Introduction

For nearly 30 years, bankruptcy courts within the Ninth Circuit were prohibited from recharacterizing purported debt as equity. This prohibition stemmed from a 1986 decision by the Ninth Circuit Bankruptcy Appellate Panel entitled In re Pacific Express, Inc., 69 B.R. 112 (B.A.P. 9th Cir. 1986). Under Pacific Express, the Bankruptcy Code “did not authorize courts to characterize claims as equity or debt, but limited courts to the statutory remedy of equitable subordination under [Bankruptcy Code section 510].” On April 30, 2013, the Ninth Circuit Court of Appeals, in In re Fitness Holdings Int’l, ­__ F.3d __, No. 11-56677 (9th Cir. 2013), reversed the long-standing precedent established by Pacific Express and recognized the authority of bankruptcy courts to recharacterize debt as equity to the extent allowed under state law.

The Fitness Holdings Transaction and Lower Court Rulings

Between 2003 and 2006, Fitness Holdings issued approximately US$24 million of promissory notes to its sole shareholder Hancock Park, with maturities ranging from 2006 to 2009. In June 2007, Fitness Holdings refinanced its debt with a US$17 million term loan and an US$8 million revolving loan. The loan agreement for the refinancing specified that approximately US$9 million of the newly extended loans should be used to pay off existing bank loans, and approximately US$12 million should be used to pay off Hancock Park’s promissory notes. On October 20, 2008, Fitness Holdings filed a Chapter 11 bankruptcy case in the Central District of California.

In the Fitness Holdings bankruptcy case, the unsecured creditors’ committee filed an adversary complaint against Hancock Park seeking to recover the payments on Hancock Park’s promissory notes as constructively fraudulent transfers, and to characterize the financing provided by Hancock Park as equity investments rather than loans. The bankruptcy court dismissed the claims against Hancock Park based on Pacific Express. On appeal, the district court upheld the bankruptcy court’s decision, finding that the district court lacked the authority to recharacterize Hancock Park’s loans as equity investments. The Chapter 7 trustee then further appealed to the Ninth Circuit Court of Appeals.

The Ninth Circuit Decision

Under Bankruptcy Code §548 and §550, a transfer by a debtor may be avoided as a constructively fraudulent transfer if a debtor does not receive “reasonably equivalent value” in exchange for the transfer, and if one of five additional conditions listed in §548(a)(1)(B)(ii) is present. The Ninth Circuit noted at the outset that, although the Bankruptcy Code does not define the phrase “reasonably equivalent value,” it does define the term “value” as including the “satisfaction or securing of a present or antecedent debt.” Based on this, the Ninth Circuit reasoned that a transfer is not constructively fraudulent “to the extent (the) transfer constitutes repayment of the debtor’s antecedent or present debt….” Thus, if a transfer is made in satisfaction of a “right to payment,” such as satisfaction of an outstanding loan, then the transfer is made for “reasonably equivalent value” and cannot be constructively fraudulent under §548. Further, the court held that under US Supreme Court precedent (Butner v. United States, 440 US 48 (1979)), whether a transaction gives rise to a right to payment should generally be determined by state law.

In ruling that a bankruptcy court has authority to determine whether a purported loan actually constitutes a “right to payment” under state law, the Ninth Circuit expressly rejected the Ninth Circuit Bankruptcy Appellate Panel’s Pacific Express decision, and sided with the majority of other US Circuit Courts of Appeal (3rd Circuit, 4th Circuit, 5th Circuit, 6th Circuit, and 10th Circuit), which had previously determined that bankruptcy courts are authorized to recharacterize debt as equity.

The Ninth Circuit then noted three approaches to recharacterization analysis that had been adopted in other circuits. The Ninth Circuit rejected two of these approaches, which rely on various provisions of federal law, as inconsistent with Butner. The Ninth Circuit ultimately adopted the Fifth Circuit’s approach as set forth in In re Lothian Oil, 650 F.3d 539, 542-43 (holding, under Butner, that claims must be defined under state law and that courts must recharacterize purported debt as equity where state law would do so). Rather than ruling on the recharacterization issue in the first instance, the Ninth Circuit vacated the district court’s dismissal of the trustee’s constructive fraudulent transfer claim and remanded the matter back to the bankruptcy court for further proceedings consistent with the Ninth Circuit’s approach as set forth above.

Implications

Because Fitness Holdings confirms bankruptcy court authority to recharacterize debt as equity, it has obvious implications on insider loans and similar transactions within the Ninth Circuit, which will now be subject to possible review and recharacterization by bankruptcy courts. In addition, the Ninth Circuit’s decision widens a circuit split over the applicable choice of law for debt recharacterization. State law may be less developed on recharacterization, and may be more or less favorable than federal law depending on the governing jurisdiction. As both the Fifth and Ninth Circuits now look to state law to determine whether a loan should be recharacterized as an equity investment, insider lenders must carefully consider choice of law in documenting financing transactions.