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Who is a Non-Statutory Insider for Preference Purposes?

Who is an Insider?My last blog post discussed what a "preference" is and how to prevent or defend a bankruptcy trustee attempt to take back, or "avoid," such a preference.

Very briefly, a preference is money you pay or property you give to one creditor within a certain amount of time before filing bankruptcy, that you paid or gave in preference to your other creditors. That one creditor could be forced to repay that money or return that property to your bankruptcy trustee so that it could be distributed among all the creditors. If you'd rather that this creditor would be able to keep the money or property, you'd want that payment or transfer not to qualify as a preference.

WHAT DIFFERENCE DOES IT MAKE IF THAT CREDITOR IS AN "INSIDER"?

Generally a payment or transfer is a preference only if a creditor takes or receives money from you within the 90 days before you file your bankruptcy case. But if this creditor is an "insider" this lookback period stretches out a full year before the bankruptcy filing.

SO WHAT'S AN "INSIDER" IN BANKRUPTCY LAW?

This simple question gets complicated because of the simple word "includes" at the beginning of the U.S. Bankruptcy Code's definition of insider: "The term 'insider' includes . . . ". (See Bankruptcy Code at Section 101(31).) This means that insiders include those people and entities listed in the statutory definition but may also include others. Indeed federal courts have explicitly acknowledged that there are "statutory insiders"—those listed in the Bankruptcy Code's definition—and "non-statutory" insiders—those not so listed.

As the U.S. Supreme Court stated in a case earlier this year:

The Code enumerates certain insiders, but courts have added to that number. . . . . Because of the word "includes" in [Section 101(31)], courts have long viewed its list of insiders as non-exhaustive. See §102(3) (stating as one of the Code's "[r]ules of construction" that "`includes' and `including' are not limiting").

U.S. Bank Nat. Ass'n v. Vill. at Lakeridge, 583 U.S. __ (2018).

WHO ARE THE "STATUTORY INSIDERS"?

Section 101(31) breaks down the definition of insiders into subsections depending on whether the debtor filing bankruptcy is an individual, a corporation and some other business or governmental entity. Focusing on individual debtors:

(31) The term "insider" includes—

(A) if the debtor is an individual—

(i) relative of the debtor or of a general partner of the debtor;

(ii) partnership in which the debtor is a general partner;

(iii) general partner of the debtor; or

(iv) corporation of which the debtor is a director, officer, or person in control

So if you pay a debt to a relative, a business "general partner" or the partnership itself, or a corporation in which you have one of the roles listed above, and do so within the year before filing bankruptcy, that payment may well be a preference that your bankruptcy trustee can to try to "avoid."

WHAT ABOUT NON-BUSINESS RELATIONSHIPS?

It's true that, except for the first part of subsection (A)(i) above regarding relatives, these definitions of insider all apply to business relationships. Putting aside payments to creditors in business relationships, the only listed individual insider category is a "relative."

"Relative" has its own definition in the Bankruptcy Code (Section 101(45)): those individuals related to you by blood or marriage or adoption to the "third degree." That including everybody related to you to the first degree—your parent, child, and spouse—to the "second degree"—your grandparents, grandchildren, aunts, uncles, nephews, nieces or half-siblings, as well as parents-in-law and sons and daughters in law—and to the "third degree—first -cousins, great-grandparents, and great grandchildren, as well as brothers – and sisters-in-law, grandchildren-in-law, and grandparents-in-law. (See this chart.)

So these relatives are the only non-business statutory insiders if you're an individual filing bankruptcy.

HOW ABOUT "NON-STATUTORY INSIDERS"?

Because the Bankruptcy Code implies there may be insiders beyond those listed in the statutory definition, it's been up to the courts to determine who those "non-statutory insiders" would include. For example, for individual debtors what non-business (personal) relationships beyond the relatives listed above would be insiders? How about a very close friend? How about adult boyfriends/girlfriends?

The rest of this blog post will focus on how some locally relevant courts have defined non-statutory insiders. This includes courts in the federal Central District of California (which includes Los Angeles and 6 other nearby counties), the 9th Circuit Court of Appeals (which covers all of California and 8 other western states), and the U.S. Supreme Court.

THE NINTH CIRCUIT STANDARD

A published decision last year in the Central District of California bankruptcy court, In re Palmdale Hills Property, Inc., cited a recent 9th Circuit Court of Appeals decision stating that

A creditor is not a non-statutory insider unless: (1) the closeness of its relationship with the debtor is comparable to that of the enumerated insider classifications in § 101(31), and (2) the relevant transaction is negotiated at less than arm's length.

