Purchase and Sale of Assets

Bankruptcy Court Redefines Who Is an 'Insider'

Bankruptcy Update

By Myron A. Bloom
Special to the Legal

Just as soon as we think we understand a concept, an opinion comes along that make us think again. Such an opinion was issued on Jan. 18, 2005 when the Bankruptcy Appellate Panel for the 9th U.S. Circuit Court of Appeals took on an interesting set of facts in determining who is an "insider."

In Miller Avenue Professional and Promotional Services Inc. v. Brady (In re Enterprise Acquisition Partners Inc.), the debtor, Enterprise Acquisition Partners Inc. borrowed $125,000 from Miller Avenue Professional Services Inc. (MAPPS). The borrowing was secured by a lien on Enterprise's accounts receivable. A UCC-1 financing statement was not, however, filed at the time of the borrowing and thus the lien was not perfected contemporaneously with the lending.

The loan came due in December 2002 but was not paid; MAPPS thereupon filed a UCC-1 to perfect its lien. Then, 92 days after the lien was perfected, Enterprise filed a Chapter 7 petition in the U.S. Bankruptcy Court for the Northern District of California.

At all times relevant, Patrick Salmon was an officer and a director of Enterprise, and the holder of 10 percent of the company's stock. MAPPS was a corporation. Its sole employee, sole director, sole officer and sole shareholder was Patricia Mapps, Salmon's wife. The Chapter 7 trustee of Enterprise's estate brought an action to avoid as a preferential transfer the perfection of MAPPS' security interest in Enterprise's accounts receivable, taking the position that MAPPS, the spouse's company, was an insider of Enterprise. (As most know, the "look-back" provision of Section 547 of the Bankruptcy Code is 90 days for non-insiders but one year for insiders.)

Shortly before trial, the Chapter 7 trustee filed a motion for summary judgment based on a stipulated set of facts, contending that as a matter of law MAPPS was an insider of Enterprise because of the relationship of Salmon and his spouse. MAPPS cross-moved, seeking a finding that as a matter of law it was not an insider.

The bankruptcy court reserved ruling on the question of whether MAPPS was an insider as a matter of law; however, because (in the words of the court) "an entity can be an insider even if it does not meet the statutory definition," it heard testimony on the question of whether MAPPS qualified as what it called a "non-statutory" insider.

At the close of testimony, the bankruptcy court ruled that MAPPS was a per se insider, that is to say, an insider as a matter of law, based on the definition of "insider" found in Section 101 of the Bankruptcy Code. The bankruptcy court went on to rule that MAPPS would not, based on the testimony, qualify as a non-statutory insider.

Having ruled that MAPPS was a statutory insider, the bankruptcy court ruled in favor of the trustee and voided the perfection of the lien. However, reflecting the court's view of the testimony, it also stated that "if the case is appealed and reversed on the appellate court's conclusion that MAPPS Inc. is not a per se insider, it need not be remanded because I would find judgment for the defendant."

MAPPS appealed.

The Bankruptcy Appellate Panel first focused on the definition of "insider," found in Section 101(31) of the Bankruptcy Code. Under that section, if the debtor is a corporation, certain named entities are by definition insiders: directors of a debtor; officers of a debtor; persons in control of a debtor; partnerships in which a debtor is a general partner; general partners of a debtor; or relatives of a general partner, director, officer or person in control of a debtor. The list is not exhaustive; however, the definition of who is an insider includes such entities. This list, noted the panel, though not inclusive, is indicative of either one or two relational classifications.

First, insider status was conferred explicitly by Congress on entities or relatives of the debtor, or of persons in control of a related entity, whose affinity or consanguinity gives rise to a "conclusive" presumption that the individual or entity commands preferential treatment.

Second, insider status may be conferred based on a professional relationship or business relationship with the debtor, where such relationship compels the conclusion that the entity's relationship is so close as to gain an advantage attributable to affinity rather to a course of dealings between that entity and a debtor. If the entity is a per se insider, the nature of the relationship need not be looked into. In a per se situation, the amount of actual control over a debtor is immaterial. Here, the panel noted, the issue before it was solely whether MAPPS was a per se insider.

In its ruling, stated the panel, the bankruptcy court found correctly that Salmon was an insider since he was both an officer and director of Enterprise. Salmon's spouse was also an insider since she was a relative of an insider. Finally, stated the bankruptcy court, the spouse and MAPPS "were one and the same," so MAPPS was an insider of Enterprise. In other words, the bankruptcy court seems to have concluded that, as a matter of law, an insider's wholly owned corporation is an insider.

The panel disagreed. The panel stated that the text of the code simply did not warrant this outcome. Citing to Lamie v. United States, the panel stated that to determine legislative intent, the starting point "is the existing statutory text." If the language is clear, it should be applied as written unless to do so would lead to absurd results.

There is no reasonable way, stated the panel, to read into the per se definition of insider a corporation which is wholly owned by a relative of an insider. Had Congress wished to include such an entity in its definition, it could have.

An example of Congress wishing this result can be found in Section 101(31)(E), which refers to an "affiliate" of a debtor (which is an insider) and an "insider of an affiliate" of a debtor (which similarly is an insider). Thus, Congress, when it so chose, clearly made certain insiders of insiders themselves potential insiders. Those entities, however, are not per se insiders.

Because of the conclusive presumption of preferential treatment that arises from a determination that an entity is a per se insider, the panel would not in effect add language to the statute to include MAPPS. Nor would it add language to make Salmon's spouse an affiliate. Therefore, under no pure definitional scheme found in the Bankruptcy Code could MAPPS be construed as an insider.

The panel recognized that under one circumstance, MAPPS could be held to be a per se insider — if, under the facts, the corporate form were to be disregarded and MAPPS were found to be an alter ego of Salmon's spouse. If the loan to Enterprise were to be found to have come from the spouse, and not MAPPS, then the insider relationship would exist.

The question, therefore, was whether, under California law and the facts as presented, MAPPS was a mere alter ego of Salmon's spouse. On this issue, the bankruptcy court's reasoning was confusing. On one hand, it concluded that MAPPS and Salmon's spouse were "one and the same;" on the other hand, it did not find that an inequitable result would occur if the corporate form were respected.

The panel, though, concluded that there was no evidence supporting a finding that MAPPS was the mere alter ego of Salmon's spouse.

The result — reversal and a ruling in favor of MAPPS.

From this case, we learn that the spouse of a corporate officer or director is an insider; the spouse's business, if properly established and maintained, is not. Loans from the corporation will not be deemed to have been made by an insider, even if the business of the corporation does not involve extending loans as a regular business activity. (This was true here.)

The lesson to be learned from this case is not so much its specific holding than the fact that every loan transaction should be thought through carefully. It may not be how much you lend, but how you lend it, that could make or break your rights in a bankruptcy case.

This article is reprinted with permission from the January 28, 2005 issue of The Legal Intelligencer.  Copyright 2005 ALM Properties, Inc.  Further duplication without permission is prohibited.  All rights reserved.