Averting an Inside Job: a Proposal to Change How Insiders Are Defined in the Bankruptcy Code
| Jurisdiction | United States,Federal |
| Publication year | 2017 |
| Citation | Vol. 34 No. 1 |
Averting an Inside Job: A Proposal to Change How Insiders Are Defined in the Bankruptcy Code
Johnathan D. Green
Are you a business debtor with massive unsecured debts and need your cramdown plan approved? Just sell the claims to a friend at a massive discount and have him vote to approve your plan over other creditors' objections. While this sounds absurd, under current insider jurisprudence in chapter 11 bankruptcies, this happens.
In most situations, the Bankruptcy Code prohibits insiders of businesses from seeking preferential treatment from a bankrupt debtor. One way the Code does this is through excluding an insider's vote from the plan approval process in a chapter 11 bankruptcy cramdown. But, if an insider can find a way to escape the narrow statutory insider definition in the Code, then the usual prohibitions on insider conduct may not apply.
In addition to the narrow, specified list of statutory insiders in the Code, courts have crafted various definitions of non-statutory insiders as well. This lack of uniform and predictable application has thwarted one of bankruptcy's main goals: the equitable treatment of creditors. This Comment examines courts' conflicting applications of insider rules, with a focus on chapter 11, and recommends a change to how insiders are defined in the Code to prevent inequitable outcomes for creditors.
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A. A Need for a Change
The chapter 11 bankruptcy process allows debtors to retain their assets, reorganize their debts, and pay off their creditors according to a plan of reorganization.1 Chapter 11 is utilized primarily by business debtors to maintain and preserve a functioning company, while modifying otherwise overwhelming debts, by spreading payments out over a repayment period or changing the terms of various debts according to a plan.2 Congress has crafted the Bankruptcy Code (the Code) to ensure that creditors and debtors receive equitable treatment and to minimize abusive use of Code provisions.3 One area of potential abuse that Congress addresses through the Code is the area of insiders.
Insiders are persons (which the Code defines broadly as including individuals and entities)4 who have clear self-interest in the outcome of a bankruptcy proceeding, such as directors, officers, or persons in control of a corporate debtor.5 Because of their close affiliation and personal stake in the reorganization, insiders are specifically prevented, among other things, from voting to approve a reorganization plan if they are also creditors holding any voting claims.6 Under the current statutory scheme, some individuals who appear to be insiders, but technically do not meet the statutory criteria, are permitted to vote on a reorganization plan and potentially force an otherwise non-confirmable plan upon dissenting creditors.7 This Comment will argue that this practice is abusive and thwarts Congress's intent to draft a Code that treats similarly situated creditors equitably.
To address this problem, Congress should amend the Code by changing how the Code defines "insider." Rather than the current inclusive list that allows courts to interpret whether a person fits the strict insider definition (thereby becoming statutory insiders), or is similar enough to be considered a non-statutory insider, Congress should define "insider" exclusively. This
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exclusive definition will improve predictability, prevent abusive claim selling by debtors, and better meet Congress's goals for chapter 11 bankruptcy.
This Comment proceeds by detailing the chapter 11 process, continues with an examination of the Code's current definition of "insider," and then explains the background and purposes of chapter 11 bankruptcy. Next, this Comment will set up the conflict between courts in defining non-statutory insiders, with some courts taking a liberal view of insiders and others taking a narrow view, and examine how commentators and courts alike have predicted future litigation and possible abuse. In the final section, this Comment will propose a solution that modifies how the Code defines insider so as to prevent these conflicting interpretations and potential abuses. This Comment will conclude with an explanation of the mechanics of the new definition's application, an examination of the benefits and potential drawbacks of a new definition, and the issues that will continue to inevitably arise with insider determinations.
