11
Lucent points to one sentence in the Bankruptcy Court’s
opinion where it stated that “the Bankruptcy Court’s factual
findings and conclusions of law . . . are . . . not clearly erroneous.”
2007 WL 1232185, at *7. A review of the District Court’s opinion
and its express statement that it applied “a plenary standard of
32
Finally, Lucent contends that it is entitled to a jury trial on
the Trustee’s breach of contract claim under the Seventh
Amendment. However, the Supreme Court has held that when a
creditor files a proof of claim, the creditor brings itself “within
the equitable jurisdiction of the Bankruptcy Court” such that the
creditor is “not entitled to a jury trial on [a] trustee’s preference
action”–even though, absent the filing of the proof of claim, a
creditor is entitled to a jury trial on such a claim–because “the
creditor’s claim and the ensuing preference action by the trustee
become integral to the restructuring of the debtor-creditor
relationship through the bankruptcy court’s equity jurisdiction.”
Langenkamp v. Culp, 498 U.S. 42, 44-45 (1990) (per curiam).
See also Granfinanciera, S.A. v. Nordberg, 492 U.S. 33, 59 n.14
(1989) (“[B]y submitting a claim against the bankruptcy estate,
creditors subject themselves to the court’s equitable power to
disallow those claims, even though the debtor’s opposing
counterclaims are legal in nature and the Seventh Amendment
would have entitled creditors to a jury trial had they not tendered
claims against the estate.”); Billing v. Ravin, Greenberg &
Zachin, P.A., 22 F.3d 1242, 1250 (3d Cir. 1994) (“It is clear that
a creditor who submits a proof of claim against the bankruptcy
estate has no right to a jury trial on issues raised in defense of
such a claim.”); Travellers Int’l AG v. Robinson, 982 F.2d 96,
98 (3d Cir. 1992) (“Travellers is neither entitled to a jury trial
nor is it entitled, in the alternative, to be heard by an Article III
judge. Rather, by submitting a proof of claim to the debtor’s
estate, Travellers effectively waived its right to a jury trial and
submitted itself to the equitable jurisdiction of the bankruptcy
court.”). Similarly, Lucent filed a proof of claim against
Winstar’s estate and therefore was not constitutionally entitled to
a jury trial on the Trustee’s related breach of contract claim.12
review” is ample basis for us to reject Lucent’s argument.
12
We also note that the fact that Winstar filed its breach of
contract claim before Lucent filed its proof of claim does not affect
the jury trial analysis. See Travellers Int’l AG, 982 F.2d at 100 n.4
(“To the extent that Travellers attempts to distinguish Langenkamp
by arguing that the Supreme Court case refers only to those
preference actions in which (as in Langenkamp) a claim is filed
33
We therefore turn to the merits of the Trustee’s contract claim.
Shortly after Lucent and Winstar entered into the two
original agreements (the First Credit Agreement and the Supply
Agreement) Lucent and Winstar entered into a subcontract by
which Wireless “agree[d] to perform for Lucent the tasks,
responsibilities and services described on the attached task
specific schedule(s) (individually a “Task Order”).” 348 B.R. at
256. Thus, the Subcontract contemplated that Lucent would
provide a Task Order to Wireless before Wireless performed the
contemplated services.
However, the Bankruptcy Court found–and the parties do
not dispute–that at most one Task Order was issued from Lucent
to Wireless, and none after the first quarter of 1999.
Nonetheless, despite a contract provision barring modification of
the Subcontract unless in writing and signed by the parties,
“between January 1999 and October 2000, Lucent paid Wireless
approximately $325 million for services performed under the
Subcontract, most, if not all, without a prior written task order.”
Id. at 257. Instead, “the parties quickly dispensed with the task
order process, opting instead to exchange less formal
documentation,” in which Wireless would perform network
construction services first and only subsequently would any
paperwork be exchanged among the parties. Id.
The Bankruptcy Court credited former Winstar Chief
Financial Officer Richard Uhl’s explanation for this less formal
process. Uhl stated: “Early on it was discovered that Lucent was
unable or not capable of defining what should go into the
purchase order. So the practice evolved . . . that inasmuch as
Lucent could not produce the details of the purchase order,
Winstar Wireless would as its subcontractor to Lucent issue an
invoice [for services already performed,] which Lucent would
then cover with a purchase order and that was the sequence.” Id.
before the preference action was brought, its position is
unsupportable. No court has made such a distinction, nor do we
find such a distinction persuasive.”).
