imsis148-063Earlier this year, the Ninth Circuit in Official Committee of Unsecured Creditors v. Hancock Park Capital II, L.P. (In re Fitness Holdings International Inc.), 714 F.3d 1141 (9th Cir. 2013) joined five other circuits in recognizing that bankruptcy courts have the power to recharacterize debt as equity, notwithstanding the fact that such recharacterization is not explicitly authorized by the Bankruptcy Code.  Whether a debt can be recharacterized as equity has serious implications because recharacterization typically results in significantly reduced recovery for the putative claimant and may also expose the claimholder to fraudulent transfer liability for amounts paid on account of the recharacterized debt.

The Third, Fourth, Fifth, Sixth, and Tenth Circuits and lower courts in the Second Circuit all have held that bankruptcy courts have the power to recharacterize claims.  Other courts, including the Ninth Circuit Bankruptcy Appellate Panel (“BAP”), have denied bankruptcy courts the ability to exercise this remedy because recharacterization is not explicitly provided for in the Bankruptcy Code.

Fitness Holdings’s Recharacterization Litigation

After Fitness Holdings International Inc. filed for Chapter 11 relief, the committee of unsecured creditors commenced an action against Hancock Park, the debtor’s sole shareholder, seeking to recover funds paid by Fitness Holdings before the bankruptcy to Hancock Park in full satisfaction of eleven outstanding promissory notes.  The committee sought (i) a declaratory judgment recharacterizing the Hancock Park promissory notes as equity and (ii) recovery of the funds paid under the notes as constructively fraudulent dividends.  Hancock Park moved to dismiss the committee’s claims, arguing recharacterization was prohibited based on the Ninth Circuit BAP’s decision.  The bankruptcy court granted the motion and dismissed the claims.  The committee appealed, but the district court agreed with the lower court, holding that it was also barred from recharacterizing based on the Ninth Circuit BAP’s decision.  Fitness Holdings’s bankruptcy case was subsequently converted to a chapter 7 and a trustee was appointed.  The trustee replaced the committee in the litigation and appealed to the Ninth Circuit.

Ninth Circuit’s Consideration of the Trustee’s Recharacterization Claim

The Ninth Circuit first made clear that the district court erred in holding that it was bound by the Ninth Circuit BAP’s decision barring recharacterization. District courts are free to decline to follow a BAP decision in order to formulate their own rules within their jurisdiction.  The Ninth Circuit then considered the trustee’s recharacterization argument.

While other circuit courts have started their recharacterization analysis by looking to the indicia of the instrument at issue (i.e., name given to the instrument, whether it provides for a fixed maturity date and/or interest rate, and the source of repayments), the Ninth Circuit started its analysis by considering whether the putative obligation constituted a right to payment under state law.  If the “obligation” or interest was not a right to payment under state law, the Ninth Circuit held that a court could recharacterize the debtors’ obligation under state law principles.  The Ninth Circuit, however, declined to determine whether the trustee plausibly alleged that the interests created by the Hancock Park promissory notes constituted equity under state law and instead, vacated and remanded the district court’s decision for further consideration.

The Import of the Ninth Circuit’s Decision

The Ninth Circuit has joined those circuit courts that uniformly recognize a bankruptcy court’s ability to recharacterize debt as equity.  Although the Fitness Holdings decision regarding recharacterization arose in context of a fraudulent transfer claim, creditors should be aware that the decision will most likely have a controlling effect in other contexts as well.  For example, the issue of recharacterization may arise in context of objections to proofs of claim and whether a filed claim should share status with other similarly situated creditors or be subordinated to all claims.