B. The Chapter 11 Bankruptcy Process
1. Restructuring and the Automatic Stay
Chapter 11 bankruptcy provides for debt restructuring of businesses under a court confirmed plan of reorganization to repay creditors.8 While a chapter 7 bankruptcy proceeding is also available for business debtors, a chapter 11 bankruptcy allows a company to continue to operate during and (hopefully) after bankruptcy, thus avoiding asset liquidation and closing of the business.9 In a chapter 7, there is no chance of saving the business because all of the debtor company's assets are liquidated to satisfy its debts.10 Under a chapter 11, the debtor maintains the business and its assets and "may seek an adjustment of debts, either by reducing the debt or by extending the time for repayment, or may seek a more comprehensive reorganization.11 " Even if a debtor is not able to emerge successfully from a chapter 11 bankruptcy, the debtor is nonetheless protected by the automatic stay12 from the time the debtor
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files the petition until discharge, dismissal, or conversion to chapter 7.13 This at least gives the debtor a significant amount of time14 to try to save the business by providing a "breathing spell . . . during which negotiations can take place to try to resolve the difficulties in the debtor's financial situation."15 Ultimately, if a business is insolvent, but management is determined to continue operating in order to eventually salvage the company, chapter 11 is likely the proper choice.
2. Classifying Claims, Impairment, and Voting
The chapter 11 process involves preparing a reorganization plan, identifying creditor claims, determining if claims are impaired, and claim voting to approve or disapprove the plan. To begin a chapter 11 bankruptcy, a business files a petition with the bankruptcy court where the business is domiciled.16 A chapter 11 debtor, known as a debtor in possession,17 must file a number of additional documents and schedules that give creditors and the courts an understanding of the business's financial situation.18 One critical document that the debtor in possession must file is a plan of reorganization, which specifically proposes how the debtor intends to modify its debts based on the type of each creditor's claims.19 The debtor's plan must assemble each creditor's claim, defined broadly in the Code as a "right to payment,20 " into a class.21 Each claim represents a creditor's right to vote in the ultimate acceptance or rejection of a plan,22 so each creditor may have a number of claims based on distinct rights to payment.
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In addition to classifying claims, the Code specifies that a plan must provide for equal treatment of each class of claims and provide "adequate means for the plan's implementation."23 The plan must also specify each class of claims as either impaired or unimpaired.24 In essence, impaired claims are those claims held by creditors who are getting a proposed amount that is less than what was initially bargained for.25 As § 1124(a)(1) puts it, a creditor's claim under the plan is not impaired if the plan "leaves unaltered the legal, equitable, and contractual rights to which such claim or interest entitles the holder of such claim or interest,"26 or otherwise restores the claim to its unaltered state.27 Therefore, depending on the treatment of each creditor's claim, it will be classified in the debtor's plan as either impaired or unimpaired.28
The Code specifies that unimpaired claims are presumed to have accepted the plan because these creditors are getting the full benefit of their bargain.29 Thus, unimpaired claims are not entitled to vote on the plan.30 Claims that receive no payment are likewise presumed to have rejected the plan, and these claims are also not entitled to vote.31 Under the plan, any claim holder who gets more than nothing but less than the full amount of its claim is considered to have an impaired claim and must vote on the plan with the other claim holders within their class.32 Impaired claims, therefore, are the target audience of the debtor's plan of reorganization because, as we will see, the votes of these impaired claim holders can ultimately decide whether the business can successfully reorganize.
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Once a claim has been labeled as impaired or unimpaired under § 1124, titled "Impairment of claims or interest," the claim will be put into a class according to § 1122, titled "Classification of claims or interests."33 Section 1122 requires that a plan "may place a claim . . . in a particular class only if such claim . . . is substantially similar to the other claims" within the same class.34 Because the substantially similar requirement is not defined in the Code, the bankruptcy courts have been left to interpret its meaning; the courts have "broad discretion in matters of classification."35
Generally, courts interpret the substantially similar requirement by evaluating "the legal attributes of the claims, not who holds them," focusing on how the "legal character of claim relates to debtor's assets and whether claims exhibit similar effect on the bankruptcy estate."36 While all claims in a class must be substantially similar, not all claims that are substantially similar are required to be placed in the same class.37 Debtors are given some latitude to classify similar claims in different classes, so long as the purpose for the different classification is...
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