Court Finds Recharacterization of "Loans" Depends on State Law

The Fifth Circuit has upheld a Texas bankruptcy court's order recharacterizing the ostensible debt of a non-insider as equity. Matter of Lothian Oil Incorporated, No. 10-50683 (5th Cir. 8/9/11). Unlike other circuits to consider the issue, the Fifth Circuit relied on Sec. 502(b) and Texas state law rather than the Court's equitable powers under Sec. 105. You can find the opinion here.

What Happened

Israel Grossman advanced $350,000.00 to Lothian Oil pursuant to two ambiguous documents. The documents stated that Grossman "loans" or "shall loan" a sum of money to the company. In return for the "loans," he would receive a royalty from certain oil wells "without further investment" and would receive repayment of the funds advanced from certain equity placements.

When Lothian filed for Chapter 11, Grossman filed numerous proofs of claim. Some were allowed. However, the Bankruptcy Court denied the two claims making up the $350,000 on the basis that they were equity rather than debt. The District Court reversed, holding that recharacterization could only be applied to insiders.

The Fifth Circuit's Approach to Recharacterization

The Fifth Circuit upheld the Bankruptcy Court's recharacterization order, but did not rely on the Court's equitable powers under Sec. 105(a). In doing so, the Court broke with the Third, Fourth and Sixth Circuits.

The opinion, authored by Chief Judge Edith Jones, relied on a seductively simple logic. Under Sec. 502(b)(1), a claim shall be allowed unless it is "unenforceable against the debtor . . . under any agreement or applicable law." The term "applicable law" refers to State law. Thus, if state law would classify an instrument as equity rather than debt, the Court should disallow the claim and recognize the interest as equity.

Taken together, Butner and § 502(b) support the bankruptcy courts’ authority to recharacterize claims. If a claim asserts a debt that is contrary to state law, the bankruptcy court may not allow the claim. Moreover, where the reason for such disallowance is that state law classifies the interest as equity rather than debt, then implementing state law as envisioned in Butner requires different treatment than simply disallowing the claim. The Fourth Circuit identified the inadequacy of traditional disallowance in noting that “[w]hen a bankruptcy court disallows a claim, the claim is completely discharged. By contrast, recharacterization is appropriate when the claimant has some rights via-a-vis the bankrupt.” In re Dornier Aviation, Inc., 453 F.3d 225, 232 (4th Cir. 2006) (internal citation omitted; emphasis in original). These rights, fixed by state law, are not irrelevant to the court’s decision to disallow a claim. To the contrary, recharacterizing the claim as an equity interest is the logical outcome of the reason for disallowing it as debt.

Opinion, p. 6.

Because Sec. 502(b) and state law provided a direct route to determining the issue, it simply was "unnecessary" to resort to Sec. 105. Similarly, equitable subordination under Sec. 510(c) was not implicated.

Equitable subordination and recharacterization, although sometimes based on the same facts, are directed at different conduct and have different remedies.

Id.

Applying the Test

Turning to Texas state law, the Court found that Texas uses a sixteen factor test imported from federal tax law. Thus, it was a case of a federal court turning to state law which redirected the Court back to federal law. The Court also noted that the Fifth Circuit has also applied a thirteen-factor test and an eleven-factor test. Fortunately, the confluence of these tests does not require the Court to weigh the sixteen, thirteen and eleven factors together in a forty-point balancing test. Instead, it is a more organic exercise of asking: Does this look more like debt or equity? (Ed.--my characterization, not the Court's).

In the specific case, although the documents used the word "loan" in them, they did not provide for an interest rate, terms of repayment or a maturity date. Instead, they would be paid from royalties and "equity placements." Critical to the Court's ruling "was the inclusion of a royalty payment, which depended on the success of Lothian's business, instead of a prescribed interest rate." Opinion, p. 8.



An Objective Test

This brief opinion is a welcome addition to bankruptcy jurisprudence. In my practice, I have often seen equitable subordination and recharacterization applied interchangably as a rule against recognizing insider debt. The Lothian opinion helpfully distinguishes between the two doctrines and applies an objective test for determining recharacterization. The opinion also diminishes the relevance of insider status. While insiders may face greater scrutiny, they do not face automatic recharacterization.