The US Court of Appeals for the Ninth Circuit recently resolved a split within the circuit when it held that a bankruptcy court has the power to recharacterize debt as equity. In In re Fitness Holdings International, Inc., the Ninth Circuit held that a bankruptcy court has the authority to recharacterize debt for the purposes of determining whether a transfer was fraudulent under section 548 of the Bankruptcy Code and “that a transaction creates a debt if it creates a ‘right to payment’ under state law.” In reaching its decision in Fitness Holdings, the Ninth Circuit joined the five other circuit courts that have reached the same conclusion that bankruptcy courts have the authority to recharacterize claims. Indeed, no circuit court has held to the contrary. These circuits have, however, applied varying legal standards for recharacterization.

In re Fitness Holdings International, Inc. -

Background -

Between 2003 and 2006, Fitness Holdings (the “Debtor”) executed 11 subordinated promissory notes in favor of Hancock Park, the Debtor’s sole shareholder, in the aggregate amount of $24,276,065. In July 2004, Pacific Western Bank made a $7 million revolving loan and a $5 million term loan to the Debtor, which were secured by all of the Debtor’s assets and guaranteed by the shareholder. Over the next three years, the parties amended the secured loans on numerous occasions.