Ninth Circuit Widens Circuit Split Over Application of State or Federal Bankruptcy Law To Determine Whether Claims of Insider-Lenders Should be Recharacterized as Equity

In an important decision for private equity sponsors and other insiders who advance loans to their businesses, on April 30, 2013, the Ninth Circuit Court of Appeals in In re Fitness Holdings International confirmed that bankruptcy courts may recharacterize debt as equity, but held that recharacterization is determined by state law. In its ruling, the Ninth Circuit joins the U.S. Court of Appeals for the Fifth Circuit in deferring to state law on this issue and explicitly rejects the various federal law based tests that have been adopted by a majority of U.S. Circuit Courts of Appeal. Under the Ninth Circuit’s approach, choice of law provisions in loan documentation will play a more important role in litigation over insider-debt transactions.

The Insider Loans -

Between 2003 and 2006, Fitness Holdings issued approximately $24 million of promissory notes with maturities ranging from 2006 to 2009 to its sole shareholder, Hancock Park. In June 2007, Fitness Holdings refinanced its debt with a $17 million term loan and an $8 million revolving loan. The loan agreement for the refinancing specified that approximately $9 million of the newly extended loans should be used to payoff existing bank loans, and approximately $12 million should be used to payoff Hancock Park’s promissory notes.

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