“A creditor does not become an insider simply by receiving a claim from a statutory insider,” held a split panel of the U.S. Court of Appeals for the Ninth Circuit on Feb. 8, 2016. In re The Village at Lakeridge, LLC, 2016 WL 494592, at *1 (9th Cir. Feb. 8, 2016) (2-1). According to the court, “Insiders are either statutory [per se] [e.g., officers, directors] or non-statutory [de facto].” Id. For a person to be a de facto insider, “the creditor must have a close relationship with the debtor and negotiate the relevant transaction at less than arm’s length,” explained the court in finding that a particular creditor (“R”) did “not qualify as a statutory or non-statutory insider” for voting on the debtor’s Chapter 11 cramdown plan. Id. The powerfully persuasive dissent agreed with the majority’s legal analysis as to the elements of insider status, but, “on the facts of this case,” deemed R a de facto insider. Id. at *7. In its view, “Without the sale of [the insider’s] claim to [R] and his anticipated vote to approve the [debtor’s cramdown] plan, that plan [was] dead in the water.” Id. According to the dissent, the “savvy debtor” here formulated “a reorganization plan … providing a payout on [an] insider claim” and then sold “the claim to a friendly third party for a price lower than the payout … ensuring [an acceptance] and thereby allowing the debtor to effectively avoid the requirement under [Bankruptcy Code] § 1129(a)(10) that at least one non-insider … approve the plan.” Id. at *10. In an accompanying unpublished memorandum opinion, the entire three-judge panel also held that R had not accepted the debtor’s reorganization plan “in bad faith,” affirming the lower court’s refusal to “designate” (i.e., disqualify) R’s vote under Bankruptcy Code (“Code”) Section 1126(e). In re The Village at Lakeridge, LLC, 2016 WL 496006, at *1 (9th Cir. Feb. 8, 2016). Statutory Context The relevant statutory requirements for confirmation of a reorganization plan are contained in Code Section 1129(a)(10) (“at least one class of claims that is impaired under the plan has accepted [it],” excluding “any acceptance of the plan by an insider”) (emphasis added) and in Section 1126 (e) (“court may designate any entity whose [vote] … was not in good faith”). The published Lakeridge decision had to resolve whether R, the sole unsecured creditor, was an insider because his acceptance of the debtor’s reorganization plan was essential to confirmation. The separate memorandum opinion only dealt with the issue of whether the bankruptcy court had properly declined to “designate” R’s claim that had been assigned to him by an insider of the debtor. © 2016 Schulte Roth & Zabel LLP | 2 Relevance Insider status in bankruptcy cases is important. It can affect a creditor’s liability for: (1) preferences; (2) equitable subordination; (3) disallowance or recharacterization of its claims; (4) the debtor’s obligations to other creditors; or (5) harm caused to the debtor. In Lakeridge, confirmation of the debtor’s plan turned on R’s not being an insider, for there was no other accepting impaired creditor class. When liability turns on insider status, a de facto lender’s exposure will usually require a “finding that something more exists between the debtor and creditor than an arm’s length, debtor-creditor relationship.” See In re Winstar Communication, Inc., 554 F.3d 382 (3d Cir. 2009) (held, in affirming preference judgment against de facto insider, “actual control not required”; instead, question was whether a close relationship existed between debtor and creditor). Whether a court can “designate” or disqualify a creditor’s vote on a reorganization plan turns on whether “a party steps over the boundary of good faith.” In re DBSD North America, Inc., 634 F.3d 79, 101 (2d Cir. 2011) (2-1). As the U.S. Court of Appeals for the Second Circuit stressed, “neither we nor the Supreme Court had many precedents on the ‘good faith’ voting requirement in any context.” Id. But when “an indirect competitor” of the debtor “bought a blocking position in … a class of claims … with the intention … to use [creditor] status … to provide advantages over proposing a plan as outsider [and] purchased the claims as votes it could use … to bend the bankruptcy process,” its claims were properly designated. Id. at 104-05. Facts The debtor limited liability company in Lakeridge had an insider (“B”) who shared a “close business and personal relationship with” R. 2016 WL 494592, at *1. The debtor also had only two creditors, a Bank with “a fully secured claim worth about $10 million, and [an insider group with] an unsecured claim worth $2.76 million.” Id. The debtor proposed a Chapter 11 plan to deal with the claims of its two creditors. Because the Bank rejected the plan, the debtor sought to cram down the Bank’s secured claim. Shortly after filing its plan and disclosure statement, the debtor’s insider group sold its unsecured claim to R for $5,000, enabling the debtor to classify R’s claim as a “general unsecured claim.” Id. The Bank moved to designate R’s claim and disallow