Determining whether a creditor or interested party to a bankruptcy proceeding is an “insider” is often critical.   In Chapter 11 proceedings, if the Bankruptcy Court determines a creditor to be an insider, then he or she is not entitled to vote in favor of approval of the Chapter 11 Debtor’s proposed plan for reorganization.  On October 31, 2017 the Supreme Court of the United States heard oral arguments on the correct standard of review applied when analyzing a Bankruptcy Court’s determination of whether a creditor is an “insider.”  Some of Justices suggested that determining the correct standard of review on appeal could not be bifurcated from setting out a legal standard for “insider” status.

Section 101(31) of the Bankruptcy Code sets forth a non-exhaustive list of persons or entities considered to be insiders.  These are known as “statutory insiders.”  However, there is also a well-established carve out for persons or entities not listed in Section 101(31) who have a close relationship with the debtor and negotiate transactions at less than an “arm’s-length.”  These are known as “non-statutory insiders.”

In re The Village at Lakeridge, LLC has made its way to the Supreme Court.  Lakeridge is an entity that has only one member – MBP Equity Partners 1, LLC.  And MBP has a five member board.  One of whom is Kathie Bartlett.  Upon filing a Chapter 11 petition for Bankruptcy, Lakeridge had only two creditors – US Bank, holding an $11 million secured claim, and MBP, holding a $2.76 million unsecured claim.  Shortly after filing, MBP’s board sold its unsecured claim to board member Kathie Bartlett’s paramour, Rabkin (otherwise unaffiliated with MBP) for $5,000.

US Bank sought to designate Rabkin as an insider in order to prevent Rabkin from voting on the proposed Chapter 11 plan.  Though the Bankruptcy Court determined that Rabkin himself was not an insider, it concluded that insider status was transferred to him when a statutory insider (MBP) sold or assigned its claim to a non-insider (Rabkin).  This determination was reversed by the Bankruptcy Appellate Panel.  And the Ninth Circuit affirmed the BAP.  In re The Village at Lakeridge, LLC 814 F.3d 993 (9th Cir. 2016).

The Ninth Circuit addressed the correct standard of review.  Whether a person (Rabkin) qualifies as a non-statutory insider, the Ninth Circuit opined, is purely a question of fact, to be reviewed under the clear error standard.  US Bank suggested to the Supreme Court that this should really be a question of law since it is too important a test to leave up to a case-by-case basis. And therefore, it should be a question a law reviewed de novo giving no deference to the Bankruptcy Court.  Of course, changing this standard would further inundate the higher courts with appeals.  If the Supreme Court were to side with US Bank, certainly there would be a shift of power away from Bankruptcy Court and in favor of the appellate courts.

Additionally, the Ninth Circuit opined that whether insider status transfers to a non-insider (Rabkin) upon the sale or assignment of a claim by an insider (MBP) is a question of law.  Lakeridge suggests this should also be a question of fact to be reviewed upon a clear error standard.  If the Supreme Court were to side with Lakeridge, the holding would likely revert back to the Bankruptcy Court’s determination that Rabkin became an insider via the transfer to him of the insider’s claim.  This decision would have massive ramifications on the ability to sell or assign claims during the pendency of the Chapter 11 Bankruptcy proceeding.