The Bottom Line:

Recently, the Fifth Circuit Court of Appeals applied recharacterization of a claim to equity to non-insiders, declining to apply a per se rule that limits recharacterization of claims to corporate insiders.  In the Matter of Lothian Oil, Inc., No. 10-50683, 2011 U.S. App. LEXIS 16404 (5th Cir. Aug. 9, 2011).  The Court held that a bankruptcy court need not rely upon its general “equitable powers” under section 105(a) but instead may recharacterize a claim under its “authority to allow and disallow claims under 11 U.S.C. § 502.”  Section 502(b) provides that a claim may be disallowed if it is “unenforceable against the debtor, under. . .applicable law.”  Under Supreme Court precedent (Butner v. United States, 440 U.S. 48, 55 (1979)), “applicable law” includes state law.  In applying Texas law (which, in turn, looked to federal tax cases for recharactization of debt to equity), the Court upheld the bankruptcy court’s decision to recharacterize the claim, which lacked the traditional indicia of debt (e.g., stated maturity, interest, etc.) and relied upon business royalties for repayment.

What Happened:

A creditor (Israel Grossman) signed a pair of handwritten “loan agreements” with the debtor corporation’s Secretary and filed proofs of claim on the basis of these agreements – along with many other proofs of claim, most of which he settled with the debtor – after Lothian sought chapter 11 protection. The language of both “loan agreements” was similar:

  1. Grossman shall loan (the “Loan”) the sum of US $150,000 to Lothian Oil;
  2. In consideration for the Loan, Grossman shall receive a royalty of one percent of Lothian Oil's share of gross production of oil and gas on the Webb properties in New Mexico without further investment to be made by Grossman;
  3. Lothian Oil shall repay Grossman the Loan from the proceeds of a $0.75 per share equity placement made in Lothian Oil or from the proceeds, subject always to the Sterling Bank Credit Agreement, of any other equity placement in Lothian Oil, which is currently in compliance.

Lothian at *2-3.

The bankruptcy court rejected the allowance of Grossman’s proofs of claim, including those premised on the handwritten agreements, holding that they “assert common equity interests at best and that insufficient evidence of the value of the interests was presented.” In re Lothian Oil, Inc., No. 07-7012, D.I. 1832 at 2 (Bankr. W.D. Tex. Dec. 17, 2008). On appeal, the district court reversed as to the recharacterization of the claims based upon the handwritten-agreement, finding that debt recharacterization did not apply to a non-insider creditor.

On further appeal, the Fifth Circuit reversed (in part) and declined to apply a per se rule excluding non-insider claims from recharacterization.  Unlike other courts which analyze recharactization as an exercise of the bankruptcy court’s equitable powers under section 105(a), the Fifth Circuit found that the power of recharacterization is rooted directly in the claims allowance and disallowance powers under section 502(b). Notably, under section 502(b), the court “shall allow” a claim except to the extent that “such claim is unenforceable against the debtor and property of the debtor . . . under applicable law.” Under Supreme Court precedent in Butner, “applicable law” includes state law; “there is no reason why [state law] interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding.” Butner v. United States, 440 U.S. 48, 55 (1979).  Under section 502(b) and following Butner, the Fifth Circuit saw no reason to refer to the bankruptcy court’s equitable powers under section 105(a) to recharacterize a proof of claim that, under state law, could be treated as an equity interest rather than debt. On the issue of insider versus non-insider status, the Fifth Circuit rejected the per se rule relied upon by the district court, noting that “[u]nless state law makes insider status relevant to characterizing equity versus debt, that status is irrelevant in federal bankruptcy proceedings.” Lothian at *10.

The Fifth Circuit declined to equate “recharacterization” with “disallowance,” because the latter nullifies a claim entirely. Rather, it held that “recharacterization is appropriate when the claimant has some rights vis-à-vis the bankrupt.” Id. at *8 (quoting In re Dornier Aviation, Inc., 453 F.3d 225, 232 (4th Cir. 2006) (emphasis original).

For the claim at issue, the Fifth Circuit held that Texas law was applicable under the controlling agreements, and that Texas courts have imported a multi-factor test from federal tax law to distinguish between debt and equity.  The Fifth Circuit concluded that the bankruptcy court committed no error in finding that Grossman’s claims “assert common equity interests at best.”  The relevant factors were (i) that Grossman would be paid from royalties and equity placements, and (ii) the lack of specified interest rate, term of repayment and maturity date.  The inclusion of the royalty payment, which depended upon the success of Lothian’s business instead of a prescribed interest rate, was a main factor supporting the ruling. 

Why the Case is Interesting:

Many courts base recharacterization on the bankruptcy court’s “equitable powers” under section 105(a) of the Bankruptcy Code. See, e.g., In re Submicron Sys. Corp., 432 F.3d 448, 454 n.6 (3d Cir. 2006); In re Hedged-Invs. Assocs., 380 F.3d 1292 (10th Cir. 2004). By referring instead to section 502(b), and what qualifies as a “claim” or “debt” under state law, the Fifth Circuit did away with the need to find an equitable ground for recharacterization.  The Court further rejected the requirement that a non-insider is treated to a different standard than an insider creditor. This, in turn, shifts the recharacterization inquiry away from the creditor and to the nature of the instrument being asserted as a claim.