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Recent 9th Circuit Decision Reverses Precedent on Debt/Equity Recharacterization

In bankruptcy proceedings, creditors often challenge loans that were made to the debtor prior to the petition for bankruptcy and argue that the loans are equity rather than debt. This kind of challenge is called a “recharacterization challenge.” The complexity of these issues makes it important for creditors and debtors alike to understand the nature of all financial transactions prior to bankruptcy and consult a knowledgeable bankruptcy attorney about the recharacterization law in the relevant jurisdiction.

For residents of the San Francisco Bay Area, a recent decision by the 9th Circuit Court of Appeals has drastically changed how recharacterization can affect creditors and debtors.

Until recently, the 9th Circuit had largely rejected claims for recharacterization and held that financing agreements could not be recharacterized. In doing so, the Court cited In re Pacific Express, an earlier case in which the 9th Circuit Bankruptcy Appellate Panel held that recharacterization was governed by Section 510(c) of the Bankruptcy Code. Section 510 is the section of the Bankruptcy Code that applies to equitable subordination, which is the power of the court to determine which valid claims should be subordinate to others. Because 510(c) does not expressly give courts the power to recharacterize claims, the Court in In re Pacific Express held that creditors did not have the right to pursue challenges based on recharacterization of debt as equity.

However, the 9th Circuit’s recent decision in In re Fitness Holdings reversed this precedent. In In re Fitness Holdings, a debtor made a large payment to an investor prior to filing for chapter 7 bankruptcy. After the debtor filed for bankruptcy, creditors sought to recover the payment to satisfy some of the debtor’s obligations. They argued that the initial funds from the investor were an equity investment, not a loan to the debtor. If, as the creditors argued, there was no underlying loan that needed to be repaid by the debtor, the transfer of the debtor’s money to the investor was a constructively fraudulent transfer, because the debtor did not receive “reasonably equivalent value” in exchange for the transfer. Under the Bankruptcy code, transfers made by a debtor for which they do not receive reasonably equivalent value may be voided, and the money may be recovered by the creditors.

The 9th Circuit held that the Court does have the authority to recharacterize debt as equity, even if a financing statement on its face refers to funds as a loan and not as an investment. The rationale behind the 9th Circuit decision was that because recharacterization determines whether or not there is a valid claim to be paid at all, recharacterization claims are not governed by section 510(c) of the Bankruptcy Code which deals only with the subordination of one valid claim to another. The 9th Circuit joined the 5th Circuit in holding that recharacterization issues are instead governed by state law, which gives courts the ability to look at other evidence, such as the circumstances surrounding a loan and the consideration for a loan, for to determine if it should instead be recharacterized as an equity investment.

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