it for plan voting purposes. After an evidentiary hearing, the bankruptcy court held that R “was not a [de facto] insider,” essentially because R had no “control over” the debtor. But the bankruptcy court “designated [R’s] claim and disallowed it for plan voting,” reasoning that R “had become a statutory insider by acquiring a claim from [the insider group].” Id. at *2. The Bankruptcy Appellate Panel vacated the designation of R’s claim and “reversed the finding that [R] had become a statutory insider as a matter of law by acquiring [the insider] claim, [but] affirmed the findings that [R] was not a [de facto] insider and that the claim assignment was not made in bad faith.” As a result, R “could vote to accept the [debtor’s] plan under [Code] § 1129(a)(10) because he was an impaired creditor who was not an insider.” Id. © 2016 Schulte Roth & Zabel LLP | 3 Ninth Circuit: Majority Opinion De Facto Insider Status A Fact Issue According to the majority of the Ninth Circuit panel, de facto insider status “is a question of fact.” Id. at *3. In its view, a de facto insider “is a person who is not [an insider per se], but who has a sufficiently close relationship with the debtor to fall within the definition” of statutory insider. Id., citing In re Winstar Comm., Inc., 554 F.3d 382, 395 (3d Cir. 2009). A “person does not become a statutory insider solely by acquiring a claim from a statutory insider,” reasoned the majority. First, because “insider status is not a property of a claim, general assignment law — in which an assignee takes a claim subject to any benefits and defects of the claim — does not apply.” Contrary to the Bank’s argument, the “term ‘insider’ is not … an adjective used to describe the property of a claim.” Id. Finally, the insider status “factual inquiry … must be conducted on a case-by-case basis.” Id. at *4. The court stressed “a number of [statutory] safeguards for secured creditors” like the Bank “who could be negatively [affected] by a debtor’s reorganization plan.” Id. Relevant here is the requirement of Code Section 1129(a)(10) that “at least one class of impaired claims has accepted the plan (and no insider can vote).” Id. Although the Bank argued that “debtors will begin assigning their claims to third parties in return for votes in favor of plan confirmation,” R had “not become a statutory insider by way of assignment and was not a statutory insider in his own capacity.” Id. at *5. The remaining issue, therefore, was whether R was a de facto insider. But a creditor will not become a de facto insider unless: “(1) the closeness of its relationship with the debtor is comparable to that of the enumerated insider classifications in [Code] § 101(31) [i.e., statutory insider], and (2) the relevant transaction is negotiated at less than arm’s length.” Id. Merely because “the creditor and debtor share a close relationship” does not make the assignee of a claim an insider. Therefore, a court “must conduct a fact-intensive analysis to determine if a creditor and debtor shared a close relationship and negotiated at less than arm’s length.” Control alone “is one of many indications that a creditor may be a [de facto] insider, but actual control is not” essential. Id. The ‘Clearly Erroneous’ Rule Applied The court found the bankruptcy court’s factual findings “not [to be] clearly erroneous.” Id. at *5-6. Nothing in the record showed “a relationship between R and” the debtor. Indeed, R “had little knowledge of” the debtor or its insider group “prior to acquiring [its] unsecured claim, much less to inside information.” Id. at *6. R did not “control” any insider or the debtor, and the debtor and its insiders had no “control” over R. Despite R’s “close personal and business relationship with [B],” B only approached R with an offer to sell the insider claim. But B did not “control” the debtor. R “did not know, and had no relationship with, the remaining” insiders. Finally, although R knew the debtor was the subject of a bankruptcy case and that “purchasing a claim was a risky investment,” R “did not know about [the debtor’s] plan of reorganization or that his vote would be required to confirm it,” believing that “it was a small investment.” Therefore, the majority of the court found the bankruptcy court’s fact findings to be “entirely plausible,” even if it might have “weighed the evidence differently.” Id. The Dissent The dissent accepted the majority’s legal analysis but rejected its application to “the facts of this case.” Id. at *7. It stressed the following undisputed facts from the record: © 2016 Schulte Roth & Zabel LLP | 4 • R paid $5,000 for a nominal claim of $2.76 million held by the insider group. • The selling insider group creditor did not offer their claim to any other party. • R did not solicit the claim. • B, an insider, proposed to R that he buy the claim. • Neither R nor B negotiated over the price for the claim. • R knew nothing or little about the debtor before buying the claim. • R made no investigation regarding the value of the claim before or after his purchase of the claim. • R