A designation of “insider” status can impact a wide range of issues within a bankruptcy proceeding and sometimes change the outcome of the case. For example, the preference clawback period is deemed extended to one year for any payments or other transfers made by a debtor to an insider. In addition, transactions involving insiders are required to be reviewed with heightened scrutiny and can impact plan voting disputes. Therefore, a bankruptcy court's determination regarding insider status is often the subject of appeal. In an important, but arguably narrow, recent decision, the U.S. Supreme Court has opined that the standard of appellate review of a bankruptcy court's finding of nonstatutory insider status is clear error, as opposed to de novo in U.S. Bank v. Village at Lakeridge, 138 S. Ct. 960 (2018).

In 2007, Village at Lakeridge, commenced Chapter 11. At the time of filing, it was wholly owned by MBP Equity Partners and had two creditors—U.S. Bank and MBP, which were owed in excess of $10 million and $2.7 million, respectively. In order to exit bankruptcy, Lakeridge filed a restructuring plan that would have impaired the claims of both, which U.S. Bank not surprisingly voted against. Therefore, Lakeridge sought to “cramdown” the plan over U.S. Bank's objection, but to do so, was required to have at least one impaired class of creditors vote in favor. Importantly, however, for a cramdown plan to succeed, the consenting impaired class cannot consist of insiders. As the owner of Lakeridge, MBP was clearly an insider, so to get around this roadblock, one of its officers, Kathleen Bartlett, sold MBP's claim to Robert Rabkin for $5,000. The transaction was consummated and Rabkin consented to the plan. The problem? Bartlett and Rabkin were reportedly involved in a romantic relationship.

U.S. Bank objected on these grounds and moved to have Rabkin deemed a nonstatutory insider. Using the established U.S. Court of Appeals for the Ninth Circuit test (“whether the transaction was conducted at arm's length, i.e., as though the two parties were strangers”), the Nevada bankruptcy court ruled that Rabkin did not qualify as a nonstatutory insider because it viewed the sale of MBP's claim as an arm's-length transaction. On appeal to the Ninth Circuit, the parties disagreed about the appropriate standard of review—Lakeridge argued for the deferential clear error standard, while U.S. Bank argued for de novo. The Ninth Circuit agreed with Lakeridge, applied the clear error standard, and found none. The Supreme Court granted certiorari, but limited the scope of the appeal to the question of the appropriate appellate standard of review in assessing whether the bankruptcy court correctly decided nonstatutory insider status.

The Bankruptcy Code provides a list of persons constituting an “insider” of the debtor. However, because that list uses the word “includes,” courts around the country have considered whether other individuals or entities can also qualify as “insiders,” using various tests. In the Ninth Circuit, the test is two-pronged: first, whether the relationship between the alleged insider and the debtor is comparably close to the statutory insiders, and second, whether the transaction was at arm's-length.

The U.S. Supreme Court affirmed the Ninth Circuit's application of the clear error standard. It acknowledged that mixed questions of fact or law might be subject to either de novo or clear error review, based on their precise nature. Boiling it down, however, the Supreme Court viewed the question as to whether review of the lower court's decision involved primarily legal or factual issues. Reframing the question as “given all the basic facts found, was Rabkin's purchase of MBP's claim conducted as if the two were strangers to each other,” it stated that such “is about as factual sounding as any mixed question gets.”

The court went on to reason that very little legal analysis would be involved in the resolution of a nonstatutory insider determination based on a finding that it was an arm's-length transaction. It noted that both its own decisions and those of lower courts do not expound on the idea of what an arm's-length transaction is, but rather state the requirement that such a transaction be at arm's-length and then evaluate the specific facts of the case to determine whether the transaction qualifies. Thus, it held that such non-statutory insider determinations based on an application of the arm's-length test, would only be subject to the deferential clear error standard of review on appeal.

Justices Anthony Kennedy and Sonia Sotomayor each wrote concurring opinions. Justice Kennedy emphasized the narrowness of the holding in this case, stating that lower courts were still free to evaluate their tests of whether someone qualified as a non-statutory insider, and that the Court was expressly not opining on the correctness of the Ninth Circuit's test. Justice Sotomayor expounded on this latter point, noting that she was not certain that the Ninth Circuit's test was the correct one. Her concern was that because the Ninth Circuit's test is conjunctive, a finding that a transaction is at arm's-length necessarily defeats a finding that the individual is a nonstatutory insider. This, she thought, did not comport with the idea that if someone is a statutory insider, it is irrelevant whether a transaction is at arm's-length or not. Thus, this test treats nonstatutory insiders differently from insiders without apparent reason.  She proposed two other tests. First, she suggested a test which would examine the similarities between the alleged nonstatutory insider and the statutory list and, if enough are found, then that would qualify them as a non-statutory insider. Second, she suggested a test which would review all the circumstances surrounding the transaction, rather than just whether the transaction was at arm's-length. She concluded by noting that, if at some point in the future the Ninth Circuit's test was found to be incorrect, then a revisit of the appropriate appellate standard of review might be warranted.

Although the Supreme Court's Lakeridge holding is narrow, it is important in that it implies a somewhat deferential attitude toward bankruptcy judges in the consideration of insider status. With that said, however, the court expressly declined to evaluate the correctness of the bankruptcy court's finding of nonstatutory insider status or to opine on the correctness of the test that the Ninth Circuit established to determine whether someone is a nonstatutory insider. Thus, while it sheds a bit more light on the subject, it is by no means the end of what will likely be many more questions arising from this important issue.

Francis J. Lawall, a partner in the Philadelphia office of Pepper Hamilton, concentrates his practice on national bankruptcy matters and workouts, including the representation of major energy and health care companies in bankruptcy proceedings and general litigation throughout the United States. 

Kate A. Mahoney is an associate in the firm's Philadelphia office, where she concentrates her practice on commercial litigation matters.