Ninth Circuit Overturns Longstanding Precedent in Ruling that Bankruptcy Courts Have Power to Recharacterize Debt Claims To Equity

In a recent decision, the Court of Appeals for the Ninth Circuit shocked observers by holding that bankruptcy courts have the power to recharacterize claims on account of unpaid debts as equity infusions that cannot be repaid until all creditor claims have been satisfied.  In In re Fitness Holdings Int’l, Inc., 714 F.3d 1141 (9th Cir. 2013), the court recognized recharacterization as a viable cause of action, and joined the Third, Fourth, Fifth, Sixth and Tenth Circuits and the countless lower courts that have long held that bankruptcy courts possess this considerable power.

Although no provision of the Bankruptcy Code authorizes a court to recharacterize debt as equity, courts outside the Ninth Circuit looked to the common law, and in particular to the bankruptcy courts’ equitable authority to ensure “that substance will not give way to form, that technical considerations will not prevent substantial justice from being done.” Pepper v. Litton, 308 U.S. 295, 305, 60 S. Ct. 238, 84 L. Ed. 281 (1939).  Notably, and in contrast to many Code-based challenges to secured and unsecured claims, recharacterization does not require a showing of misconduct.  Under the doctrine of recharacterization, courts technically do not alter any party’s substantive rights.  When a court recharacterizes a debt as equity, it is merely acknowledging economic reality by treating as equity a capital contribution that was only nominally a “loan” from the outset.  Indeed, the traditional focus of the recharacterization inquiry is whether a “debt” actually exists, and what is the proper characterization in the first instance of the investment at issue.

On its face, the dispute in the Fitness Holdings case seemed like an unlikely candidate to break new doctrinal ground.  The debtor in that case received significant prepetition funding from two sources: Hancock Park (its sole shareholder) and Pacific Western Bank. Between 2003 and 2006, Hancock Park provided more than $24 million to the debtor pursuant to eleven unsecured promissory notes.  In an adversary proceeding filed during the bankruptcy, the official committee of unsecured creditors sought, among other things, a declaration that the financing provided by Hancock Park to the debtor in connection with the promissory notes should be characterized as an equity investment.  In dismissing the declaratory relief claim, the bankruptcy court relied on In re Pacific Express, Inc., 69 B.R. 112 (B.A.P. 9th Cir. 1986), which held that recharacterization was an impermissible exercise of a bankruptcy court’s equitable power, as well as more than 25 years of adherence by Ninth Circuit courts to the conclusion of the court in that case.  On appeal by the trustee, the district court affirmed.

In finding that recharacterization is a viable remedy, the Ninth Circuit undertook an extensive analysis of fraudulent transfer law, and the “series of interlocking statutory definitions” that inform section 548 of the Code.  The court noted that while the term “reasonably equivalent value” is not defined in the statute, the term “value” is, and expressly includes “satisfaction or securing of a present or antecedent debt of the debtor.” Fitness Holdings Int’l, Inc., 714 F.3d at 1145.  The court then observed that “debt,” is defined by the Code as “liability on virtually any type of ‘right to payment.’”  Id. at 1146.  The court then concluded that where a transfer is made in satisfaction of a claim (i.e., right to payment), that transfer was made for “reasonably equivalent value” and cannot not be avoided as a fraudulent transfer absent fraudulent intent.  The court noted, however, that in order to determine whether an entity possesses a “right to payment” that constitutes a “claim” under section 548, a court must first consider whether the “transfer is for the repayment of a ‘claim’ at all,” the essence of the recharacterization analysis regularly undertaken by courts outside of the Ninth Circuit.  Id.   Thus, the court recognized the legitimacy of recharacterization actions, explicitly overruled Pacific Express and its progeny, and remanded for further proceedings on whether the Hancock Park claim should be treated as debt or equity.

While the Fitness Holdings decision marks an important step in building consensus between circuit courts regarding the scope a bankruptcy court’s equitable powers, it has also re-ignited a long simmering conflict between appellate courts regarding the standard that courts should apply in recharacterization actions.   The majority of courts, including the Third, Fourth and Sixth Circuits, determine the true nature of a claim by applying an 11-factor federal common law test that stresses the importance of the intent of the parties, the names given to the documents giving rise to the claim, the presence of fixed interest rates and maturity dates, the relationship between the claimant and the debtor, and the debtor’s ability to obtain financing from outside lending institutions.  In Fitness Holdings, the Ninth Circuit eschewed this dominant approach, and instead spoke favorably of the standard applied by the Fifth Circuit Court of Appeals, which bases recharacterization analyses on factors provided by applicable state law.  In so doing, the court solidified a split among the circuits on this issue, potentially setting up its eventual resolution by the Supreme Court.

Nevertheless, the Fitness Holdings decision represents an undeniable victory for trustees, creditors committees, and holders of general unsecured claims.  Indeed, due to the explosion of second lien financings and overleveraged capital structures over the past decade, general unsecured creditors regularly face a daunting mountain of secured debt ahead of them on the proverbial food chain that far exceeds the proceeds available for distribution to creditors.  Under these circumstances, the ability of unsecured creditors to receive a meaningful distribution from bankruptcy estates is often dependent upon unsecured creditors’ ability to recharacterize the claims of nominally secured creditors.  The Fitness Holdings decision provides litigants in California and elsewhere in the Ninth Circuit with a powerful new weapon in these disputes.

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