knew nothing regarding the debtor’s proposed treatment of the claim under its plan prior to his later deposition by the Bank. • After learning of a $30,000 distribution on the claim during his deposition, R still rejected the Bank’s offer to purchase the claim for $60,000. • The motives of B and the other insiders were undisputed: They needed R’s acceptance of the plan, which could not “be approved unless there is a class of creditors willing to vote to approve it.” • The debtor’s insiders were “primarily motivated to place the unsecured claim in the hands of a friendly creditor who could be counted on to vote in favor of the reorganization plan, opening the door to … approval of the proposed plan.” • R had a “close business and personal relationship” with B, the person who proposed the sale of the claim to him. Id. at *7-8. The dissent’s characterization of R as a de facto insider turns on the premise that the sale of the claim was not negotiated at arm’s length. Id. at *8. It accepted the majority’s analysis requiring a close relationship and a transaction “negotiated at less than arm’s length.” Id. at *7. Relying on the definition of “arm’s length transaction” contained in Black’s Law Dictionary (10th ed. 2014), the dissent stressed that R and B were not “unrelated and unaffiliated parties.” Id. at *8. Although the bankruptcy court found that R and B were “separate financial entities,” it did not and could not find that the transaction “was conducted as if they were strangers.” Id. at *9. The dissent also rejected the majority’s reliance on the so-called “clearly erroneous rule” in accepting the bankruptcy court’s fact findings. Id. According to the dissent, “the problem here is not with the facts as found by the bankruptcy court but with the legal test that the bankruptcy court applied.” Because that court never discussed whether the sale of the claim “was conducted at arm’s length,” whether R was a de facto insider was “a mixed question of law and fact, subject to de novo review” by the Ninth Circuit. Id. In any event, “even if the clear error standard applies, the finding that [R] was not a [de facto] insider cannot survive scrutiny.” No reviewing court, in the dissent’s view, “could reasonably conclude that this transaction was conducted as if [R] and [B] were strangers.” Because the “bankruptcy court never actually [found] that the transaction was at arm’s length or that the parties conducted the transaction as if they were strangers,” R had to be a de facto insider. Id. © 2016 Schulte Roth & Zabel LLP | 5 The majority’s holding, said the dissent, “effectively negates” the Code’s requirement “that at least one class of impaired creditors — excluding insiders — vote for a plan before it can be approved.” Id. at *11. In the dissent’s view, the majority “effectively rendered that statutory requirement [Section 1129(a)(10)] meaningless because its holding enables “insiders … to evade the requirement simply by transferring their interest for a nominal amount … to a friendly third party, who can then cast the vote the insider could not have cast itself.” Id. at *10. Comment The strong dissent will undoubtedly encourage the Bank to seek an en banc rehearing by the entire Ninth Circuit. The majority’s holding, if it stands, can have a long-term negative effect on the formulation of reorganization plans in other cases. It will facilitate creative plan manipulation by “savvy” debtors. In contrast, the U.S. Court of Appeals for the Sixth Circuit held within the past month that a Chapter 11 plan’s contrived impairment of two unsecured claims held by the debtor’s former lawyer and accountant “was transparently an artifice to circumvent the purposes of” the Bankruptcy Code. In re Village Green I GP, 2016 WL 325163, at *2 (6th Cir. Jan. 27, 2016). Affirming the reversal of the bankruptcy court’s finding in Village Green that the debtor had “proposed its plan in good faith” under Code Section 1129(a)(3), the Sixth Circuit rejected the debtor’s “assertion that it could not safely pay off the [two] minor [friendly] claims (total value: less than $2,400) up front rather than in over sixty days.” Id. Had the Bank in Lakeridge raised the debtor’s lack of good faith in proposing its plan, as evidenced by the apparently collusive sale of the insider claim to R, the result might have been different. See also In re KB Toys, Inc., 736 F.3d 247, 255 (3d Cir. 2013) (“Claim purchasers are entities who knowingly and voluntarily enter the bankruptcy process … . [A] purchaser should know that it is taking on the risks … attendant to the bankruptcy process … . [A] claim purchaser’s opportunity to profit is partly created by the risks inherent in bankruptcy. Disallowance of a claim … is among these risks”; transferred claim disallowed because transferor had received preference); In re Metiom, Inc., 301 B.R. 634, 642 (Bankr. S.D.N.Y. 2003) (because the Code “disallows the claim … [t]he claim and the defense to the claim … cannot be altered by the claimant’s subsequent assignment of the claim to another entity”) (emphasis in original).