Supreme Court Lakeridge Decision Clarifies the Standard of Review of Mixed Questions of Law and Fact

In another decision affecting Chapter 11 cases, U.S. Bank National Association v. Village at Lakeridge, --- S. Ct. ---, 2018 WL 1143822 (2018), on March 5, 2018, the United States Supreme Court issued a unanimous decision, authored by Justice Kagan, affirming the Ninth Circuit’s decision to review the Bankruptcy Court’s determination of a mixed question of fact and law for clear error, rather than de novo.  The decision concerned whether a particular creditor was a non-statutory “insider” of the Chapter 11 debtor following a transfer of a claim by an insider to a third party that (favorably) impacted the ability of the debtor to confirm a cram-down plan.  

Bankruptcy Code Section 101(31) describes various relationships that parties may have with a debtor that would qualify those parties as “insiders” of a debtor.  Courts have also found that other parties not covered by Section 101(31), such as parties who did not transact with a debtor at arms’ length, fall into the category of “non-statutory insiders.”  Determination of whether transactions were conducted at arm's length is a mixed question of fact and law that may require extensive factual analysis.

The designation of a creditor as an “insider” takes on particular importance in the context of Section 1129(a)(10) cramdown plans, where an impaired accepting class must accept the debtor’s plan.  Insiders do not count for the purposes of determining whether an impaired accepting class exists.

In the Lakeridge decision, the Supreme Court affirmed the Ninth Circuit’s ruling that a Bankruptcy Court’s determination of whether a party is a non-statutory insider is reviewed only for clear error, and not de novo, thereby deferring to the trial court.

The Facts

Village at Lakeridge, LLC ("Lakeridge"), the appellee, is wholly owned by MBP Equity Partners ("MBP"). When it filed for bankruptcy in 2011, Lakeridge owed MBP $2.76 million, and U.S. Bank more than $10 million.  Lakeridge, at 3.  Lakeridge’s proposed Chapter 11 plan separately classified MBP and U.S. Bank and impaired both classes.  U.S. Bank (in its own class) rejected the proposed plan, and as MBP was Lakeridge’s owner, and thus an insider, the Bankruptcy Court found that there was no qualifying impaired accepting class and thus the plan could not be confirmed.  Id.

To circumvent this issue, MBP transferred its claim against Lakeridge to a non-insider, Mr. Rabkin, for $5,000.  The Chapter 11 plan provided for a $30,000 distribution on account of this unsecured claim.  Mr. Rabkin voted in favor of the proposed plan.  U.S. Bank objected, arguing that he was a non-statutory insider, as Mr. Rabkin was engaged in a romantic relationship with the MBP board member from whom he bought the claim.  Id. at 3-4.

While the parties testified that they were, indeed, romantically involved, the Bankruptcy Court held that Mr. Rabkin nonetheless purchased the claim as a ‘“speculative investment’ for which he did adequate due diligence,” and, as such, that Mr. Rabkin was not a non-statutory insider based upon that relationship.  Lakeridge, at 4.  The Bankruptcy Court “noted that Rabkin and Bartlett, for all their dating, lived in separate homes and managed their finances independently.”  However, the Bankruptcy Court did find that Mr. Rabkin was a statutory insider by virtue of buying the claim from a statutory insider.  Lakeridge appealed, and the Ninth Circuit Bankruptcy Appellate reversed the Bankruptcy Court’s holding that Mr. Rabkin was a statutory insider based upon the purchase of the claim from an insider.  U.S. Bank appealed.  

The Ninth Circuit recognized that insider status is a factual question determined on a case-by-case basis.  The court then laid out its two-part test for insider status:  A creditor qualifies as a non-statutory insider if two conditions are met: “(1) the closeness of its relationship with the debtor is comparable to that of the enumerated insider classifications in [the Code], and (2) the relevant transaction is negotiated at less than arm’s length.”  In re Village at Lakeridge, LLC, 814 F. 3d 993, 1001 (9th Cir. 2016).  The Ninth Circuit affirmed the holding that Mr. Rabkin was not a non-statutory insider, finding that the transaction was conducted at arms’ length.  The Ninth Circuit did not remand to the Bankruptcy Court because the lower court had found that the sale transaction was at arm’s length, thereby defeating insider status. 