34
at 257-58.
As early as June 1999, Lucent became unhappy with this
“pass-through” arrangement in that it “could not recognize
revenue on the pass-through transaction because it did not have
sufficient control over the services being performed by Winstar’s
[technically Wireless’s] employees to allow revenue recognition
under the accounting rules.” 348 B.R. at 258. Additionally,
Lucent was “concerned that financing any additional services [as
opposed to equipment] would hamper its ability to sell Winstar’s
loans,” which Lucent attempted to do in 1999 and 2000. Id.
Thus, in June 1999, Lucent “informed Winstar that it would not
pass through any additional services” even though “Lucent was
still unwilling or unable to build the turnkey operation.” Id.
However, after high level discussions between the
companies’ executives, “ultimately Lucent agreed to continue
the [pass-through] arrangement.” Id. As found by the
Bankruptcy Court, Lucent “agreed to finance Wireless-
performed services and facilitate the favorable accounting
treatment that Winstar desired . . . as an accommodation to
Winstar.” Id.
In September 2000, Lucent again threatened to refuse to
pay for approximately $65 million in services provided by
Wireless without the prior issuance of a Task Order. Lucent
informed Winstar that “we believe it is not appropriate for
Lucent to accept Purchase Orders for these services” in light of
the Supply Agreement’s target for provision of services by
Lucent. 348 B.R. at 259. Lucent called for negotiations to
complete a transition agreement that would turn over
responsibility for these services from Wireless to Lucent. The
Bankruptcy Court, however, found that Lucent “had still not
developed the core competencies needed for it to assume the
buildout by itself” and therefore Lucent’s request for
negotiations “was nothing more than an attempt to create a
pretext for denying further draws under the Second Credit
Agreement so that Lucent could renegotiate the terms of the
‘strategic partnership’ for its benefit.” Id.
Winstar objected to Lucent’s refusal to pay and
35
threatened not to complete the Software Pool transaction
described above. Lucent then agreed to pay for the contested
services, but required Winstar to agree to “lock-up” negotiations
regarding a transition agreement. Moreover, Lucent demanded
in a letter dated September 27, 2000, that Winstar and Wireless
would perform work on the network “only upon prior receipt of
a mutually acceptable written purchase order from Lucent (and
not at [Winstar’s] sole initiative)” or else “Lucent would not be
able to accept purchase orders or invoices for any Winstar
performed services.” 348 B.R. at 262. The Bankruptcy Court
credited the testimony of two Winstar executives. The executive
who signed and returned the letter testified that, although
Winstar assented to Lucent’s letter, he “did not understand this
letter to terminate the original agreement in the event the parties
were unable to enter into a new agreement” and the other
testified that he believed that Lucent was demanding the letter
“because they needed to book revenue.” Id.
In December 2000, Winstar again billed Lucent for
services provided by Wireless without a prior Task Order. That
is, Winstar sought another “pass-through” transaction by
simultaneously requesting to draw approximately $62 million
under the Second Credit Agreement and billing Lucent for the
Wireless services. Initially, Lucent internally questioned
whether payment was appropriate, but concluded that “Winstar
can draw down upon the credit facility” and Lucent “really had
not the option of denying their rights here.” 348 B.R. at 268.
Finally, in March 2001, Winstar again simultaneously
requested to draw approximately $62 million under the Second
Credit Agreement and billed Lucent for services provided by
Wireless in the preceding quarter. Lucent refused to pay because
no Task Order authorized the work, and the Trustee seeks
damages of approximately $62 million for this alleged breach of
contract.
Lucent contends it had no obligation to pay the amount
requested because no Task Order had been submitted, as
required by the Subcontract. The Bankruptcy Court held that the
course of conduct between Lucent, Winstar, and Wireless
36
amounted to a modification of the Subcontract. The parties
agree that New York state law controls the Trustee’s claim for
breach of the Subcontract. The question of whether a contract
has been modified is one of fact and therefore subject to review
only for clear error.13 See Carnes Co. v. Stone Creek Mech.,
Inc., 412 F.3d 845, 852 (7th Cir. 2005) (“Whether a contract has
been modified is a question of fact subject to the clearly
erroneous standard of review.”).
