By Benjamin Clarke
In its second clarificatory ruling in the space of a week, the US Supreme Court has found that appeals courts should apply a “clear error” standard when reviewing bankruptcy court rulings that determine whether an individual is an “insider”.
The unanimous decision handed down by Justice Elena Kagan on 5 March affirmed a Ninth Circuit ruling from February 2016 that federal courts should defer to the factual findings of the bankruptcy courts when hearing challenges over insider relationships, rather than conduct their own de novo reviews – where they would not have to place any weight on the bankruptcy court’s findings.
While the US Bankruptcy Code’s definition of an insider includes directors, officers, general partners and any “person in control” of the debtor entity, the US courts have developed tests to identify non-statutory insiders, which focus on whether transactions with the debtor are carried out “at arm’s-length”.
In the 5 March judgment, Justice Kagan concluded: “Appellate review of the arm’s-length issue – even if conducted de novo – will not much clarify legal principles or provide guidance to other courts resolving other disputes.”
“The issue is therefore one that primarily rests with a bankruptcy court, subject only to review for clear error,” she added.
Lawyers tell GRR that the ruling provides a “clear deference” to the bankruptcy court’s determination of insider status.
Mixed question of law and fact
The seven-year journey to the Supreme Court started in June 2011 when real estate company Village at Lakeridge filed for Chapter 11 protection in Nevada, owing US Bank over US$10 million and its sole owner, MBP equity partners a further US$2.76 million.
US Bank opposed the restructuring plan, which placed the two creditors in separate classes, and a potential cramdown plan – based on MBP’s consent – was prevented from proceeding because insiders cannot provide the agreement needed for cramdowns.
To get around the obstacle, Kathleen Bartlett – a member of the MBP board, and an officer of Lakeridge – offered to sell MBP’s entire claim to a retired surgeon, Robert Rabkin, so he could agree to the cramdown plan as a non-insider.
Following this move US Bank commenced litigation arguing that Rabkin was a “non-statutory insider” because he had a “romantic relationship” with Bartlett, and the purchase of MBP’s debt was therefore not an “arm’s-length transaction”.
The Nevada court rejected US Bank’s arguments and found that while Bartlett and Rabkin were in a romantic relationship, the purchase was made as a “speculative investment” and Rabkin had carried out the necessary due diligence.
When the matter subsequently made its way to the Court of Appeals for the Ninth Circuit, a divided vote affirmed the bankruptcy court’s position. The opinion handed down by Judge Norman Smith on 8 February 2016 said the bankruptcy court’s decision was based on a finding that the transaction was conducted at arm’s length. The decision was entitled to a clear error review, but could not be reversed under such a review, the Ninth Circuit said.
After the split decision the matter was allowed to proceed to the Supreme Court, for the determination of a single question: whether the Ninth circuit was right to review the bankruptcy court’s determination for clear error rather than de novo.
In a unanimous decision the Supreme Court agreed with the Ninth Circuit’s standard.
Justice Kagan said a “’mixed question’ of law and fact” remained at the heart of the case. The bankruptcy court had to determine whether the historical facts found regarding the relationship between Bartlett and Rabkin satisfied the legal test for conferring non-statutory insider status.
The standard of review for dealing with such mixed questions depends on whether answering it “entails primarily legal or factual work,” the court explained.
Using the test identified by the Ninth Circuit for determining Rabkin’s insider status – whether the transaction was carried out at arm’s length – the court decided the “mixed question” was primarily factual: was Rabkin’s purchase of the MBP claim conducted as if the two parties were strangers?
“That is about as factual sounding as any mixed question gets,” the court found.
Justice Kagan concluded that the Ninth Circuit applied the proper standard in reviewing the bankruptcy court’s determination that Rabkin did not qualify as an insider because his transaction 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,” Justice Kagan finished.
Speaking to GRR after the verdict, retired bankruptcy judge for the Southern District of New York Judge Allan Gropper says the decision was only a narrow one given that the court’s ruling was limited to the standard of review an appellate court should use.
