Recharacterization of Debt as Equity: It’s Substance Of Transaction That Matters
When should debt be recharacterized as equity? The answer to this question will have an enormous impact upon expected recovery in bankruptcy since equity does not begin to get paid until all prior classes of claims are paid in full. In a recent unpublished opinion, the Fourth Circuit Court of Appeals provided some guidance on when and in what circumstances recharacterization is appropriate. The Court’s decision also serves as warning to purchasers of debt that they may not be able to hide behind the original debt transaction in a recharacterization fight.
In PEM Entities, LLC v. Province Grand Old Liberty, LLC (No. 15-1669), the Debtor Province Grande Old Liberty, LLC (the “Debtor”) borrowed approximately $6.5 million from a bank (the “Loan”). The Debtor subsequently defaulted on the Loan and the lender instituted foreclosure proceedings. In order to settle the foreclosure action, the Debtor, its principal and other related entities entered into a settlement agreement with the lender. Under the settlement, the lender sold the $6.5 million Loan to PEM Entities, LLC (“PEM”) for approximately $1.2m. PEM was owned by insiders of the Debtor.
There were a number of interesting, and to the Court unsettling, facts surrounding the settlement, including.
PEM did not sign the settlement agreement and was not involved in the negotiations. Instead, the lender understood that the Debtor’s principals had the authority to bind PEM.
Even though PEM was not a party to the settlement agreement, the agreement bound the lender to sell the loan to PEM.
The agreement was purported to be “in settlement of the Loan.”
PEM contributed only $300,000 towards the purchase price, and PEM financed the remaining amounts, including by borrowing $292,000 from the lender.
Some of the financing required by PEM to purchase the loan was secured by the Debtor’s property, and the financing was partially paid back by the Debtor.
Following the settlement, the Debtor transferred approximately $202,000 to PEM and PEM thereafter “re-advanced” $50,000 to the Debtor for operating expenses.
The Debtor subsequently filed bankruptcy and scheduled PEM with a $7,000,000 claim, including principal and accrued interest. Two creditors of the Debtor filed an adversary proceeding seeking to equitably subordinate and/or recharacterize PEM’s claim. The bankruptcy court granted summary judgment in favor of the creditors, holding that PEM’s loan purchase was a settlement and satisfaction of the Loan and recharacterized the $300,000 portion of the purchase price as an equity investment in the Debtor. The court rendered PEM’s $7,000,000 claim void. The district court affirmed on appeal, and the Fourth Circuit affirmed the district court’s judgment.
In its ruling, the Court applied an eleven factor test (the Dornier factors) to the question of whether to recharacterize PEM’s debt. In its analysis, the Court agreed with the lower courts that the following factors supporting recharacterization: (1) the naming of the settlement agreement and the fact that it was entered into “in settlement of the Loan”; (2) the fact that the Debtor’s principals negotiated the settlement agreement on behalf of PEM; (3) the lack of any payment schedules, actual interest payments or a ledger for the financial transactions between the Debtor and PEM; (4) the Debtor’s partial payment of the loan purchase; (5) the Debtor’s total reliance on PEM for its operating expenses; (6) the identity of interests between the Debtor and PFM; and (7) the securing of PEM’s debt by the Debtor’s property.
The Court rejected PEM’s argument that the bankruptcy court considered the wrong transaction. Specifically, PEM argued that the bankruptcy court should have applied the Dornier factors to the inception of the Loan rather than the later settlement agreement. The Court noted that the bankruptcy court must look beyond “form to substance” in recharacterization claims. In this case, the “substance of the transaction” was the settlement agreement, and not the inception of the Loan, since the settlement agreement gave rise to PEM’s claims. The Court found that there was ample evidence that the Debtor had “used PEM as an extension of itself to complete, what was, in effect, a satisfaction” of the Loan.
The Fourth Circuit’s decision was certainly not surprising. PEM’s purchase of the Loan had numerous troublesome elements, all of which supported recharacterization. Nonetheless, the Court’s rejection of PEM’s argument that the bankruptcy court should have looked at the inception of the Loan itself, rather than the settlement agreement, should serve as a wake-up call to parties that the courts will look at the substance of a transaction in a recharacterization fight. Purchasers of claims cannot defend a recharacterization claim by arguing that the underlying claim is debt. Instead, they will need to show that the economic substance of their purchase should not be recharacterized.