SCOTUS Takes Bankruptcy Case Recharacterizing Debt as Equity

By Diane Davis

The U.S. Supreme Court June 27 said it will consider whether bankruptcy courts should apply federal or state-law rules when deciding to recharacterize a debt claim in bankruptcy as a capital contribution ( PEM Entities LLC v. Levin, U.S., No. 16-492, rev. granted 6/27/17 ).

Circuits are split with five holding that courts should apply federal rules, and two favoring state law.

Resolve Circuit Split

The majority view relies on the bankruptcy court’s powers under Bankruptcy Code Section 105(a), which gives bankruptcy courts the authority to “issue any order, process or judgment that is necessary or appropriate to carry out the provisions” of the law.

The minority view, on the other hand, holds that a state law rule of decision applies because under the Bankruptcy Code’s statutory scheme, bankruptcy courts determine the allowance of claims under state law.

The Fourth Circuit affirmed a decision that recharacterized certain debt as equity in a bankruptcy proceeding. Recharacterization is well within the broad powers afforded a bankruptcy court, the Fourth Circuit said.

Recharacterization is important because it affects how much other creditors can recover.

Petitioner PEM Entities LLC argued that state law governs the recharacterization of debt claims as capital contributions in bankruptcy.

“Debt recharacterization is not an obscure and rare bankruptcy doctrine,” PEM Entities said in its petition.

“The rule does not just matter during the bankruptcy case—it matters when a party is deciding whether to make the loan before bankruptcy, with the intention to rescue the business and avoid bankruptcy,” PEM Entities said.

Recharacterization Is Critical

“The issue of recharacterization is critical because, outside of bankruptcy, tax and accounting laws and rules allow solvent parties to characterize their contributions—as debt or as equity—to a company in very liberal ways,” Bruce A. Markell, a bankruptcy professor at Northwestern Pritzker School of Law, Chicago, told Bloomberg BNA June 27.

“Since the debtor (at start up) is usually solvent—it can pay its debts as they become due—that status is thought to justify deference to the party’s choices as to how to characterize contributions,” Markell said. “Debt gives rise to (usually) deductible interest payments,” he said, but payments to equity holders are dividends that usually aren’t deductible by the debtor.

“When the debtor is insolvent or in financial trouble, however, the ability to characterize payments/contributions is the ability to affect other creditors’ recoveries,” Markell said.

“The basic rule is the absolute priority rule: debt must be paid before equity receives anything in any liquidation,” Markell said.

Loan in Default

PEM Entities purchased a third-party loan taken out by debtor Province Grand Olde Liberty. The loan was secured by the Olde Liberty Club golf course.

The loan was in default and the golf course was in foreclosure when PEM Entities purchased the loan. Without PEM Entities’ loan purchase, Province Grand Olde Liberty wouldn’t have been able to successfully get its Chapter 11 plan approved by the court.

The bankruptcy court recharacterized Province’s $7 million secured claim based on a federal rule of debt characterization.

The Fourth Circuit found that “broad recharacterization power is integral to the consistent application of the Bankruptcy Code.”

PEM Entities was formed by an insider of the debtor for the “supposed acquisition” of a $6.45 million bank note to Paragon Commercial Bank, respondent Eric M. Levin said in his brief in opposition.

This “deal was in fact a transparent effort by insiders to strip equity” from the debtor and prevent payment to creditors of the debtor who have been awarded a constructive trust over the debtor’s property, Levin’s brief states.

Incentivizes Debt

“Insiders of a debtor have an incentive to characterize contributions as debt and reduce the liquidation or reorganization proceeds payable to other, outside, creditors,” Markell said. “In essence, they are obtaining the upside of owning equity, and blunting the downside of liquidation,” he said.

“If the insider debt is secured by the debtor’s assets, and the contribution is respected as secured debt, the insiders can take their collateral and leave nothing for the other creditors,” Markell said.

“As courts of equity, bankruptcy courts are expert at developing rules that apply in insolvency to the pre-bankruptcy characterization of contributions as debt or equity,” Markell said. The court’s role is “proper since the issue is how to distribute funds when not everyone will be paid in full,” he said.

“Federal law as developed by these bankruptcy courts is used because state law tends to be undeveloped with respect to recharacterization, since the lawsuits do not arise in state courts,” Markell said.

The case will be argued in the court’s next term, which begins Oct. 2. A date for oral argument hasn’t been scheduled yet.

Douglas Hallward-Driemeier of Ropes & Gray LLP, Washington, D.C., represents PEM Entities; James C. White, Parry Tyndall White, Chapel Hill, N.C., represents Eric M. Levin.

To contact the reporter on this story: Diane Davis in Washington at DDavis@bna.com

To contact the editor responsible for this story: Jay Horowitz at JHorowitz@bna.com

Copyright © 2017 The Bureau of National Affairs, Inc. All Rights Reserved.