On April 30, 2013, the United States Court of Appeals for
the Ninth Circuit held that the bankruptcy court has authority to
recharacterize as equity, rather than debt, advances of funds made purportedly
as a loan to the recipient prior to its bankruptcy. In re Fitness Holdings
International, Inc., --- F.3d ----, 2013
U.S. App. LEXIS 8729 (9th Cir. 2013) [an enhanced version of this opinion is available to lexis.com
subscribers]. The Ninth Circuit, in reversing the district court,
held that the fact that the same result of recharacterization can be obtained
through the statutory remedy of equitable subordination under section 510 of
the Bankruptcy Code does not deprive the bankruptcy court of the authority to
employ the separate and distinct remedy of recharacterization.
The dispute in Fitness Holdings
concerned a constructively fraudulent transfer claim under section 548(a)(1)(B)
of the Bankruptcy Code, seeking to undo certain pre-bankruptcy transfers made
in payment of a purported loan. In analyzing the fraudulent transfer claim, the
Ninth Circuit addressed two related issues: (i) whether the debtor "received
less than a reasonably equivalent value in exchange for such transfer or
obligation," and (ii) whether the court has the authority to recharacterize the
With respect to the first issue, the Court concluded that
a transfer is made for a "reasonably equivalent value" if it is made in
repayment of a claim that the Court concluded to be a "right to payment"
determined under state law.
Regarding the second issue, the Court held that "a court
may recharacterize an obligation that does not constitute 'debt' under state
law." In so holding, the Court disagreed with the decision of the Ninth Circuit
BAP in In re Pacific Express, Inc., 69 B.R. 112, 115 (B.A.P. 9th Cir.1986))
[enhanced version], which held that bankruptcy courts
were limited to the statutory remedy of equitable subordination under 11 U.S.C.
§ 510. The Court found the BAP's conclusion to be incorrect because
"recharacterization and equitable subordination address distinct concerns."
In holding courts have the authority to recharacterize
claims, the Ninth Circuit joins other circuits, including the Fifth Circuit
that reached a similar conclusion in In re Lothian Oil, 650 F.3d 539,
542-43 (5th Cir. 2011) [enhanced version]. The Ninth Circuit also approved
of the Fifth Circuit's approach to recharacterization. According to the Ninth
Circuit, Lothian Oil's multi-factor approach based on state law for
distinguishing between debt and equity, rather than a federal test based on the
court's equitable power under 11 U.S.C. § 105, is the approach more consistent
with the Supreme Court precedent.
lends significant strength to a claim of recharacterization in the Ninth
Circuit, which was previously perceived to be difficult to maintain. It is now
possible to make a claim for recharacterization separate from and in addition
to a claim for equitable subordination under section 510 of the Bankruptcy
Code. In contrast to equitable subordination, recharacterization does not
usually require a finding of inequitable conduct. As such, the lack of
inequitable conduct by parties extending credit to a potentially troubled
company can no longer insulate their claims from being relegated to a lower
priority in the company's potential bankruptcy case. In addition, such parties
should be vigilant in ensuring that the terms of such credit are properly
documented in compliance with the applicable state law requirements for
creating a "right to payment."
This article is not intended to provide legal or
other advice or to create an attorney-client relationship.
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