Fifth Circuit Rejects Per Se Rule That Recharacterization Applies Only to Insiders

In a recent ruling, the Fifth Circuit Court of Appeals rejected a per se rule that only corporate insiders can have their debt claims recharacterized as equity. Instead, in In re Lothian Oil Inc., 2011 WL 3473354 (5th Cir. Aug. 9, 2011), the Court of Appeals held that "recharacterization extends beyond insiders and is part of the bankruptcy courts' authority to allow and disallow claims under 11 U.S.C. § 502." Thus, all creditors, regardless of their insider status, are susceptible to having their claims recharacterized as equity.

While the case involved extensive litigation between the parties, the issue decided by the Court of Appeals – whether a bankruptcy court can recharacterize a claim as equity rather than debt – focused on two agreements between the debtor Lothian Oil Inc. ("Lothian") and a non-insider third-party, Israel Grossman ("Grossman"). Specifically, on each of April 27 and May 12, 2005, Grossman and Lothian signed documents pursuant to which Grossman "loaned" Lothian $200,000 and $150,000, respectively. Both agreements provided that Grossman would receive a royalty of one percent of Lothian's share of gross production of oil and gas on certain properties and that each of the loan amounts would be repaid from the proceeds of an equity placement made in Lothian.

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