A preference defendant sought to amend its answer more than 21 months after the answer was filed to deny its “insider” status. The chapter 7 trustee objected on the basis of undue delay, prejudice, and futility.
Brooke Corporation and Brooke Capital filed bankruptcy in 2008. In early 2012 the Chapter 7 trustee filed a complaint against the preference defendant (CJD) seeking, among other things, to avoid preferential transfers made by Brooke Capital to CJD. The trustee alleged that CJD was an “insider” because it constituted an “affiliate,” and consequently the trustee could attack transfers made within a year prior to bankruptcy (as opposed to only 90 days, as is the case for a non-insider).
CJD was a wholly owned subsidiary of Brooke Brokerage Corporation, which was a wholly owned subsidiary of Brooke Corporation. Brooke Corporation also owned the majority of its subsidiary, Brooke Capital. In essence, CJD was an indirect sister corporation of Brooke Capital.
The original answer filed by CJD did not take issue with the allegation that it was an insider of the debtors. However, almost two years later, it sought leave to file an amended answer to deny that it was an insider.
The court declined to deny the motion on the basis of undue delay – noting that delay is not measured by time alone. Since there had been very little progress in the litigation, the court was not convinced that the trustee would be unduly prejudiced.
Consequently, the issue turned on whether the motion should be denied because the amendment would be futile – which turned on whether a limited liability company (LLC) is a corporation for purposes of definitions in the Bankruptcy Code. Specifically, the trustee argued that CJD was a per se insider of Brooke Corp. because:
- Section 101(31)(E) of the Bankruptcy Code defines an “insider” to include an “affiliate, or insider of an affiliate as if such affiliate were the debtor.”
- Section 101(2)(B) defines an “affiliate” to include a “corporation 20 percent or more of whose outstanding voting securities are directly or indirectly owned, controlled, or held with power to vote, by the debtor, or by an entity that directly or indirectly owns, controls, or holds with power to vote, 20 percent or more of the outstanding voting securities of the debtor.”
- Section 101(9)(A)(i) defines “corporation” to include “association having a power or privilege that a private corporation, but not as individual or a partnership, possesses.”
Since Brooke Corporation indirectly owned more than 20% of CJD, and also owned more than 20% of Brooke Capital, CJD and Brooke Capital would be affiliates if CJD was considered to be a corporation.
Although interpretation of the term “corporation” is a matter of federal law, the court turned to state law to define the powers and privileges of a limited liability company. The court noted that under applicable state law “an LLC is a business organization ‘which offers the possibility of combining the limitation on individual liability normally associated with the corporate form was a conduit tax treatment of items of income, gain, loss, deduction and credit normally associated with the partnership form.’”
Like a corporation, an LLC can own its own property and members do not have any interest in the LLC property. Similarly the LLC’s liabilities are limited to the LLC, and members and managers are not liable solely as a result of their status. Consequently, the court concluded that a limited liability company had the powers and privileges of a corporation, as opposed to an individual or partnership.
Turning to treatment by other courts: Other contexts in which it has been held that an LLC is within the definition of a corporation include (1) the ability to file a bankruptcy petition and (2) the requirement that an ownership statement be filed in an adversary proceeding. On the issue of whether LLCs come within the definition of corporation for purposes of being classified as an affiliate (and thus an insider), the court noted several cases in which other courts held that an LLC was an affiliate, either because it was sufficiently analogous to a corporation or because it came within the statutory definition.
In contrast, CJD advocated the approach taken in a 9th Circuit BAP case that held that “in light of the conclusive presumption of preferential treatment that arises from the determination that an entity is a per se insider, there is no justification for expanding the definition of per se insider beyond what is plainly contained in the statute.” Relying on that case, a couple of other cases held that an LLC was not an insider because it was not in the per se list of statutory insiders.
However, the Brooke court was persuaded that a limited liability company came within the statutory definition of corporation as used in the definition of an affiliate. Once it determined that CJD came within the definition of corporation, it followed that CJD was an affiliate of Brooke Corp. and Brooke Capital under the direct or indirect 20% voting control test, and consequently was an insider of both debtors. The court emphasized that it was not expanding the definitions by analogy, but rather was applying the definitions. Consequently, the court denied CJD’s request to amend its answer as futile since CJD was a per se insider.
Given that limited liability companies are so ubiquitous today, it is hard to remember that the legal landscape was very different when the Bankruptcy Code was enacted in 1978. States were just beginning to adopt LLC statutes, and the Internal Revenue Service was almost 20 years away from its “check the box” regulations (which significantly increased the flexibility in structuring LLCs). Given this context, it is not surprising that the Bankruptcy Code does not explicitly address LLCs. Since LLCs do not fit neatly into either corporate or partnership constructs, some interesting issues can arise in interpreting how the Bankruptcy Code applies to LLCs.
Vicki R. Harding, Esq.