“Fundamental to the establishment of a contract
modification is proof of each element requisite to the
formulation of a contract, including mutual assent to its terms.”
Beacon Terminal Corp. v. Chemprene, Inc., 429 N.Y.S.2d 715,
718 (N.Y. App. Div. 1980). Where, as here, the alleged
modification arises from the parties’ course of performance, the
“conduct of a party may manifest assent if the party intends to
engage in such conduct and knows that such conduct gives rise
to an inference of assent. Thus, a promise may be implied when
a court may justifiably infer that the promise would have been
explicitly made, had attention been drawn to it.” Maas v.
Cornell Univ., 721 N.E.2d 966, 970 (N.Y. 1999) (citations
omitted).
Lucent argues that the Bankruptcy Court’s findings were
insufficient to demonstrate that Lucent assented to modification
of the Subcontract. According to Lucent, “the fact that Lucent
decided to perform in a given quarter without insisting on Task
Orders by no means demonstrates that it agreed to the permanent
removal of that condition as to all future quarters.” Appellant’s
Br. at 65-66 (emphasis in original). Lucent also notes that the
Subcontract provided that the “waiver of [a] . . . breach shall
13
We note that if the Bankruptcy Court had jurisdiction over
this matter only as a “related to” proceeding, “we [must] treat the
district court as the trial court, accepting its findings of fact unless
clearly erroneous.” Copelin v. Spirco, Inc., 182 F.3d 174, 180 (3d
Cir. 1999). Here, the District Court adopted the Bankruptcy
Court’s findings regarding the Trustee’s breach of contract claim,
and our review, therefore, is for clear error.
37
[not] constitute a waiver . . . with respect to any subsequent other
. . . breach.” App. at 1558. In sum, Lucent contends that the
Trustee failed to satisfy its burden to prove that Lucent assented
to any modification of the Subcontract. Instead, Lucent
contends that it simply unilaterally waived the Task Order
requirement on a quarter by quarter basis. See Nassau Trust Co.
v. Montrose Concrete Prods. Corp., 436 N.E.2d 1265, 1269
(N.Y. 1982) (noting the distinction “between an oral agreement
that purports to modify the terms of a prior written agreement
and an oral waiver by one party to a written agreement of a right
to require of the other party certain performance in compliance
with that agreement”). Moreover, Lucent argues that it validly
withdrew that waiver by letter dated September 27, 2000, which
provided that “Winstar would perform . . . work only upon prior
receipt of a mutually acceptable written purchase order from
Lucent (and not at its sole initiative).” App. at 952.
The record evidence is inconsistent with Lucent’s waiver
argument. The Bankruptcy Court noted that, “beginning as early
as the communications surrounding the invoice for the second
quarter of 1999 [i.e. the second quarter of dealings under the
Subcontract], Lucent warned Winstar that it would pay for
Wireless’ services ‘one last time’ without a task order,” but the
Bankruptcy Court concluded that “there were too many ‘one last
times’ for that warning to be effective.” 348 B.R. at 269.
Moreover, Lucent’s September 27, 2000, letter sought Winstar’s
assent to, inter alia, a requirement that Lucent would not pay for
Wireless services without a prior task or purchase order from
Lucent. If Lucent had simply waived the Task Order
requirement to that point, Winstar’s assent to the letter would
have been unnecessary.
Finally, Lucent provided funds under a December 28,
2000, draw request under the Second Credit Agreement to which
Winstar attached an invoice for Wireless services already
rendered in the quarter ending December 31, 2000–the very
same structure as the March 2001 transaction that Lucent refused
to pay and that gave rise to this claim. In sum, we agree with the
Bankruptcy Court’s conclusion that “it is not credible that almost
two years after the pattern had been established that Lucent
38
would insist upon compliance with the letter of the Subcontract,
particularly when Lucent [had] used this tactic in the past to try
to pressure Winstar.” Id. at 270.
