Lenders Beware: Debt Can Now Be Recharacterized as Equity in the Ninth Circuit

For the last 27 years, bankruptcy courts in the Ninth Circuit consistently held that debt could not be recharacterized as equity unless the movant proved inequitable conduct by the debt holder. On April 30, 2013, the Ninth Circuit Court of Appeals rejected that precedent and joined other circuit courts in holding that bankruptcy courts do have the authority to recharacterize a loan as an equity investment to the extent allowed under state law even without inequitable conduct. This decision has obvious implications for loans whose repayment schedule, interest rate or other terms, among other things, are suspect.

The Fitness Holdings Background

Hancock Park, the sole shareholder of Fitness Holdings, made subordinated unsecured loans to Fitness Holdings totaling more than $24 million. A bank made a $7 million revolving loan and $5 million installment loan to Fitness Holdings secured by all of Fitness Holdings' assets and guaranteed by Hancock Park. In 2007, the bank agreed to refinance Fitness Holdings' debt. The bank issued Fitness Holdings a new $17 million term loan and an $8 million revolving line of credit, of which $8.8 million was used to pay off the bank's original secured loan, and $11.9 million was used to pay off Hancock Park's unsecured loans.

In October 2011, Fitness Holdings filed chapter 11 in the Central District of California. First, the Unsecured Creditors' Committee, and then after the bankruptcy case was converted to chapter 7, the bankruptcy trustee sued Hancock Park, the bank, and Fitness Holdings' principals to recover the $11.9 million paid to Hancock Park on the grounds that the Hancock Park's debt was really equity. They argued the payment of $11.9 million for Hancock Park's "loans" was a fraudulent transfer and must be returned to the estate. Relying on the Ninth Circuit Bankruptcy Appellate Panel's decision in In re Pacific Express, Inc., 69 B.R. 112 (B.A.P. 9th Cir. 1986), the bankruptcy court dismissed the complaint stating that Hancock Park's debt could not be recharacterized as equity. On appeal, the district court affirmed. The bankruptcy trustee appealed to the Ninth Circuit.

The Ninth Circuit Decision

The Ninth Circuit Court of Appeals vacated and remanded, holding that bankruptcy courts can recharacterize debt as an equity investment to the extent allowed under state law. In re Fitness Holdings Int’l, __ F.3d __, No. 11-56677 (9th Cir. 2013).

The claim asserted against Hancock Park was that the payment it received from the refinancing was a constructively fraudulent transfer. Under the Bankruptcy Code, a transfer by a debtor may be avoided and recovered for the estate's creditors if the debtor does not receive “reasonably equivalent value” in exchange for the transfer and the debtor is insolvent or undercapitalized at the time the transfer was made. Although the Bankruptcy Code does not define "reasonably equivalent value," it does define the term "value" as including the "satisfaction or securing of a present or antecedent debt of the debtor." Therefore, to the extent a transfer is repayment of the debtor’s debt, the transfer is not constructively fraudulent. The terms "debt" and "claim" are both defined under the Bankruptcy Code as a "right to payment." Thus, if a transfer is made in satisfaction of a debt, that is, the creditor's "right to payment," such as an outstanding loan, then the transfer is made for “reasonably equivalent value” and cannot be avoided. Following a Supreme Court ruling, the Ninth Circuit concluded that state law determines whether a transaction (i.e., purported loan) gives rise to a "right to payment" and that therefore the fraudulent transfer claim should not have been dismissed.

In ruling that a bankruptcy court has authority to and should determine whether a purported loan actually constitutes a “right to payment” under state law, the Ninth Circuit rejected the Ninth Circuit Bankruptcy Appellate Panel’s Pacific Express decision and sided with the majority of other circuit courts (Third Circuit, Fourth Circuit, Fifth Circuit, Sixth Circuit, and Tenth Circuit), which previously determined that courts are authorized to recharacterize debt as an equity interest in the debtor.

The Ninth Circuit noted three different recharacterization analyses adopted by other circuits. The Ninth Circuit rejected two of these, which rely on various provisions of federal and/or tax law. The Ninth Circuit adopted the Fifth Circuit’s approach as set forth in In re Lothian Oil, 650 F.3d 539, 542-43, holding that claims must be defined under state law and that courts must recharacterize purported debt as equity investments where state law would do so. Rather than ruling on the recharacterization issue on the record before it, the Ninth Circuit vacated the district court’s dismissal of the trustee’s fraudulent transfer claim and remanded the matter back to the bankruptcy court for further proceedings.

Implications

Because Fitness Holdings confirms bankruptcy court authority to recharacterize debt as equity investments within the Ninth Circuit, we can expect that insider loans will now be subject to close scrutiny and recharacterization challenges by unsecured creditor committees and/or trustees. Since bankruptcy courts within the Ninth Circuit can and should now look to state law to determine whether a loan may be an equity investment, insider lenders should consider choice of law in documenting financing transactions, in addition to making sure the borrower is adequately capitalized and their loans are on market terms.

Topics:  Debt, Equity Investors, Lenders, Loans, Re-Characterization

Published In: Bankruptcy Updates, Civil Procedure Updates, General Business Updates, Finance & Banking Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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