A Cautionary Tale For Insider Lenders: Ninth Circuit Endorses Recharacterization Remedy In Bankruptcy

The ability of a bankruptcy court to reorder the priority of claims or interests by means of equitable subordination or recharacterization of debt as equity is generally recognized. Even so, the Bankruptcy Code itself expressly authorizes only the former of these two remedies. Although common law uniformly acknowledges the power of a court to recast a claim asserted by a creditor as an equity interest in an appropriate case, the Bankruptcy Code is silent upon the availability of the remedy in a bankruptcy case. This has led to uncertainty in some courts concerning the extent of their power to recharacterize claims and the circumstances warranting recharacterization. The Ninth Circuit Court of Appeals recently had an opportunity to consider this issue. In Official Committee of Unsecured Creditors v. Hancock Park Capital II, L.P. (In re Fitness Holdings International, Inc.), 714 F.3d 1141 (9th Cir. 2013), the court ruled that "a court has the authority to determine whether a transaction creates a debt or an equity interest for purposes of § 548, and that a transaction creates a debt if it creates a 'right to payment' under state law." By its ruling, the Ninth Circuit overturned longstanding Ninth Circuit bankruptcy appellate panel precedent to the contrary and became the sixth federal circuit court of appeals to hold that the Bankruptcy Code authorizes a court to recharacterize debt as equity. The decision is a cautionary tale for private equity sponsors and other corporate insiders who advance money to their businesses, as well as lenders considering taking an equity stake in a borrower.

Equitable Subordination and Recharacterization

Although the distinction between courts of equity and law has largely become irrelevant in modern times, courts of equity have traditionally been empowered to grant a broader spectrum of relief in keeping with fundamental notions of fairness, as distinguished from principles of black-letter law. One of the tools available to a bankruptcy court in exercising its broad equitable mandate is "equitable subordination." Equitable subordination is a remedy developed under common law prior to the enactment of the current Bankruptcy Code to remedy misconduct that results in injury to creditors or shareholders. It is expressly recognized in Bankruptcy Code section 510(c), which provides that the bankruptcy court may, "under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest." However, the statute explains neither the concept nor the standard that should be used to apply it. This has been left to the courts. In In re Mobile Steel Co., 563 F.2d 692 (5th Cir. 1977), the Fifth Circuit Court of Appeals articulated what has become the most commonly accepted standard for equitable subordination of a claim. Under the Mobile Steel standard, a claim can be subordinated if the claimant engaged in some type of inequitable conduct that resulted in injury to creditors (or conferred an unfair advantage on the claimant) and if equitable subordination of the claim is consistent with the provisions of the Bankruptcy Code. Courts have refined the test to account for special circumstances. For example, many courts make a distinction between insiders (e.g., corporate fiduciaries) and noninsiders in assessing the level of misconduct necessary to warrant subordination. A related but distinct remedy is "recharacterization." Like equitable subordination, the power to treat a debt as if it were actually an equity interest is derived from principles of equity. It emanates from the bankruptcy court's power to ignore the form of a transaction and give effect to its substance. However, because the Bankruptcy Code does not expressly empower a bankruptcy court to recharacterize debt as equity, some courts disagree as to whether they have the authority to do so and, if so, the source of such authority. According to some courts (albeit a minority), because the statute authorizes subordination but is silent concerning recharacterization, Congress intended to deprive bankruptcy courts of the power to recharacterize a claim. This was the approach taken by a Ninth Circuit bankruptcy appellate panel in In re Pacific...

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