In addition to its contention that it did not breach the
Subcontract in March 2001 because no Task Order authorized
the services for which Wireless was attempting to collect, Lucent
contends that any purported modification created by the parties’
course of conduct was ineffective because the Subcontract
required any modification to be in writing.14 Once again, we
agree with the Bankruptcy Court’s rejection of Lucent’s
contention that the modification of the Subcontract’s
requirement of a preceding Task Order was ineffective in light
of the Subcontract’s provision barring non-written
modifications. New York law provides that any contract may be
modified by a course of performance, even if that contract
otherwise requires modifications to be in writing. See Rosen
Trust v. Rosen, 386 N.Y.S.2d 491, 499 (N.Y. App. Div. 1976)
(“[A]ny written agreement, even one which provides that it
cannot be modified except by a writing signed by the parties, can
be effectively modified by a course of actual performance.”).
Lucent contends that the non-written modification can only be
effective if one of the exceptions to N.Y. Gen. Oblig. Law § 15-
301 enunciated in Rose v. Spa Realty Asscs. is satisfied. See
366 N.E.2d 1279, 1281 (N.Y. 1977) (“Partial performance of an
oral agreement to modify a written contract, if unequivocally
referable to the modification, avoids the statutory requirement of
a writing. Moreover, when a party’s conduct induces another’s
significant and substantial reliance on the agreement to modify,
albeit oral, that party may be estopped from disputing the
modification notwithstanding the statute.”). Assuming that Rose
applies to modifications based on the parties’ course of
14
Lucent relies on a New York statute that provides, “[a]
written agreement . . . which contains a provision to the effect that
it cannot be changed orally, cannot be changed by an executory
agreement unless such executory agreement is in writing and
signed by the party against whom enforcement of the change is
sought or by his agent.” N.Y. Gen. Oblig. Law § 15-301(1).
39
performance, we believe that the parties’ performance under the
Subcontract was unequivocally referable to the modification at
issue. Wireless’ performance of Subcontract services without a
prior Task Order, and Lucent’s payment thereof, were
incompatible with the express terms of the Subcontract.
Moreover, we agree with the Bankruptcy Court that “[b]ased
upon Lucent’s past practices, neither Wireless nor Winstar was
unreasonable in relying upon Lucent’s practice of funding and
paying for services upon presentation of an invoice . . . and
neither was unreasonable in expecting this practice to continue.”
348 B.R. at 270.
We conclude, as did the Bankruptcy Court, that the
Subcontract was indeed modified by the parties’ course of
performance. The record shows that only one Task Order was
ever issued by Lucent and that the parties thereafter dispensed
with the Task Order requirement for nearly two years, during
which time Lucent paid Wireless approximately $325 million for
services under the Subcontract. Winstar’s then-President and
Chief Operating Officer testified that he understood that the
Task Order requirement had been replaced by an exchange of
invoices and purchase orders after Wireless performed work.
Winstar’s then-Chief Financial Officer also testified that this
more informal exchange of documents after Wireless completed
work under the Subcontract was necessary because “[e]arly on it
was discovered that Lucent was unable or not capable of
defining what should go into the purchase order.” 348 B.R. at
257. Similarly, a Lucent executive testified that “we clearly
were in a relationship that was commercially binding because
there were purchase orders and invoices between the companies
where we subcontracted with them.” 15 Id. at 269. Together, this
15
The Bankruptcy Court also cited internal Lucent
documents that it interpreted as implying that Lucent executives
believed that Lucent was obligated to pay for Wireless services
under the Subcontract without a prior Task Order. However,
Lucent convincingly argues that these documents refer not to
Wireless’ right to payment under the Subcontract, but rather to
Winstar’s right to borrow funds under the Second Credit
40
evidence demonstrates that the Subcontract was modified by the
parties’ course of performance such that no Task Order was
required prior to Wireless’ provision of services under the
Subcontract.
In sum, we hold that the Subcontract was modified in
light of the parties’ course of performance such that the parties
dispensed with the Task Order requirement in favor of an
informal exchange of documents after Wireless performed
services. Moreover, we conclude that this modification was
effective under New York law. Thus, we agree with the lower
courts that Lucent breached the Subcontract when it refused to
pay Wireless’ March 2001 invoice for services rendered under
the Subcontract.
