Members May Be Insiders of an LLC Debtor in the Seventh Circuit

Contributed by Frank Grese
In a recent decision, In re Longview Aluminum, L.L.C., No. 10-2780, 2011 U.S. App. LEXIS 18302 (7th Cir. Sept. 2, 2011), the United States Court of Appeals for the Seventh Circuit affirmed the holdings of both the bankruptcy court and district court that a member of a limited liability company can be an “insider” of a debtor for purposes of the preference lookback period under section 547(b) of the Bankruptcy Code.
Section 547(b)(4)(A) of the Bankruptcy Code empowers a bankruptcy trustee to avoid certain transfers made by a debtor to a non-insider within 90 days of the debtor’s bankruptcy filing.  Section 547(b)(4)(B), however, extends the avoidance period with respect to payments made by a debtor to an “insider” to one year before the bankruptcy filing.  Although section 101(31)(B) of the Bankruptcy Code defines what constitutes an “insider” for a corporation, and section 101(31)(C) sets forth what constitutes an “insider”  of a partnership, the Bankruptcy Code provides no express guidance for what entities may be considered “insiders” of a limited liability company.
The Longview debtor was a Delaware limited liability company that had been formed by five members, each of whom sat on the debtor’s Board of Managers.  Among the members of the Board were appellant Dominic Forte, who held a 12 percent interest in Longview, and Michael Lynch, whose 50 percent interest was the largest interest in Longview.  Longview’s three other Board members held a combined 38 percent interest.  From 2001 until mid-2002, Forte repeatedly requested access to Longview’s business records, but was never granted access.  Forte eventually sued Lynch, alleging that Lynch used his controlling interest to prevent Forte from obtaining access to Longview’s business records and exclude Forte from participating in any management decisions.  All the members of the Board other than Forte subsequently executed a majority written consent formally suspending Forte’s right to access Longview’s records until, among other things, the completion of an investigation into whether Forte’s requests were made for a proper purpose.
On November 7, 2002, Forte and the defendants to Forte’s lawsuit entered into a settlement agreement under which Forte would be paid $400,000, plus attorney’s fees and costs, in exchange for Forte’s agreement to leave the Board.  That same day, Forte received a $200,000 initial payment from Longview.  On March 4, 2003, Longview filed a chapter 11 bankruptcy petition, and the bankruptcy trustee eventually commenced an adversary proceeding against Forte seeking to recover the settlement payments as preferential transfers made to an insider within one year of Longview’s bankruptcy filing.  The bankruptcy court ruled in the trustee’s favor, finding Forte to be an insider as defined by section 101(31) of the Bankruptcy Code, thereby avoiding the $200,000 transfer.  On appeal, the district court affirmed the bankruptcy court, and Forte appealed to the Seventh Circuit.
The Seventh Circuit began its analysis by noting that the insider analysis is a case-by-case decision based on the totality of circumstances.  The court then described two approaches that courts consider when conducting an insider analysis.  One approach, sometimes referred to as the “similarity” approach, focuses on the similarity of the alleged insider’s position to the enumerated categories set forth in section 101(31).  For a corporation, an “insider” would include a director of the debtor; officer of the debtor; person in control of the debtor; partnership in which the debtor is a general partner; general partner of the debtor; or relative of a general partner, director, officer, or person in control of the debtor.
Another approach, however, focuses on the alleged insider’s control of the debtor.  Under this approach, courts often examine the closeness of the relationship between the parties to determine whether the alleged insider’s conduct should be subject to closer scrutiny than those dealing at arm’s length with the debtor.
Forte argued that the district court erred when it applied the similarity approach by improperly analogizing a director of a corporation to a member of an LLC and expanding the term “director” in the definition to include members and managers of an LLC.  The Seventh Circuit disagreed, noting that the definition of insider is not an exhaustive list and has been expanded by courts to include positions analogous to those enumerated, including in the LLC context.  The court explained that when the position held by an alleged insider is not enumerated in section 101(31), the relevant inquiry is whether the relationship at issue is similar to or has characteristics of any of the statute’s defined relationships.
