The Bottom Line
One critical issue affecting complex restructuring cases are efforts by the estate or creditors to recharacterize debt into equity. This can happen in a variety of factual contexts, including where an existing equity stakeholder puts capital into a distressed company as “rescue capital” in the hopes of implementing an out-of-court turnaround. When the turnaround fails, the rescue capital becomes a target of attack. Over the years, various courts have approached this legal theory differently and one issue in dispute is whether to apply state law or federal law. Recently, the Supreme Court has agreed to hear a dispute over the circumstances in which it is appropriate to “recharacterize” debt as equity. The Supreme Court’s decision – to be heard next term – will resolve a circuit split on the issue of whether federal or state law governs the recharacterization of debt claims as capital contributions in bankruptcy. This blog reviews the underlying case that will be addressed by the High Court next term.
In PEM Entities LLC v. Eric M. Levin & Howard Sharef, No. 15-1669 (4th Cir. Aug. 12, 2016), the Fourth Circuit affirmed a decision by the Bankruptcy Court for the Eastern District of North Carolina, applying the Fourth Circuit’s multi-factor federal test to recharacterize a loan as a capital contribution.
The case arises out of a series of investments in Province Grande Olde Liberty, LLC (the “Debtor”), a portfolio company formed for the purpose of acquiring a golf and residential real estate development in North Carolina. To finance the investment, the Debtor took out a $6,465,000 bank loan secured by the real estate. The Debtor also obtained $188,000 in financing from a real estate investment company managed by one of the Debtor’s principals. The appellees in this case, Eric M. Levin and Howard Shareff, each invested $500,000 into this company.
In 2010, the Debtor defaulted on the bank loan, and the bank initiated foreclosure proceedings. To resolve the foreclosure dispute, the bank agreed to sell its loan to a new company, called PEM, at a discounted rate pursuant to a settlement agreement with the Debtor, its principals, and several other related entities. PEM was owned by insiders of the Debtor. To finance the loan purchase, PEM used equity contributions from its members, as well as outside debt. Importantly, the Debtor’s principals negotiated the settlement agreement on behalf of PEM.
Later, PEM “readvanced” $50,000 to the Debtor for miscellaneous operating expenses. Several other cash transfers went between Debtor, PEM, and the Debtor’s principal— sometimes called “loans” and other times “readvances.”
The Debtor filed its bankruptcy petition on March 11, 2013. In that filing, it listed PEM’s claim at $7,000,000, including principal and accrued interest. The appellees, who had each invested money into the project, filed an adversary proceeding seeking, among other things, to subordinate and recharacterize PEM’s claim.
The bankruptcy court granted summary judgment in favor of the appellees on their equitable claim of recharacterization. Specifically, the bankruptcy court concluded that the PEM’s loan purchase was, in effect, a settlement and satisfaction of the bank loan. The court recharacterized the portion of the PEM loan purchase that was financed with contributions from insiders, totaling $300,000, into an equity investment in the Debtor. By doing so, the court rendered PEM’s $7,000,000 claim void.
On appeal, the district court and later the Fourth Circuit agreed with the bankruptcy court. In its ruling, the Fourth Circuit applied the 11-factor test it had articulated in In re Official Committee of Unsecured Creditors for Dornier Aviation (North America) Inc., 543 F.3d 225 (2006), finding that all factors weighed in favor of recharacterization, including:
(1) the naming of the settlement agreement and the fact that it was entered into “in settlement of the loan”;
(2) the fact that Debtor’s principals negotiated the settlement agreement and note purchase on behalf of PEM;
(3) the lack of any formalities between the Debtor and PEM;
(4) Debtor’s total reliance on money from PEM to meet expenses;
(5) the identity of interests between Debtor and PEM; and
(6) the fact that PEM’s debt was secured by the Debtor’s property.
The Fourth Circuit found that the bankruptcy court properly “looked beyond form” to consider “the substance of the transaction.” The Fourth Circuit agreed that the Debtor had essentially used PEM as an extension of itself to satisfy the original bank loan.
On June 27, 2017, the Supreme Court granted PEM’s petition for a writ of certiorari. On appeal, PEM argues that bankruptcy courts should apply state, rather than federal, law to debt recharacterization in bankruptcy. U.S. Courts of Appeals are now split 5-2 on the issue, with the majority applying a federal rule of decision. PEM argues that the use of state law is more appropriate, and that the application of North Carolina law would have resulted in a different outcome in this case. According the PEM, a court following North Carolina case law would not apply the multi-factor test, and would instead simply look to whether funds were delivered from one party to another with an expectation of repayment.
Why This Case is Interesting
The Supreme Court’s decision in the case will have significant implications for business owners and insiders making loans or other investments to troubled companies. PEM argues that “the difference between a federal and state rule of decision is outcome determinative in this case.” Deciding the issue of which law courts should apply to the recharacterization of debt will result in more predictable outcomes. This in turn will better enable lenders, distressed borrowers, and other parties in interest to engage in successful out-of-court restructuring transactions.