C. Equitable Subordination
Finally, we reach the Bankruptcy Court’s decision, on the
Trustee’s request, to equitably subordinate Lucent’s claims. The
Bankruptcy Code provides that a “court may (1) under principles
of equitable subordination, subordinate for purposes of
distribution all or part of an allowed claim to all or part of
another allowed claim or all or part of an allowed interest to all
or part of another allowed interest; or (2) order that any lien
securing such a subordinated claim be transferred to the estate.”
11 U.S.C. § 510(c). Section 510(c) simply “codified” existing
judge-made doctrine, and development of the substantive
standards for equitable subordination has been left to the courts.
This court has described equitable subordination as a “remedial
rather than penal” doctrine designed “to undo or to offset any
inequality in the claim position of a creditor that will produce
injustice or unfairness to other creditors in terms of the
bankruptcy results.” Citicorp Venture Capital, Ltd.v. Comm. of
Creditors Holding Unsecured Claims, 323 F.3d 228, 233-34 (3d
Cir. 2003) (Citicorp II).
Agreement. The Trustee does not allege that Lucent breached the
Second Credit Agreement.
41
As outlined in the influential case of Benjamin v.
Diamond (In re Mobile Steel Co.), 563 F.2d 692, 699-700 (5th
Cir. 1977), “three conditions must be satisfied before exercise of
the power of equitable subordination is appropriate:” (1) “[t]he
claimant must have engaged in some type of inequitable
conduct;” (2) “[t]he misconduct must have resulted in injury to
the creditors of the bankrupt or conferred an unfair advantage on
the claimant;” and (3) “[e]quitable subordination of the claim
must not be inconsistent with the provisions of the Bankruptcy
[Code].” See also United States v. Noland, 517 U.S. 535, 538-
39 (1996) (favorably citing the In re Mobile Steel analysis);
Citicorp II, 323 F.3d at 233-34 (same). We have previously
stated that a Bankruptcy Court’s findings as to the amount of a
creditor’s claims that should be subordinated under the
principles of equitable subordination are subject to review only
for clear error. Citicorp II, 323 F.3d at 235.
Lucent argues that the Bankruptcy Court erred under all
three of these factors when it subordinated Lucent’s unsecured
claims against the Winstar estate to the claims of all of Winstar’s
creditors, as well as certain equity interest holders, and
transferred Lucent’s secured claim to the Trustee.
Lucent’s claim against the Winstar estate had two parts:
(1) an unsecured claim and (2) a secured claim stipulated to be
worth approximately $21 million. Appellant’s Reply Br. at 43.
The Bankruptcy Court essentially subordinated the first part to
Winstar’s other creditors and transferred the second part to the
Trustee. The Trustee’s counsel advised us at oral argument that
Lucent is unlikely in any case to recover on any of its unsecured
claims against Winstar’s estate. Thus, the parties’ battle is
primarily over the $21 million in stipulated secured claims.
First, Lucent argues that the Bankruptcy Court did not
make sufficient findings of inequitable conduct. The inequitable
conduct underlying equitable subordination may be “unrelated to
the acquisition or assertion of the particular claim whose status
[is] at issue.” In re Mobile Steel, 563 F.2d at 701. “A claim
arising from the dealings between a debtor and an insider is to be
rigorously scrutinized by the courts.” In re Fabricators, Inc., 926
42
F.2d at 1465. Thus, “the trustee bears the burden of presenting
material evidence of unfair conduct . . . [that] the [insider]
claimant then must [rebut by proving] the fairness of his
transactions with the debtor.” Estes v. N & D Props., Inc. (In re
N & D Properties, Inc.), 799 F.2d 726, 731 (11th Cir. 1986). On
the other hand, “[i]f the claimant is not an insider, then evidence
of more egregious conduct such as fraud, spoliation or
overreaching is necessary.” In re Fabricators, Inc., 926 F.2d at
1465.