The matter was further appealed. Of note, the Supreme Court did not grant review of the question of whether Mr. Rabkin automatically inherited MBP’s statutory insider status when he purchased its loan and, as such, the decision does not address this argument.

The Opinion

Justice Kagan, writing a unanimous opinion, noted that the issue of “insider” status is relevant under a variety of circumstances in Chapter 11 cases, yet there is no uniform approach to identifying non-statutory insiders.  “The decisions are not uniform, but many focus, in whole or in part, on whether a person’s ‘transaction of business with the debtor is not at arm’s length.’”  The Court observed the relevance of insider status to the cram-down plan at issue since, absent the claim purchaser being a non-insider, the Chapter 11 plan could not be confirmed through a cram-down over the objection of the dissenting secured creditor.  To confirm the plan, the insider creditor (MBP) would need to transfer the claim to a non-insider who, in turn, would vote to accept the plan.  As aptly summarized by Justice Kagan:  “So that was what MBP attempted.  Kathleen Bartlett, a member of MBP’s board and an officer of Lake-ridge, approached Robert Rabkin, a retired surgeon, and offered to sell him MBP’s $2.76 million claim for $5,000.  Rabkin took the deal.  And as the new holder of MBP’s old loan, he consented to Lakeridge’s proposed reorganization.  As long as he was not himself an insider, Rabkin’s agreement would satisfy one of the prerequisites for a cramdown plan.”  Lakeridge, at 3.

Justice Kagan emphasized that a bankruptcy judge must deal with three issues when determining whether a creditor is a non-statutory insider.  “To decide whether a particular creditor is a non-statutory insider, a bankruptcy judge must tackle three kinds of issues—the first purely legal, the next purely factual, the last a combination of the other two.  And to assess the judge’s decision, an appellate court must consider all its component parts, each under the appropriate standard of review.  In this case, only the standard for the final, mixed question is contested.” Lakeridge, at 5. 

The first  “purely legal question,” to be reviewed de novo, is what legal test should be used to determine whether a creditor is a non-statutory insider.  Lakeridge, at 5-6.  Here, the Ninth Circuit endorsed a two-part test: whether the creditor’s relationship with the debtor was similar to those of listed insiders, and whether the transaction was negotiated at arm’s length.  There was no dispute that the Bankruptcy Court applied the Ninth Circuit’s governing test.  As to the merits of that legal test, Justice Kagan stated:  “We do not address the correctness of the Ninth Circuit’s legal test; indeed, we specifically rejected U. S. Bank’s request to include that question in our grant of certiorari.  See 580 U.S. ___; Pet. for Cert. i. We simply take that test as a given in deciding the standard-of-review issue we chose to resolve.”  Lakeridge, at 6.

Next, along with adopting the legal standard, the bankruptcy judge must then make findings of “basic” or “historical” facts, “addressing questions of who did what, when or where, how or why.”  Id.  This determination is reviewed only for clear error.  “By well-settled rule, such factual findings are reviewable only for clear error—in other words, with a serious thumb on the scale for the bankruptcy court.”  Id.

Finally, the findings of fact are applied to the chosen legal test, resulting in a mixed question of fact and law.  Lakeridge, at 6-7.  “A mixed question asks whether the ‘historical facts’. . . satisfy the statutory standard, or to put it another way, whether the rule of law as applied to the established facts is or is not violated.”  Lakeridge, at 7, citing Pullman-Standard v. Swint, 456 U.S. 273, 289 n. 19 (1982).  The standard of review for this third question was the crux of the appeal to the Supreme Court.  “The parties, after traveling so far together, part ways at this crucial point. U. S. Bank contends that the Bankruptcy Court’s resolution of the mixed question must be reviewed de novo.”  Lakeridge, at 7.  Lakeridge argued for the clear error standard.  “In Lakeridge’s view, the ultimate law-application question is all ‘bound up with the case-specific details of the highly factual circumstances below’ —and thus falls naturally within the domain of bankruptcy courts.”  Lakeridge, at 7-8.

