SCOTUS Considers Standard of Review on Bankruptcy Insider Claims

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By Diane Davis

The U.S. Supreme Court will hear arguments Oct. 31 on what the correct standard of review for determining a creditor’s insider status in Chapter 11 reorganizations is ( U.S. Bank N.A. v. The Village at Lakeridge, LLC, U.S., No. 15-1509, review granted 3/27/17 ).

“The court frequently uses bankruptcy cases to establish principles of general importance and this is one of those cases,” G. Eric Brunstad Jr., a partner at Dechert LLP, Hartford, Conn., senior research scholar in law at Yale Law School, New Haven, Conn., and adjunct professor of law at New York University School of Law, New York, told Bloomberg Law.

The standard of review determines the amount of deference the appellate court will give to a decision by a lower court.

Although the case is procedural, it is “huge” and “we should pay close attention to it,” Brunstad said, who has argued 10 cases before the Supreme Court.

“The standard of review is something the Justices know and are interested in,” he said.

The question is whether an appellate court will defer to the findings of a bankruptcy court, or substitute its own judgment about whether the lower court correctly applied the law.

‘Insider’ Status Matters

Before a bankruptcy court approves a Chapter 11 reorganization plan, it must determine if any of the persons voting to accept the plan are insiders.

Bankruptcy Code Section 101(31) contains a non-exhaustive list of persons and entities considered insiders. Those on the list are considered “statutory insiders;" those who have a close relationship with the debtor and negotiate transactions at less than arm’s-length are “non-statutory insiders.”

A bankruptcy court can generally confirm a proposed Chapter 11 plan only if each class of creditors has accepted the plan, or isn’t impaired or negatively affected under the plan. A creditor’s claim is impaired if the original debt terms are changed to the creditor’s detriment.

In certain circumstances, however, a plan that impairs the claims or interest of a non-consenting class of creditors can be confirmed. This is known as a “cramdown” plan. Under Bankruptcy Code Section 1129(a)(10), at least one class of claims that is impaired must accept the plan.

Insider votes, however, can’t be used to validate a cramdown.

Standards of Review

Questions of law are always reviewed de novo. Appellate courts give no deference to what the bankruptcy judge has done. They are free to decide completely different, Brunstad said.

Questions of fact, however, are usually reviewed under a clearly erroneous standard, and higher court judges are highly deferential to such determinations, Brunstad said. They are almost impossible to get overturned on appeal, he said.

The problem here is what standard to apply to mixed questions of law and fact, such as whether a creditor is a non-statutory insider.

“Many key concepts in bankruptcy are mixed questions of law and fact,” Brunstad said.

But the U.S. Court of Appeals for the Ninth Circuit, below, in a split decision, held that non-statutory insider status is a pure question of fact reviewed for clear error.

U.S. Bank N.A. argues that because the Bankruptcy Code doesn’t comprehensively define the term “insider,” the determination of non-statutory insider status is a mixed question of law and fact and requires de novo appellate review.

According to the bank, insider status is “too important an issue” to be “subject to disparate rulings and tests that vary according to the predilections of individual bankruptcy court judges.”

Debtor The Village at Lakeridge LLC, however, says the Ninth Circuit applied the correct legal standard because whether a person qualifies as a non-statutory insider is “question of ultimate fact.”

“Clear-error review accommodates ‘the respective institutional advantages of trial and appellate courts,’ … and it best respects judicial economy and scarce resources,” The Village at Lakeridge said in their brief filed with the court.

The Justice Department, which had recommended the court deny review of the case, filed a friend of the court brief supporting The Village at Lakeridge.

Appellate courts have reviewed arm’s-length determinations for clear error both within and without the bankruptcy context, the Justice Department said in their brief. The bankruptcy court properly analyzed whether the transaction was conducted at arm’s length, and the Ninth Circuit reviewed the factual record and applied the correct standard, the Justice Department said.

Second Chances

Determining the correct standard of review may “very well change the outcome of the case,” Matthew Bruckner, associate professor of law at Howard University School of Law, Washington, told Bloomberg Law. Bruckner teaches business and commercial law courses.