As we noted earlier in the discussion of Lucent’s insider
status, the Bankruptcy Court viewed Lucent’s conduct to be
“egregious.” 348 B.R. at 284. We have already rejected
Lucent’s contention that it was “merely . . . exercising its
bargained-for contractual rights under the Subcontract and the
Second Credit Agreement” and that it therefore did not engage in
any inequitable conduct. Appellant’s Br. at 81. The Bankruptcy
Court’s findings on equitable subordination constitute “material
evidence of unfair conduct,” In re N & D Props., Inc., 799 F.2d
at 731, such that the Trustee has met her burden on the first
Mobile Steel factor. The Bankruptcy Court found that Lucent
used threats of non-payment under the Subcontract in order to
force Winstar to purchase unneeded equipment from Lucent–all
financed under the Second Credit Agreement, thereby triggering
Lucent’s ability to issue the refinancing notice because these
equipment transactions pushed Winstar over the borrowing
threshold for that notice. The Bankruptcy Court also found that
Lucent deliberately delayed issuing such a refinancing notice (“a
financial death knell”) under the Second Credit Agreement until
after Winstar closed on the Siemens loan (which, of course,
Winstar was obligated to pay to Lucent) as well as a private
equity deal for $270 million. Although Lucent had the right to
issue the refinancing notice “at its sole discretion” after a
triggering event, App. at 1663, Lucent essentially delayed the
refinancing notice to prevent public disclosure of Winstar’s poor
financial health and thereby induce other creditors to provide
funds to Winstar. Cf. Citicorp II, 323 F.3d at 235 (“Although
the pursuit of one’s legal rights may not be grounds for equitable
subordination, protracted and unjustified litigation tactics that
harm the estate by causing it to incur fees may justify
43
subordination.”). See also Collier on Bankruptcy at § 510.05
(stating that, in cases finding equitable subordination
appropriate, many courts look to whether “the claimant’s
conduct may have been the direct or indirect cause for the other
[creditors] having changed their positions”). In sum, we cannot
conclude that the Bankruptcy Court’s finding of inequitable
conduct was clearly erroneous.
Turning to the factor of harm to creditors, “[A] claim or
claims should be subordinated only to the extent necessary to
offset the harm which the bankrupt and its creditors suffered on
account of the inequitable conduct.” In re Mobile Steel, 563
F.2d at 701. However, this court has stated that
quantification [of harm] may not always be feasible and,
where that is the case, it should not redound to the benefit
of the wrongdoer. A bankruptcy court should . . . attempt
to identify the nature and extent of the harm it intends to
compensate in a manner that will permit a judgment to be
made regarding the proportionality of the remedy to the
injury that has been suffered by those who will benefit
from the subordination.
Citicorp Venture Capital, Ltd. v. Comm. of Creditors Holding
Unsecured Claims, 160 F.3d 982, 991 (3d Cir. 1998) (Citicorp
I).
The Bankruptcy Court found that “Lucent’s conduct
resulted in substantial damages to Winstar and ultimately
Winstar’s creditors,” including (1) interest paid to Lucent for
financing Winstar’s purchases of unneeded equipment, (2)
storage costs and insurance associated with these purchases, (3)
Winstar’s purchase of approximately $244 million in Lucent
equipment eventually sold for pennies on the dollar and (4)
Lucent’s intentional withholding of the refinancing notice to
induce the Siemens loan and $270 million in private equity
financing. 348 B.R. at 284. Based on these findings, the
Bankruptcy Court subordinated Lucent’s claim “to the claims of
all creditors, including all unsecured claims . . . and to the
interests of those entities who infused the $270 million of equity
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in Winstar on December 7, 2000.” Id. at 285 (emphasis
removed). Moreover, Lucent’s secured claim was “preserved for
the benefit of the estate and . . . transferred to the Trustee.” Id.
Lucent contends that the Bankruptcy Court erred because
“[n]one of these purported ‘damages’ constitutes the kind of
harm to the estate or to other creditors that could justify
equitable subordination.” Appellant’s Br. at 82. Further, Lucent
notes that the Bankruptcy Court made no finding as to the extent
of the injury arising from the interest, storage, and insurance
payments. Appellant’s Br. at 83. Finally, Lucent contends that
the Bankruptcy Court erred because it “made no attempt to tailor
its remedy” to the alleged harm. Appellant’s Br. at 83.
