Court recharacterizes claim, declines to adopt a per se rule that recharacterization only applies to insiders

Grossman v. Lothian Oil Incorporated, 650 F.3d 539 (5th Cir., 2011)  

CASE SNAPSHOT

In a case of first impression in the Fifth Circuit, the court recharacterized a claim of a non-insider, declining to create a per se rule that recharacterization could only apply to insiders.

FACTUAL BACKGROUND

Mr. Israel Grossman executed two “loans” with the corporate Secretary of Lothian Oil Incorporated, pursuant to which Grossman loaned Lothian $350,000 in exchange for, inter alia, a specified percentage of royalties related to Lothian’s share of gross production of oil and gas from properties in New Mexico. The loans included no specified interest rate, repayment terms or maturity date. Two years later, Lothian Oil filed its chapter 11 petition. Grossman filed proofs of claim based on the two “loan” documents. In evaluating those claims, the Bankruptcy Court held that Grossman’s interests were common equity interests, and that, at best, insufficient evidence of the value of those interests had been presented. The District Court affirmed in part and reversed in part. Notably, the District Court reversed the lower court’s recharacterization of Grossman’s interests as equity, and “declin[ed] to extend the concept of debt recharacterization to a non-insider creditor.” The debtor appealed to the Fifth Circuit Court of Appeals.

COURT ANALYSIS

The Court of Appeals, in this case of first impression in the Fifth Circuit, rejected the District Court’s contention that there is a per se rule prohibiting the recharacterization of non-insider claims. Instead, the Court of Appeals held that recharacterization may apply to non-insiders as well as insiders.  

The court determined that the correct framework for evaluating the claim is to look to the applicable state law. Specifically, the court held that, although section 502(b) of the Bankruptcy Code permits a bankruptcy court to recharacterize claims, it must rely on state law to determine if a claim characterized as debt is, in fact, debt, or if it is equity. The court applied Texas state law to the Grossman documents, and concluded that Grossman’s interests were equity interests. In particular, the court noted that there was no specified interest rate, repayment term or maturity date, and that Grossman would be repaid from royalties (which depended on Lothian’s success) rather than interest and principal payments. “Because Texas law would not have recognized Grossman’s claims as asserting a debt interest, the bankruptcy court correctly disallowed them as debt, and recharacterized the claims as equity interests. Moreover, because insiders and non-insiders alike can mischaracterize their claims in contravention of state law, we decline to limit recharacterization to insider claims.”  

PRACTICAL CONSIDERATIONS

Bankruptcy courts look to state law to define property and the nature of property interests. As a result, per se rules prohibiting the recharacterization of non-insider claims will not be adopted by the bankruptcy court unless they are supported by the applicable state law.