U.S. Bank will essentially get an “extra bite at the apple” if the Supreme Court says that de novo review should be applied and reverses the Ninth Circuit, he said.

The court would likely send the case back to the U.S. Bankruptcy Appellate Panel for the Ninth Circuit to apply a de novo review standard, Bruckner said.

The Supreme Court will focus on what “arm’s length” means in a transaction and whether the appropriate standard was used to review the lower court’s decision, or whether the analysis needs to be more “granular,” he said.

If the analysis is more granular, however, “questions like whether arm’s length transactions always include an element of intent are considered,” Bruckner said.

According to U.S. Bank, whether the transaction was at arm’s length is more of an ambiguous question than a strict question of fact.

Who’s an Insider?

The Village at Lakeridge owned and operated a commercial real estate complex in Reno, Nev. It has only one member, MBP Equity Partners 1, LLC.

When it filed Chapter 11, The Village at Lakeridge owed $17.6 million to U.S. Bank as a secured creditor.

Robert Rabkin was the only other creditor. He purchased the $2.76 million insider claim for $5,000, from Kathleen Bartlett, a member of MBP’s board of managers and the company’s corporate designee. She had a close business and personal relationship with Rabkin. U.S. Bank says it was a romantic relationship.

Rabkin testified that he purchased MBP’s unsecured claim as a business investment but he had no idea how much it was worth.

U.S. Bank objected to The Village at Lakeridge’s Chapter 11 plan. It wanted the bankruptcy court to designate Rabkin’s claim as an insider claim and disallow it for voting purposes.

The bankruptcy court held that Rabkin wasn’t a non-statutory insider because he didn’t exercise control over Lakeridge, didn’t cohabitate or pay Bartlett’s bills, and never purchased gifts for Bartlett.

But the court found that Rabkin had become a statutory insider by acquiring a claim from MBP, and disallowed his vote on the plan. When a statutory insider sells or assigns a claim to a non-insider, the non-insider becomes a statutory insider as a matter of law, the bankruptcy court said.

The Ninth Circuit BAP reversed the bankruptcy court, concluding that Rabkin’s vote could be considered for plan acceptance. It upheld the bankruptcy court’s determination that Rabkin wasn’t a non-statutory insider.

A majority of the Ninth Circuit affirmed.

It reviewed the determination that Rabkin was a non-statutory insider for clear error, holding that the determination of Rabkin’s non-statutory insider status was a factual finding.

Judge Richard R. Clifton dissented in part, arguing that the panel should have applied a de novo standard of review applied by other circuits.

How Will SCOTUS Rule?

Brunstad predicts that the Supreme Court will hold that insider status is a question of law, which means de novo review.

“De novo review is how we will get a more orderly development of the law,” he said.

“Ultimately, it is a question of statutory interpretation,” Brunstad said. In the absence of evidence it is intended to be a question of fact, it should be treated as a question of law, he said.

Bruckner noted that there isn’t a circuit split here, so the court wouldn’t have taken up the case unless they wanted to reverse the Ninth Circuit’s decision.

The Village at Lakeridge has a better argument, however, because it seems to be more of a question of fact, he said.

This is an “important procedural case about manipulating the cramdown process,” Bruckner said.

If this case was a manipulated cramdown, the outcome “weighs in favor of U.S. Bank,” he said.

Gregory A. Cross and Mitchell Y. Mirviss, Venable LLP, Baltimore, and Keith C. Owens and Jennifer L. Nassiri, Venable LLP, Los Angeles, represented U.S. Bank. Daniel L. Geyser, Stris & Maher LLP, Dallas, Peter K. Stris, Brendan S. Maher, and Douglas D. Geyser, Stris & Maher, Los Angeles, and Alan R. Smith and Holly E. Estes, Law Offices of Alan R. Smith, Reno, Nev., represented The Village at Lakeridge.

To contact the reporter on this story: Diane Davis in Washington at DDavis@bna.com

To contact the editor responsible for this story: Jay Horowitz at JHorowitz@bna.com

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