In such circumstances where questions of mixed law and fact are considered, the Supreme Court noted that the standard of review “is often determined on the basis of which judicial actor is better positioned to make the decision,” he says.
In this case, the court held that it was the bankruptcy judge who was best placed to make the decision, as he had heard the evidence and weighed the facts, and applied them to a legal standard that was not at issue, Judge Gropper explains.
In terms of the impact of the decision, Judge Gropper says he predicts losing parties will be less ready to appeal factual decisions made by bankruptcy or other trial courts, as a decision which is primarily factual in nature can only be reversed for clear error.
“Since either a debtor or a creditor can be on the losing end of a factual dispute, I don’t think the impact of the decision will fall more heavily on one or the other,” he adds.
Finally, Judge Gropper says that, as federal court judges are appointed for life under article III of the US constitution, and bankruptcy judges are appointed for 14-year terms under article I, he was “struck” by the Supreme Court’s decision to treat the factual findings of the bankruptcy court “with the same deference it would treat the factual findings of any other trial court”.
“In recent years, the Supreme Court and some other appellate courts have written opinions stressing the limited power of the bankruptcy courts to issue final decisions on certain issues, generally said not to be ‘core’ bankruptcy issues,” he says.
As the issue at play in this case was about the construction of a term defined in the Bankruptcy Code – surely a “core” issue – it is notable that the Supreme Court did not deem it relevant that the bankruptcy judge who made the initial factual findings was a non-article III judge.
“In my view, that aspect of the Supreme Court’s opinion should be important in confirming the role that the bankruptcy courts have in our judicial system,” Judge Gropper adds.
Annette Escobar, founding shareholder and partner at Sequor Law in Miami, agrees. She says that the specialised nature of the bankruptcy courts and the experienced judges that sit in them put them in the “best position as to facts and evidence presented to them”.
“I think it is a well-deserved recognition of the deference due to bankruptcy courts in matters pertaining to their areas of specialisation,” she tells GRR.
On the likely impact of the decision, Escobar also notes the issue resolved was a “very narrow one” and could vary from case to case in the future.
“The impact it will have on bankruptcy stakeholders or creditors on an individual basis is likely to be minimal,” she says, “but the question resolved might have extensive effects on appeals from bankruptcy courts more generally.
“[I]n all bankruptcy appeals in which mixed questions of law and fact are present, appellate courts will have to engage in the case by case analysis set forth by the Supreme Court,” Escobar adds. “I think we can expect a great deal more haggling about and briefing on the ‘nature’ of the questions on appeal”
Kristopher Aungst, bankruptcy and restructuring partner at Wargo French in Miami agrees that the decision provides a “clear deference” to the determination of insider status provided by the bankruptcy courts, but notes it does not offer any further clarity on the “limited but important” question of who is an insider under the bankruptcy code.
“Insider status, while relatively limited in scope of importance, clearly matters in the context of the look-back period in certain avoidance actions,” Aungst tells GRR. He suggests an expansion of the definition would create greater potential avoidance powers.
Coordinating editor of international for the American Bankruptcy Institute, Tally Wiener says she doesn’t think the Supreme Court missed an opportunity to offer more clarification on the definition of insiders. “[W]e know them when we seem them,” she says.
With regard to the substance of the ruling, Wiener tells GRR there is potential for courts to apply a broad construction. The decision could be cited to try to achieve a deferential standard of review with respect to other mixed issues of law and fact, she suggests.
“This strikes me as unfortunate,” Wiener says, “perhaps because I live in New York and am accustomed to federal appellate courts applying a de novo standard of review to many mixed issues of law and fact arising in bankruptcy appeals”.
The Supreme Court’s decision comes just six days after its landmark “safe harbour” ruling, in which it unanimously found that defendants who are not financial institutions or market participants should not be able to invoke the Bankruptcy Code’s safe harbour clawback.