Restructuring

Contributed by Brian Wells
In the recent decision In re Fitness Holdings, the United States Court of Appeals for the Ninth Circuit held that bankruptcy courts can recharacterize a “debt” as “equity” in the context of a fraudulent conveyance action brought under section 548(a)(1)(B) of the Bankruptcy Code, and in particular when considering whether the challenged transfer was made on account of an antecedent debt.  In so holding, the circuit court overruled the Ninth Circuit Bankruptcy Appellate Panel’s decision in In re Pacific Express, a longstanding precedent that forbade bankruptcy courts from recharacterizing claims because the ultimate effect – subordination of such claims – was governed by section 510(c) of the Bankruptcy Code.  Importantly, the extent to which Pacific Express was overruled – and whether recharacterization is now permitted beyond the context of fraudulent conveyance actions – remains uncertain.  The Fitness Holdings ruling brings Ninth Circuit law into alignment with the other circuits, insofar as recharacterization is now permitted, but it also widens a circuit split on the appropriate framework for determining whether to recharacterize a claim.  Unlike the Third Circuit, which roots recharacterization in bankruptcy courts’ equitable authority and discretion, or the Sixth Circuit, which determines the character of a claim using an 11-factor test based on federal tax law, the Ninth Circuit followed the approach of the Fifth Circuit, which eschews federally-created rules and looks to state law to determine the proper characterization of a claim.  As a result, transferees of a potential debtor in the Ninth Circuit must look to applicable state law when assessing their exposure to constructive fraudulent transfer actions.
Equitable subordination and recharacterization of claims operate through different mechanics and turn on different issues.  Specifically, debt recharacterization goes to whether a given right is in fact a “claim” under the Bankruptcy Code, while equitable subordination goes to the priority of distribution accorded to an accepted claim.  Both, however, can be used by a bankruptcy court to effect the same practical outcome – subordination of a claim.  One key difference, which up until now has driven the law of the Ninth Circuit, is that equitable subordination is governed by a specific Bankruptcy Code section – section 510(c) – while recharacterization has no foundation in the text of the Bankruptcy Code.  For that reason, recharacterization historically has been prohibited in the Ninth Circuit.  As reasoned in the Pacific Express decision, “[w]here there is a specific provision governing [subordination] determinations, it is inconsistent with the interpretation of the Bankruptcy Code to allow such determinations to be made under different standards through the use of the court’s equitable powers.”
As shown by the facts of Fitness Holdings, however, the overlap between recharacterization and equitable subordination is not exact.  Fitness Holdings involved allegations of constructive fraudulent transfer, and specifically allegations that, prepetition, the debtor had improperly used loan proceeds to pay off promissory notes held by an insider.  Although transfers in satisfaction of antecedent debts cannot be constructively fraudulent (because under the Bankruptcy Code such payments are for “reasonably equivalent value”), creditors argued that the insider’s notes should have been recharacterized as equity interests, and the exception for payments of antecedent debts thereby rendered inapplicable.  Following the Pacific Express precedent, though, both the bankruptcy court and district court rejected the creditors’ attempt to recharacterize the insider debts and dismissed their fraudulent conveyance action.
The Ninth Circuit reversed and remanded for further determination of whether the notes should have been recharacterized as equity interests, and in so doing overruled the Pacific Express decision (at least, in part).  The circuit court found that in Pacific Express the appellate panel had erred by conflating the remedies of recharacterization and equitable subordination.  Though both can result in the effective subordination of claims, the circuit court recognized that the doctrines addressed different concerns and implicated different areas of the Bankruptcy Code.  Thus, while section 510(c) permits a bankruptcy court to subordinate all or part of an allowed claim, when considering a motion to avoid payment as constructively fraudulent under section 548(a)(1)(B) a court must determine whether the transfer is repaying a “claim” at all – a question clearly beyond the purview of section 510(c).  To to the extent that the circuit court held that recharacterization is now permitted, it brought Ninth Circuit law into alignment with the other circuits (and an end to a circuit split on the issue).