Justice Kagan observed that for their differences, the parties point to the same question: “[W]hat is the nature of the mixed question here, and which kind of court (bankruptcy or appellate) is better suited to solve it?”  Lakeridge, at 8.  Some mixed questions “immerse courts in case-specific factual issues—compelling them to marshal and weigh evidence, make credibility judgments, and otherwise address what we have (emphatically if a tad redundantly) called “multifarious, fleeting, special, narrow facts that utterly resist generalization.”  Lakeridge, at 8, quoting Pierce v. Underwood, 487 U.S. 552, 561 (1988).  Justice Kagan concluded: “In short, the standard of review for a mixed question all depends—on whether answering it entails primarily legal or factual work.”  Lakeridge, at 9.

Applying the matter to the issue of non-statutory insider status under the Ninth Circuit’s standard, the Court reasoned as follows:

But the court’s use of the Ninth Circuit’s legal test for identifying such insiders reduced that question to a more particular one: whether the facts found showed an arm’s-length transaction between Rabkin and MBP.  See ibid.  And still, we can further delineate that issue just by plugging in the widely (universally?) understood definition of an arm’s-length transaction: a transaction conducted as though the two parties were strangers.  See, e.g., Black’s Law Dictionary 1726 (10th ed. 2014).  Thus the mixed question becomes:  Given all the basic facts found, was Rabkin’s purchase of MBP’s claim conducted as if the two were strangers to each other?

That is about as factual sounding as any mixed question gets.

Lakeridge, at 9-10 (footnote omitted).  The Court also reasoned that viewed from the “opposite direction,” the dispute requires “precious little” legal work to resolve.  Id.

After determining that the mixed question of fact and law at issue was more factual in nature, the Supreme Court concluded that the Bankruptcy Court and the Ninth Circuit had applied the appropriate standard of review — clear error.  Lakeridge, at 11.  In this instance, even a de novo review by the appellate court would “not much clarify legal principles,” and the factual determinations were best left to the court closest to the factual record.  Lakeridge, at 11.

The Concurrences

The two concurring opinions, the first authored by Justice Kennedy, and the second by Justice Sotomayor, and joined in by Justices Kennedy, Thomas and Gorsuch, emphasized that the Supreme Court passed no judgment on the propriety of the Ninth Circuit’s test.  Justice Sotomayor expressed some concern that the Ninth Circuit’s two-prong test was not necessarily appropriate in all instances, and that different tests may prompt different standards of review. 

Specifically, Justice Sotomayor noted that statutory insiders do not lose their status as insiders by negotiating at arm’s length, and “it is not clear why the same should not be true of non-statutory insiders.”  Sotomayor Concurrence, at 3.  Justice Sotomayor proposed two alternative tests: (i) focusing on other aspects of the parties’ relationships if the transaction were negotiated at arm’s length, or (ii) focusing on commonalities between the insiders and characteristics of the alleged non-statutory insider.  Sotomayor Concurrence, at 4-5.  Justice Sotomayor implied that using one of those proposed tests might lead to a different result in this case.

Looking Ahead

Guidance from the Supreme Court on matters affecting Chapter 11 cases is always something to be well-heeded.  The decision in Lakeridge reaffirms bankruptcy courts’ ability to decide certain mixed questions of fact and law as the court closest to the factual record in a bankruptcy proceeding.  When the appellate court’s review of a mixed question of fact and law will not clarify any legal principles, and would deal largely with factual issues, the bankruptcy court’s decision should now be afforded the more deferential review standard (clear error).  If there are legal matters that require interpretation, that will open up the issue to a potentially different result.  Turning to the concurrences, the Justices also indicated that had it been the Ninth Circuit’s legal standard up for review, the case may have turned out differently, and that the two-prong test used may be under question.  Going forward, there is now greater clarity on how these types of disputed matters will be dealt with on appeal, which always provides greater clarity on how to structure transactions in the first instance.