In a new, unpublished decision1 in the U.S. Court of Appeals, the Fourth Circuit affirmed a bankruptcy court’s order re-characterizing a portion of a loan to a bankruptcy debtor purchased by a creditor as equity instead of debt, impairing that creditor’s ability to recover from the debtor.

Because in bankruptcy, equity gets paid last and usually not at all, a lender may find it is “out of the money” if it doesn't properly perform its due diligence at the outset of the loan or loan purchase, or if it fails to document the loan or loan purchase correctly. In this particular decision, the Appeals Court found the following factors paramount in affirming the bankruptcy court’s decision to re-characterize the debt as equity:

  • The loan arose from a settlement agreement of a previous debt;
  • The debtor's principals negotiated the settlement and debt acquisition on behalf of the lender;
  • Formalities of payment schedules, interest payments, and ledgers on the debt were disregarded by the lender and debtor;
  • The seeming inability of the debtor to obtain other financing from more traditional sources;
  • The overlapping identities of interest between the debtor and creditor; and
  • The purchase of the loan by the lender was secured by a lien on the debtor’s property.

This decision shows that bankruptcy courts will look beyond the form of a transaction to the substance and draw conclusions from the conduct and relationship of the debtor and its lenders.  

Businesses are advised to consult with experienced attorneys who have knowledge of creditors’ rights and commercial bankruptcy to ensure that their loans or loan purchase transactions can withstand scrutiny as bona fide loans, and not later be subject to re-characterization as equity investments in their borrowers.  

It is worth noting that the risks are especially heightened where a lender has an insider relationship with the debtor, where the debt arose from settlement of an earlier credit, or where the transaction could skeptically be viewed as an infusion of cash into the business.