Ninth Circuit Overrules Longstanding (But Questionable) Bankruptcy Appellate Panel Precedent To Allow Bankruptcy Court To Re-Characterize Debt As Equity

Bankruptcy trustees and lenders to a potentially insolvent debtor — particularly any lender who has or intends to acquire an equity stake in the borrower — should take note of a recent decision by the U.S. Ninth Circuit Court of Appeals. In Official Committee of Unsecured Creditors v. Hancock Park Capital II, LP (In re Fitness Holdings Int'l, Inc.), __ F.3d __; Case No. 11-56677, slip op., (9th Cir. April 30, 2013), the Ninth Circuit overturned a longstanding - albeit criticized - decision by the Ninth Circuit Bankruptcy Appellate Panel and held that a bankruptcy court has the power to retroactively determine whether an advance of money from a party to a debtor should be characterized as an equity contribution or loan. The decision also clarified the standards a bankruptcy court must apply in making that determination. The decision is important to lenders in that it offers guidance on how to structure loan transactions in order to insulate them from the risk that a bankruptcy court will treat their advances as equity contributions, and it offers trustees and other representatives of a bankruptcy estate a roadmap for treating a less than careful lender not as a creditor, but as an equity owner who stands behind all other creditors for purposes of receiving distributions from the debtor's estate, and for purposes of applying the Bankruptcy Code's avoidance powers.

In In re Fitness Holdings, the Official Committee of Unsecured Creditors appointed in the debtor's case sued Hancock Park Capital II, L.P., the debtor's former majority shareholder, alleging that the debtor's payment of nearly $12 million to Hancock Park was avoidable as a constructively fraudulent conveyance under 11 U.S.C. § 548(a). Hancock Park moved to dismiss the complaint arguing that the $12 million repaid pre-existing loans it had made to the debtor, and therefore, the debtor necessarily received "reasonably equivalent value" (i.e., in the form of reduction of that indebtedness) in exchange for the payment which barred the fraudulent conveyance claim in the complaint. Although acknowledging that Hancock Park had infused cash to the debtor and taken promissory notes stating that the infusions were loans, the Creditors Committee responded by contending that Hancock Park's original infusions of cash should be re-characterized as equity contributions, and therefore, the debtor's payment was an avoidable fraudulent conveyance because it did not reduce any "debt" owed to Hancock...