Lucent’s argument that the Bankruptcy Court failed to
identify harm to the estate or creditors of a type that could justify
equitable subordination is largely a repackaging of its argument
that it did not engage in inequitable conduct. Moreover,
although this court has indicated that a creditor’s claim should
only be subordinated to the extent necessary to remedy the harm
caused by that creditor’s misconduct, we have never required the
bankruptcy estate to quantify specific harms to the estate or other
creditors. Indeed, the key question on appellate review is
whether the bankruptcy court’s findings demonstrate the
“proportionality of the remedy to the injury.” Citicorp I, 160
F.3d at 991.
Here, the Bankruptcy Court’s findings demonstrated
concrete harm to Winstar and its creditors and equity holders.
For example, the Bankruptcy Court found that Lucent’s
inequitable conduct caused substantial damages to Winstar
arising out of the purchase of unneeded equipment. Similarly,
the Bankruptcy Court found that Lucent harmed other Winstar
creditors and equity holders, perhaps most especially Siemens
and the private equity investors who provided Winstar with
hundreds of millions of dollars in December 2000, because
Lucent purposefully delayed issuing its refinancing notice in
order to induce those investments. Finally, the magnitude of
these injuries (e.g. approximately $240 million in unnecessary
purchases plus associated interest, storage and insurance costs;
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the $200 million Siemens loan; and $270 million in private
equity investments) is in at least a rough proportionality with the
value of Lucent’s claims against Winstar’s estate (roughly $900
million). In sum, we cannot conclude that the Bankruptcy Court
clearly erred in finding that Lucent’s inequitable conduct harmed
Winstar’s estate and its creditors.
Finally, Lucent contends that the Bankruptcy Court’s
equitable subordination holding was inconsistent with the
Bankruptcy Code because § 510(c) does not permit the
subordination of debt to equity. We agree. Section 510(c)
provides that a court may equitably subordinate “all or part of an
allowed claim to all or part of another allowed claim or all or
part of an allowed interest to all or part of another allowed
interest.” (emphasis added). The Bankruptcy Code
distinguishes between a “proof of claim,” which may be filed by
a “creditor,” and a “proof of interest,” which may be filed by an
“equity security holder.” 11 U.S.C. § 501(a). See generally In re
Insilco Techs., Inc., 480 F.3d 212, 217-18 (3d Cir. 2007) (noting
that, under the Bankruptcy Code, “the distinction between
creditors (who hold ‘claims’ against the estate) and equity
investors (who hold ‘interests’ in the estate) is important, for
holders of claims receive much more favorable treatment than
holders of interests. Equity investment brings not a right to
payment, but a share of ownership in the debtor's assets-a share
that is subject to all of the debtor's payment obligations.”). Thus,
we read § 510(c) to clearly incorporate the distinction between
claims and interests such that creditors’ claims may not be
equitably subordinated to equity interests. See Collier on
Bankruptcy at § 510.05 (“Under subsection (c)(1), claims may
be subordinated to claims, and interests may be subordinated to
interests, but claims may not be subordinated to interests.”).
Although the Bankruptcy Court did not directly address
this point, the District Court (and the Trustee on appeal) relied
on In re Lifschultz Fast Freight, 132 F.3d 339, 342 (7th Cir.
1997) for the proposition that the “power of equitable
subordination . . . allows a bankruptcy court to relegate even a
secured claim to a lower tier, even to the lowest--the equity tier.”
That statement was dicta; in fact, the power of a bankruptcy
46
court to subordinate debt (claims) to equity (interests) was not at
issue in In re Lifschultz.
In sum, § 510(c)’s language plainly provides that a
creditor’s claim can be subordinated only to the claims of other
creditors, not equity interests. Thus, we will modify the
Bankruptcy Court’s equitable subordination order such that
Lucent’s claims are subordinated only to the claims of other
creditors.
IV.
Conclusion
For the above-stated reasons, we agree with the judgment
of the Bankruptcy Court with respect to the Trustee’s preference
and breach of contract claims, but will modify the judgment with
respect to equitable subordination such that Lucent’s claims are
subordinated only to Winstar’s other creditors and not any equity
interests.
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