The Ninth Circuit also decided that recharacterization must be determined by reference to applicable state law, in this respect joining the Fifth Circuit (and, specifically, its Lothian Oil decision).  This ruling largely followed from a textual analysis of the Bankruptcy Code and reliance upon the Supreme Court’s decision in Butner, in which it was held that, because “[p]roperty interests are created and defined by state law, . . . [u]nless some federal interest requires a different result, there is no reason why such interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding.”  Through a chain of cross-references and Bankruptcy Code definitions, the circuit court reasoned that a transfer is only constructively fraudulent under section 548(a)(1)(B) where it is not made for “reasonably equivalent value,” that “value” means “satisfaction of a . . . debt of the debtor,” that “debt” means “liability on a claim,” and that a “claim” means, in relevant part, a “right to payment” (or, to connect the dots, that a payment is for reasonably equivalent value where it is made in satisfaction of a right to payment).  Turning to the Butner line of decisions, including the relatively recent Traveler’s decision, the circuit court noted that a bankruptcy court may not fashion a rule of its own creation when determining what constitutes a “claim” for bankruptcy purposes, but instead must determine whether an asserted interest is (or is properly characterized as) a “right to payment” under state law.
By staking its position to Butner, the circuit court established a rule that contrasts with those of other circuits, which have rooted bankruptcy courts’ ability to recharacterize claims in the equitable authority granted by section 105(a) of the Bankruptcy Code (e.g., the Third Circuit in Submicron) and have created their own tests to determine when recharacterization is appropriate (e.g., the Sixth Circuit in Autostyle Plastics, Inc.).  The circuit court’s reasoning challenges the law of these circuits and shows an inherent tension between expansive readings of section 105(a) and the deference, exemplified in Butner, to non-bankruptcy law.   The decision also carries on the spirit, if not the holding, of Pacific Express, which had been decided on the premise that a bankruptcy court’s equitable authority should be limited by the Bankruptcy Code (and, by extension and pursuant to Butner, state law that has not been preempted by the Bankruptcy Code). 
Although the Ninth Circuit’s ruling clearly holds that recharacterization is permissible in a context wholly beyond the reach of equitable subordination (i.e., when deciding whether a transfer is repayment of a “claim” for purposes of constructive fraudulent transfer rules), it is less clear whether recharacterization remains forbidden in areas that overlap with the subordination provided for under section 510(c).  For example, in Pacific Express, the bankruptcy court had sought to recharacterize a debt claim for equitable reasons under its authority to “determine the amount, characterization, and allowance or disallowance” of claims.  Although subordination and recharacterization address distinct conceptual issues and can arise in different substantive contexts, in that particular decision the two would have been applied with essentially the same result (as was pointed out by the appellate panel).  The concerns driving Fitness Holdings (i.e., that state law should govern in areas that are not specifically governed by the bankruptcy code) seem absent, and the concerns driving Pacific Express (i.e., that bankruptcy courts should not apply different standards for areas governed by a specific code provision) remain valid.  Plus, the Ninth Circuit framed its holding in Fitness Holdings narrowly, with a focus on recharacterization “in an action to avoid a transfer as constructively fraudulent under section 548(a)(1)(B).”  On the other hand, when discussing the relevant framework for determining when to recharacterize a claim, the circuit court expressly followed the Fifth Circuit’s approach in Lothian Oil and noted that in that decision the court had recharacterized loans as equity interests in the context of a request to disallow a claim under section 502 (essentially the same context in which the Pacific Express decision was rendered).  The circuit court also “agreed” with Lothian Oil in general terms, stating that “to determine whether a particular obligation owed by the debtor is a ‘claim’ for purposes of bankruptcy law [a determination made in a number of contexts other than fraudulent transfer actions] it is first necessary to determine whether that obligation gives the holder of the obligation a ‘right to payment’ under state law.”
The implications of the Fitness Holdings decision on recharacterization in contexts other than a constructive fraudulent transfer action remain uncertain.  In that context, however, the decision is clear.  As a result of this decision, transferees now have an increased risk of having a transfer clawed back in the Ninth Circuit.  To the extent that parties are considering entering a transaction with a potential Ninth Circuit debtor that would result in the satisfaction of an antecedent debt, their diligence should now include a review of applicable state law.  To the extent their interest could be recharacterized as something other than a “right of payment,” they are no longer insulated from avoidance actions brought under section 548(a)(1)(B).