In re The Vill. at Lakeridge, 814 F.3d 993, 1001 (9th Cir. 2016). This 9th Circuit decision was affirmed the U.S. Supreme Court in the very recent decision mentioned above, U.S. Bank Nat. Ass'n v. Vill. at Lakeridge, 583 U.S. __ (2018). More about that Supreme Court decision in a moment.

This 9th Circuit standard seems to make sense. As to its first part, since Congress "enumerated" what relationships constitutes insider relationships, but left open the door for other non-listed classes of insiders, any such additional insiders common sensibly should be "comparable" in the "closeness of its relationship" to the statutory "insider classifications."

The second part of the 9th Circuit also seems to make sense. The legislative history for the definition of "insider" states that "[a]n insider is one who has a sufficiently close relationship with the debtor that his conduct is made subject to closer scrutiny than those dealing at arms [sic] length with the debtor." S.Rep. No. 95-989, at 25 (1978), 1978 U.S.Code Cong. & Admin.News 5787, 5810; H.R.Rep. No. 95-595, at 312 (1977). So the "arm's length" element seems sensible.

HOW DID THE 9TH CIRCUIT APPLY ITS STANDARD FOR NON-STATUTORY INSIDERS?

The problem with this standard is that it is quite new, is clearly difficult to apply, and a majority of the U.S. Supreme Court has indirectly but quite strongly cast doubt on the standard's appropriateness.

The 9th Circuit decision, In re The Vill. at Lakeridge, that established this standard two years ago itself illustrates how difficult it is to apply. (The case was not about a preferential payment but another issue involving the same statutory and non-statutory meaning of insider.)

The potential insider was a man, Rabkin, who had a "close business and personal relationship" with a woman, Bartlett, who was on the board of directors of a Limited Liability Company, MBP. MBP was the sole member of the Village at Lakeridge, LLC, ("Lakeridge") which filed for Chapter 11 reorganization. Lakeridge had only two debts, one owed to MBP for about $3 million, the rights to which Rabkin bought for $5,000. Under Chapter 11 law this would give him a right to vote to approve the Chapter 11 reorganization plan for Lakeridge, unless he was determined to be an insider.

The bankruptcy court held that Rabkin was not a non-statutory insider, because

(a) Dr. Rabkin does not exercise control over [Lakeridge;] (b) Dr. Rabkin does not cohabitate with Ms. Bartlett, and does not pay [her] bills or living expenses; (c) Dr. Rabkin has never purchased expensive gifts for Ms. Bartlett; (d) Ms. Bartlett does not exercise control over Dr. Rabkin[;] (e) Ms. Bartlett does not pay [Dr.] Rabkin's bills or living expenses; and (f) Ms. Bartlett has never purchased expensive gifts for Dr. Rabkin.

In re The Vill. at Lakeridge, 814 F.3d 993, 1005.

The matter was appealed and the Bankruptcy Appellate Panel affirmed this part of the bankruptcy court's holding. It said that insider status has to be decided "on a case-by-case basis, after the consideration of various factors."

At the next level of appeal, the 9th Circuit Court of Appeals affirmed that Rabkin was not a non-statutory insider as it presented the 2-part standard cited and

discussed above.

The Court of Appeals then made the important choice of reviewing the bankruptcy court's pertinent factual finding at the highly deferential standard of "for clear error." That is, it accepted the bankruptcy court's finding of fact that Rabkin's relationship to the debtor, Lakeridge, was not a non-statutory insider as long as that finding is "plausible in light of the record viewed in its entirety."

The Court of Appeals summarized the factual record as follows:

U.S. Bank presents no evidence that Rabkin had a relationship with Lakeridge comparable to those listed in § 103(31). Rather, the evidence shows Rabkin had little knowledge of Lakeridge — or its sole member MBP — prior to acquiring MBP's unsecured claim, much less access to inside information. Rabkin does not control MBP or Lakeridge, nor does Lakeridge or MBP have any control over Rabkin. U.S. Bank has shown that Rabkin had a close personal and business relationship with Bartlett, and that Bartlett approached Rabkin, and only Rabkin, with an offer to sell MBP's claim. However, Bartlett does not control MBP or Lakeridge. Rather, Bartlett was one of MBP's five managing members, all of whom discussed potential buyers and agreed to offer the claim to Rabkin. Rabkin did not know, and had no relationship with, the remaining four managing members of MBP.

