Fifth Circuit Rejects Per Se Rule that Recharacterization of Debt Applies Only to Corporate Insiders
The United States Court of Appeals for the Fifth Circuit reversed a district court’s decision which applied a per se rule prohibiting bankruptcy courts from recharacterizing contributions from anyone other than corporate insiders as equity. The Fifth Circuit concluded that recharacterization reaches beyond corporate insiders and is permitted under the bankruptcy court’s authority to allow and disallow claims under 11 U.S.C. § 502. As a consequence of the decision, both corporate insiders and non-insiders are subject to recharacterization of their claims as equity interests.
Bankruptcy Court Recharacterizes Claims as Equity Interests
In 2005, Israel Grossman (“Grossman”) and Lothian Oil, Inc. (“Debtor”) entered into two separate agreements, pursuant to which Grossman loaned Debtor $200,000 and $150,000, respectively. In return, Grossman was to receive a 1% royalty on Debtor’s oil production and a promise of repayment from the proceeds of a future equity placement in Debtor. Subsequently, Debtor filed for chapter 11 bankruptcy protection and Grossman filed numerous claims in the case relating to the “loans” made in 2005. Ultimately, the bankruptcy court rejected the majority of Grossman’s claims, holding that they asserted common equity interests at best or asserted claims against non-debtor entities for which the Debtor was not liable.
District Court Reverses Bankruptcy Court’s Recharacterization of Debt
Grossman, along with other claimants, appealed to the district court which affirmed in part and reversed in part the bankruptcy court’s ruling. Reversing the recharacterization of Grossman’s claims as equity, the district court cited the 11-factor test for distinguishing debt and equity set forth in Jones v. United States, 659 F.2d 618, 622 (5th Cir. 1981) and held that it would not extend the concept of debt recharacterization to non-insider creditors. Debtor then appealed to the Fifth Circuit, challenging the district court’s recharacterization decision, and Grossman cross-appealed, contesting the remainder of the district court’s holdings.
Fifth Circuit Affirms Recharacterized Claims
Rendering its decision on appeal, the Fifth Circuit began by rejecting the district court’s application of a per se rule prohibiting the bankruptcy court from recharacterizing contributions from anyone other than corporate insiders as equity. Alternatively, the Fifth Circuit concluded that recharacterization extends beyond insiders and is part of the bankruptcy courts’ authority to allow and disallow claims under § 502(b). In this regard, the Fifth Circuit relied upon § 502(b), which provides that a bankruptcy court is required to determine whether a claim is enforceable against the debtor under any agreement or “applicable law,” and noted that, the Supreme Court has interpreted the phrase “applicable law” as referring to state law unless Congress has stated otherwise. Butner v. United States, 440 U.S. 48, 54 (1979). Taking Butner and § 502(b) together, the Fifth Circuit concluded that where state law classifies an interest as equity rather than debt, implementing state law as envisioned in Butner requires that the court reclassify the claim rather than disallowing it in its entirety. See In re Dornier Aviation, Inc., 453 F.3d 225, 232 (4th Cir. 2006). In so holding, the Fifth Circuit declined to follow the reasoning other circuit courts that have approved recharacterization based on the bankruptcy courts’ equitable authority under 11 U.S.C. § 105(a), see, e.g., In re Submiron Sys. Corp., 432 F.3d 448, 454 (3d Cir. 2006), or based on the bankruptcy court’s equitable subordination power expressed in 11 U.S.C. § 510(c), see In re Autostyle Plastics, Inc., 269 F.3d 726, 748-49 (6th Cir. 2001), and instead found that the authority for recharacterization is provided more directly under § 502(b) and the Butner decision.
Applying this holding to the instant case, the Fifth Circuit resolved that, in recharacterizing Grossman’s claims, the bankruptcy court had properly considered numerous factors relevant under Texas law. Those factors included whether Grossman would be paid from royalties and “equity placements,” the lack of a specified interest rate, term of repayment, and maturity date, and affirmed its holding that Texas law would not have recognized Grossman’s claim as a debt interest, irrespective of whether he was a non-insider of Debtor. Arch Petroleum, Inc. v. Sharp, 958 S.W.2d 475, 477 (Tex.Ct.App. 1997).
Fifth Circuit Affirms Bankruptcy Court’s Recharacterization of Grossman’s Claims
Accordingly, the Fifth Circuit affirmed the bankruptcy court’s judgment and, in so doing, reversed the district court’s ruling that Grossman’s claims should not be recharacterized as equity because he was a non-insider.
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