United States Supreme Court to Decide Whether Recharacterization of Debt Should Be Decided by State or Federal Law

by Buchanan Ingersoll & Rooney PC
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On June 27, 2017, the United States Supreme Court granted the petition for writ of certiorari regarding the decision In re Province Grande Olde Liberty, LLC, 655 Fed.Appx. 971 (4th Cir. Aug. 12, 2016) to decide a circuit split on the applicable standard for debt recharacterization.

In Province Grande, the Fourth Circuit Court of Appeals affirmed the decisions of both the bankruptcy court and district court that had relied on the Bankruptcy Code to recharacterize a debt arising out of a loan transaction from a secured claim to an equity interest. The underlying transaction involved a series of real estate investments involving three separate limited liability companies that had a common member. The common member had obtained a loan from one LLC and additional outside secured financing to acquire certain real property in the name of another LLC. When that LLC defaulted and was unable to repay the secured loan, a third LLC was created to purchase the secured debt from the outside lender at a discount. The defaulting LLC eventually sought bankruptcy relief. During the bankruptcy, investors in the LLC that had loaned funds for the property acquisition sought to have the secured debt, now owed by the other LLC, recharacterized as a capital investment. The bankruptcy court applied an eleven factor test previously adopted by the Fourth Circuit Court of Appeals in In re: Official Committee of Unsecured Creditors for Dornier Aviation (North America), Inc., 453 F.3d 225 (4th Cir. 2006) that held that the Bankruptcy Code grants a bankruptcy court broad powers to recharacterize as equity obligations that are in the form of debt in order to implement the priority provisions of the Bankruptcy Code requiring debt to be paid before equity. The eleven factor test originated in a case from the Sixth Circuit, Bayer Corp. v. MascoTech, Inc. (In re AutoStyle Plastics, Inc.), 269 F.3d 726, 749-750 (6th Cir. 2001), which imported the test from Roth Steel Tube Co. v. Comm’r, 800 F.2d 625, 630 (6th Cir.1986), a federal tax case. The eleven factors include such things as the name of the instruments documenting the transaction, the source of repayments, the adequacy or inadequacy of capitalization of the debtor, and the relationship between the purported creditor and the equity holder to enable the court to look beyond the form of the transaction to the substance of the transaction. In affirming the decisions of the bankruptcy court and district court, the Fourth Circuit reiterated that the ability to recharacterize debt was integral to the consistent application of the Bankruptcy Code.

In seeking certiorari review, the petitioners argued that the circuit courts are split regarding whether state or federal law applies in deciding a request for debt recharacterization. The majority of circuit courts apply federal law, while two more recent cases, from the Fifth and Ninth Circuits, apply state law. The petitioners also argued that state law should apply because the Bankruptcy Code defers to state law to determine the allowance of a claim, with only certain specified exceptions, none of which is applicable to an attempted recharacterization. The respondents unsuccessfully challenged the assertion that the circuit courts are split on the standard for claim recharacterization and argued that it is just the analysis of that standard that differs between the circuits. The Supreme Court granted certiorari to determine whether bankruptcy courts should apply a federal rule of decision (as five circuits have held) or a state law rule of decision (as two circuits have held, expressly acknowledging a split of authority) when deciding to recharacterize a debt claim in bankruptcy as a capital contribution.

It is yet to be determined how the United States Supreme Court will rule but the outcome of this appeal could have a significant impact on lenders, especially those that also hold equity. If the Fourth Circuit is reversed, then recharacterization in a bankruptcy proceeding would be dictated by underlying state law, which could vary state by state and lead to inconsistent results. In our opinion, however, application of the law of most states would be less likely to result in recharacterization.    

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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