The Seventh Circuit also found that the district court properly applied the similarity approach by consulting both Delaware corporate and LLC law to properly analogize a director of a corporation to a member of an LLC.  Delaware law provides that a corporation must “be managed by or under the direction of a board of directors . . . .” 8 Del. C. § 141(a).  With respect to an LLC, Delaware law states that “[u]nless otherwise provided in a limited liability company agreement, the management of a limited liability company shall be vested in its members . . . .” 6 Del. C. § 18-402.  Based on the above, the district court found a member of an LLC analogous to a director of a corporation because directors generally have the authority to manage a corporation and members generally have the authority to manage an LLC.
Forte argued that because an LLC manager’s powers can be specified by an LLC agreement, an LLC manager’s authority can be vastly different from that of a director of a corporation, depending on the LLC agreement, and therefore, the district court’s analogy was incorrect.  The Seventh Circuit rejected such reasoning, noting that the default position under Delaware law is that authority is vested in the members of an LLC.  In addition, the court noted that Longview’s own LLC agreement specifically provided its members with authority analogous to that of a director of a corporation.  Consequently, the court found that the district court did not err in concluding that a member of an LLC can be a statutory insider within the meaning of section 101(31)(B) of the Bankruptcy Code.
The Seventh Circuit clarified, however, that the alleged insider’s title by itself does not necessarily render an individual an insider; instead, it is also necessary to examine the alleged insider’s relationship to the debtor so as to understand the legal rights that party actually holds.  Forte argued that he had no control over Longview because he was prevented from managing or participating in a meaningful way in some of Longview’s affairs and pointed to his inability to access Longview’s books and records and the formal written consent executed by a majority of the Board that excluded him from viewing Longview’s books and records.  In response, Longview argued that the written consent only temporarily suspended Forte’s access to its books and records and, moreover, did not remove Forte from his position as a member of the Board.  The Seventh Circuit rejected Forte’s argument, concluding that he retained meaningful rights and control given to members under Longview’s LLC agreement and pointed to the fact that there was never a formal vote or document executed that removed Forte’s member status.  The court found it significant that Forte retained voting rights in the debtor and still held a position on the Board at the time that the $200,000 transfer was made.
The Seventh Circuit also distinguished case law cited by Forte for the proposition that an individual in a position akin to a director was found not to have insider status because such individual did not actively participate in corporate management.  The court emphasized that in those cases, unlike Longview, the officer, director, or member completely relinquished, either by sale, ouster, or otherwise, all of his or her rights and authority in the respective corporation or LLC, but his or her resignation or departure was not formalized until later.  The court noted that the individuals in those cases had surrendered all rights in the company before their formal resignation or departure, whereas Forte still had rights and control over Longview as a member of the Board.
Finally, the Seventh Circuit held that when the issue before the court is whether a member of an LLC is a statutory insider, the similarity approach should be applied instead of the control approach because such an approach “yields a better interpretation of the statute.”  Forte had contended that because members and managers of an LLC are not included within section 101(31), the district court should have applied the control approach instead of the similarity approach.
Notably, the Longview court did not directly address what the result might have been if Forte exclusively had been a 12% member, and not a Board member.  Under section 101(2) of the Bankruptcy Code, an “affiliate,” generally speaking, is defined as having 20% or more of the direct or indirect voting power in the debtor, and an affiliate is a statutory insider of the debtor pursuant to section 101(31)(E).  One might argue that, even under a similarity test, particularly when a board is in place for an LLC, a member holding only a 12% interest in an LLC should not be considered an insider because a shareholder that only held a 12% direct or indirect stake in a debtor, without more, would not be considered an insider.  Whether the fairly expansive test applied in Longview will be adopted remains to be seen.  At least in the Seventh Circuit, even when an LLC member is made by the other members to feel like an outsider, it should understand the risk that it may still be considered an insider.