The Supreme Court recently granted certiorari in PEM Entities LLC v. Levin, in which it will decide whether federal or a state law should apply when a debt claim held by a debtor’s insider is sought to be recharacterized in bankruptcy as a capital contribution and treated as equity. The case raises important questions about the extent to which the commencement of a proceeding under the U.S. Bankruptcy Code can and should affect parties’ rights and interests as they exist under non-bankruptcy law. For this reason alone, the impact of PEM Entities is likely to be significant.

It is also possible that it could lead the Court more broadly to consider the scope of Congress’s bankruptcy power. In such event, PEM Entities potentially could provide the Court with a coherent rationale to start resolving the uncertainty it created six years ago in Stern v. Marshall regarding the constitutional authority of bankruptcy courts.

The facts of PEM Entities are straightforward. A group of investors created an investment vehicle, Province Grande Olde Liberty, LLC (“Province”), in order to acquire real estate in North Carolina for the purpose of developing a golf course and surrounding homes. Province obtained a bank loan of approximately $6.5 million, secured by the real estate itself, and received a separate, unsecured loan in the amount of $188,000 from an investment fund, Lakebound Fixed Return Fund LLC (“Lakebound”).

When the secured loan went into default and the bank threatened to foreclose, certain of Province’s investors formed PEM Entities LLC, and purchased the secured loan from the bank for approximately $1.24 million. The development efforts ultimately failed, however, and Province filed for protection under chapter 11 of the Bankruptcy Code. When PEM sought to enforce its rights as a secured creditor under the purchased bank loan, certain investors in Lakebound brought an action to have the claim recharacterized as equity, and thus subordinate to Lakebound’s unsecured claim.

The bankruptcy court ruled in favor of the Lakebound investors, applying a federal standard for recharacterization in bankruptcy cases that is broader than the test that would have applied had it looked to applicable (North Carolina) state law. Under North Carolina law, the form of the transaction would probably have determined the outcome and, since PEM had purchased a loan made by a third party, PEM would have been able to enforce its rights as a secured creditor. Under the federal test, adapted from decisions in tax cases, courts look beyond the form of the transaction to consider whether, in essence, the money at issue was invested for the purpose of being repaid with interest at an established date, or instead was a bet on the ultimate success of the venture. The bankruptcy court, among other things, determined that when PEM acquired the bank loan, Province would not have been able to obtain financing from a non-affiliated third party, and that the PEM investors were mainly motivated to salvage their initial investment in Province.

The bankruptcy court’s ruling was affirmed on appeal by both the district court and the U.S. Court of Appeals for the Fourth Circuit, both of which similarly applied the federal standard. The Supreme Court granted certiorari in order to resolve a split among circuits as to whether federal or state law governs debt recharacterization.

PEM will argue that debt recharacterization is essentially a form of claim disallowance and is therefore governed by the plain language of section 502(b) of the Bankruptcy Code. That section provides that claims filed against a bankruptcy estate are allowed unless the “claim is unenforceable . . . under applicable law[.]” Since under North Carolina state law, the “applicable law” in this circumstance, the debt would not be subject to recharacterization, PEM will contend that its secured claim must be allowed. PEM will also point to the Court’s decision in Butner v. United States, in which the Court expressly held that property rights in bankruptcy are determined by applicable state law unless “some federal interest” requires otherwise.

The Lakebound investors will counter that the equitable power of bankruptcy courts allows for the rejection of form over substance, and that the majority of circuit courts which have considered the issue have found that bankruptcy courts have the authority to recharacterize debt under section 105(a) of the Bankruptcy Code, which provides that bankruptcy courts “may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.” They will argue that recharacterization by bankruptcy courts is an essential part of maintaining the Bankruptcy Code’s priority scheme, and that using the federal test is well within the “appropriate” means of section 105(a).

In its petition for Supreme Court review, PEM described the question as a split among federal courts of appeal as to “whether (a) the doctrine [of recharacterization] is part of some general power of bankruptcy administration or (b) the existing obligations of the debtor based on the law of the [fifty] states.” (emphasis added). This description could apply equally to numerous other provisions of the U.S. Bankruptcy Code, which in essence constitutes a federal law structure overlaying substantive rights between private parties which are governed by applicable state law. Bankruptcy judges must often determine whether “some federal interest,” mandates a different outcome for the parties under the Bankruptcy Code than under state law.

The Court will probably rule on this question narrowly in PEM Entities and limit it to the issue of debt recharacterization. However, it is intriguing to consider where a broader ruling on the extent of “some general power of bankruptcy administration” could lead. In particular, it could provide the Court with a pathway out of the constitutional maze it created a few years ago in Stern v. Marshall regarding bankruptcy court authority.

In Stern, the Court disrupted a long standing delicate constitutional balance between the need for an effective system of specialized courts existing pursuant to Congress’s bankruptcy power under Article I, Section 8, and the vesting of the judicial power of the United States in the federal courts under Article III. Since the Court in cases going back to the nineteenth century had limited the final decisional authority of Article I courts to cases involving “public” rights (e.g., cases involving claims of citizens against the government), the ability of bankruptcy courts to hear and determine cases under the Bankruptcy Code was predicated on the notion that “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power,” constituted a type of “public” right which could be heard and decided by an Article I bankruptcy judge.

Bankruptcy courts accordingly have since 1984 been statutorily authorized under section 157 of the Judicial Code to issue final orders with respect to a variety of enumerated “core” bankruptcy matters, such as resolving claims against a debtor’s bankruptcy estate and confirming plans of reorganization, and required to issue findings of fact and conclusions of law for review and determination by an Article III district court judge for all “non-core” matters. Stern put this balance out of kilter by focusing on parties’ “private” rights, and ruling that even “core” matters would in some situations require adjudication by an Article III judge. Stern involved a challenge to a bankruptcy court’s authority to hear and determine a bankruptcy estate’s counterclaim against an estate claimant. Even though such counterclaims are listed as “core” matters under section 157, the Court in Stern ruled that it would be unconstitutional for the counterclaim in that case to be decided by an Article I bankruptcy judge, on the basis that it involved a “private” right because the cause of action would exist under state law “without regard to any bankruptcy proceeding.”

Stern has created a constitutional quandary. Since (per Butner) parties’ rights in bankruptcy are usually based on state law, “core” matters will often implicate “private” rights. The ability of bankruptcy judges to rule on fundamental matters such as determining whether certain property belongs to a bankruptcy estate has been questioned because they are governed by state law. Although Stern’s quandary has been narrowed somewhat by subsequent Court decisions, it continues to cause confusion and uncertainty in the adjudication of bankruptcy cases.

The constitutional authority questions arising from Stern and the decisional law question of PEM Entities are very different. However, if the Court in PEM Entities were to issue a ruling broadly focused on the scope of “the general power of bankruptcy administration” as a “federal interest” requiring the application of federal law to the question of debt recharacterization, it could lead to a viable view of such power as a “public” right. This in turn could allow courts to make the key constitutional factor in resolving questions of bankruptcy court authority to be the nexus of a particular dispute to “the restructuring of debtor-creditor relations,” instead of whether parties’ rights would separately exist under state law. Such a focus on the “public” side of the public/private rights dichotomy could provide a path away from the confusion engendered by Stern, and restore the constitutional balance of bankruptcy court authority.