U.S. Bank has not shown that Rabkin's relationship with Bartlett — who is indisputably a statutory insider of MBP and Lakeridge — is sufficiently close to compare with any category listed in § 103(31). Rabkin had no control over Bartlett, and Bartlett had no control over Rabkin. Rabkin and Bartlett kept separate finances, lived separately, and conducted business separately. The bankruptcy court properly evaluated these factors to determine whether Rabkin's relationship with Bartlett was close enough to make him an insider who was conducting business at less than arm's length with MBP.

….

These facts do not leave us with a "definite and firm conviction that a mistake has been committed." Rather, the bankruptcy court's finding that, on the record presented, Rabkin was not a non-statutory insider is entirely plausible, and we cannot reverse even if we may "have weighed the evidence differently."

[Footnote and citations excluded.]

So even though Rabkin had romantic and financial ties to Bartlett, he was considered not to be sufficiently close to the business entity filing bankruptcy, Lakeridge, to be a non-statutory insider.

Note that one of the judges in the 9th Circuit Court of Appeal's 3-judge panel strongly dissented regarding both the appropriateness of the "clear error" standard and that Rabkin was not a non-statutory insider.

WHAT DID THE U.S. SUPREME COURT SAY ABOUT ALL THIS?

This is where it gets truly interesting and muddled. The Ninth Circuit Court of Appeals standard is hard enough to apply. But the Supreme Court's opinion cast severe doubt on its viability altogether.

The Court's ruling was explicitly a narrow one:

The Court of Appeals therefore applied the appropriate standard in reviewing the Bankruptcy Court's determination that Rabkin did not qualify as an insider because his transaction with MBP was conducted at arm's length. A conclusion of that kind primarily rests with a bankruptcy court, subject only to review for clear error. We accordingly affirm the judgment below.

The 9th Circuit's standard for non-statutory insiders was itself not up for review by the Court. Nevertheless four of the nine Supreme Court justices went out of their way in concurring opinions to deeply question the 9th Circuit standard. One of the concurring opinions, by Justice Sotomayor, joined by three other justices, included the following:

The Court's discussion of the standard of review . . . begs the question of what the appropriate test for determining non-statutory insider status is. I do not seek to answer that question, as the Court expressly declined to grant certiorari on it. I have some concerns with the Ninth Circuit's test, however, that would benefit from additional consideration by the lower courts.

She expressed a variety of concerns with the Ninth Circuit's formulation, and then stated:

courts must develop some principled method of determining what other individuals or entities fall within the term "insider" other than those expressly provided. I can conceive of at least two possible legal standards that are consistent with the understanding that insider status inherently presumes that transactions are not conducted at arm's length. First, it could be that the inquiry should focus solely on a comparison between the characteristics of the alleged non-statutory insider and the enumerated insiders, and if they share sufficient commonalities, the alleged person or entity should be deemed an insider regardless of the apparent arm's-length nature of any transaction. Cf. In re Longview Aluminum, LLC, 657 F. 3d 507, 510-511 (CA7 2011) (considering only whether a manager of a debtor corporation was comparable to the enumerated insiders, regardless of whether any transaction was conducted at less-than-arm's length).

Second, it could be that the test should focus on a broader comparison that includes consideration of the circumstances surrounding any relevant transaction. If a transaction is determined to have been conducted at less-than arm's length, it may provide strong evidence in the context of the relationship as a whole that the alleged nonstatutory insider should indeed be considered an insider. Relatedly, if the transaction does appear to have been undertaken at arm's length, that may be evidence, considered together with other aspects of the parties' relationship, that the alleged non-statutory insider should not, in fact, be deemed an insider.

Neither of these conceptions reflects the Ninth Circuit's test.

She concluded:

Even if the proper test for insider status called for clear error review, it is possible that the facts of this case when considered through the lens of that test, as opposed to one focused solely on arm's length, may have warranted a finding that Rabkin was a non-statutory insider.

This is all to say that I hope that courts will continue to grapple with the role that an arm's-length inquiry should play in a determination of insider status.

So this concurring opinion deeply criticized the Ninth Circuit's standard and presented ideas for a different one. Had the question of the appropriateness of the Ninth Circuit's standard been squarely in front of the Supreme Court there is serious doubt the Court would have approved it.

WHERE DOES THIS LEAVE THE NINTH CIRCUIT STANDARD?

It is the law of the Ninth Circuit and therefore of the bankruptcy courts in Southern California. So arguments about whether a person is an insider or not need to be made based on this standard. But it is a standard that doesn't really give much practical guidance. And there is plenty of reason to believe it is not the last word on this issue locally. Courts definitely "will continue to grapple with" the question: who a non-statutory insider?

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