Before a bankruptcy court may confirm a chapter 11 plan, it must determine if any of the persons voting to accept the plan are “insiders,”i.e., individuals or entities with a close relationship to the debtor. Because the Bankruptcy Code’s drafters believed that insider transactions warrant heightened scrutiny the classification of a creditor as an “insider” can have a profound impact on a debtor’s ability to reorganize. One particularly important example is section 1129(a)(10) of the Code, which requires that at least one class of impaired claims (claims that are not paid in full) votes in favor of the plan, not counting the votes of insiders provided that certain other Code requirements are met.

In U.S. Bank N.A. v. The Village at Lakeridge, LLC (In re The Village at Lakeridge, LLC), the Court of Appeals for the Ninth Circuit considered whether a close associate of a board member of the debtor’s owner qualified as an “insider” for plan voting purposes. Because of the unique nature of the debtor’s capital structure, the confirmability of the debtor’s plan and the viability of the debtor’s business as a going concern hung in the balance.

Lakeridge filed for chapter 11 relief on June 16, 2011 with only two creditors: (i) U.S. Bank, which held a $10 million fully secured claim; and (ii) MBP Equity Partners, Lakeridge’s 100% owner, which held an unsecured claim of $2.76 million. Shortly after the case was commenced, MBP decided to sell its claim, and Kathie Bartlett, one of its board members, approached Robert Rabkin, a friend and business associate in matters unrelated to Lakeridge, about purchasing the claim. Rabkin quickly agreed to buy the claim for $5,000, later testifying that he had done so after completing little or no due diligence and with full recognition that his acquisition was a risky investment.

While Bartlett later testified that MBP’s board elected to sell its claim because it believed there were tax advantages in doing so, the claims transfer had a significant additional benefit for Lakeridge’s chances to successfully reorganize. Indeed, because the MBP claim (the only unsecured claim asserted against the debtor) was initially held by an insider, it could not be counted for the purposes of plan voting. As a result, at the outset of the case, no unimpaired class of non-insider claims existed and the debtor was unable to propose a confirmable plan. Subsequent to the transfer, the MBP claim was in the hands of a nominal non-insider, freeing up Lakeridge to propose a restructuring so long as it could comply with the other technical requirements of section 1129 of the Bankruptcy Code.

The transfer of the MBP claim had profound implications for U.S. Bank. At the start of the case, U.S. Bank stood poised to assert its leverage as a secured creditor to force Lakeridge to sell its assets pursuant to section 363 of the Code or otherwise liquidate its business in a manner that guaranteed it payment in full in short order. After the transfer, the bank faced the prospect of Lakeridge proposing a so-called “cram-down” plan that, with Rabkin’s support and over the bank’s objection, forced the bank to accept payment over time, the reinstatement of its liens against the assets of Reorganized Lakeridge, or any other package that the bankruptcy court deemed to be the “indubitable equivalent” of its claim. Faced with the potential of losing control over Lakeridge’s bankruptcy as a result of the sale of the MBP claim to Rabkin, U.S. Bank commenced an action to challenge Rabkin’s designation as a non-insider.

U.S. Bank faced an uphill battle in its attempt to classify Rabkin as an insider. Bankruptcy law recognizes two types of insiders: “statutory” insiders consist primarily of a debtor’s directors, officers, or managers, while “non-statutory” insiders are those parties who have a close relationship with a debtor and who do not negotiate the relevant transaction with the debtor at arm’s length. The bank first argued that Rabkin became a statutory insider when he acquired the claim from MBP. The Ninth Circuit disagreed, distinguishing between the status of a claim and that of a claimant, and finding that Rabkin did not become an insider merely as a result of the type of claim he possessed. The Ninth Circuit similarly concluded that Rabkin’s relationship with Lakeridge was not so close as to confer “non-statutory” insider status upon him, as the record before it indicated that Rabkin (i) had little knowledge of Lakeridge or MBP prior to acquiring the claim and no control over either entity; and (ii) did not know of Lakeridge’s plan of reorganization or that his vote would be required to confirm it. While the court acknowledged the existence of the close relationship between Bartlett and Rabkin, it noted that Rabkin had no relationship with any of the other four members of the MBP board (all of whom agreed to sell the MBP claim to Rabkin) and that Bartlett had no authority to bind MBP without the other members’ support.

Notably, the Ninth Circuit’s decision was not unanimous, as a member of the panel issued a partially concurring and dissenting opinion that agreed with the general proposition that a person does not necessarily become an insider solely by acquiring a claim from an insider so long as the claim was acquired by an independent party, for bona fide reasons and “uninfected with the unique motivations of the insider.” But the dissenting portion of the opinion concluded that the claims purchase was not negotiated at arms-length because:

  • Rabkin paid only $5,000 for a $2.76 million claim;
  • MBP did not offer the claim to anyone else;
  • The purchase was not solicited by Rabkin;
  • There was no evidence of any negotiation over price; and
  • After learning that the payment under the plan would be $30,000, he was offered as much as $60,000 from U.S. Bank for the claim and declined the offer.

In light of these facts, the dissent determined that the motivations for MBP and Bartlett to transact with Rabkin were clear: MBP was primarily motivated to place the unsecured claims in the hands of a friendly creditor who could be counted on to vote in favor of the reorganization plan. As to Rabkin, the dissent found his intentions a bit “murkier.” After concluding that Rabkin was clearly not acting as economically rational actor in acquiring the claim (and noting that there was no evidence that he had a history of making blinds bets, “say by helping out Nigerian princes or buying the Brooklyn Bridge”), the dissent surmised that Rabkin was simply doing a favor for a friend with the chance of making some money for himself in the process. As such, the dissent concluded that Rabkin should have been deemed an insider.

As noted by the dissent, the majority opinion in Lakeridge creates a clear path for debtors who want to avoid the limitations of the insider voting restrictions of the Bankruptcy Code. Under the court’s holding, insiders are free to evade the requirements of section 1129(a)(10) by simply transferring their claims for a nominal amount to a friendly but technically unaffiliated third party, who can cast the vote that the insider could not cast themselves. Such a result effectively nullifies section 1129(a)(10) in cases in which a debtor has only a few non-insider creditors. This is precisely what occurred in Lakeridge.