A recently-issued Ninth Circuit decision creates potentially new avenues of recovery for creditors of an insolvent debtor.
Fitness Holdings International, Inc. (FHI), a home fitness corporation, had received significant funding between 2003 and 2006 from two entities: Hancock Park, its sole shareholder, and Pacific Western Bank. FHI’s unsecured obligations to Hancock Park, totaling $24 million, were subordinated to $12 million in secured financing by Pacific Western Bank in the form of a $5 million term loan and a $7 million line of credit (all guaranteed by Hancock Park).
In 2007, after numerous amendments, FHI re-financed its remaining obligations to Pacific Western Bank and to Hancock Park with a new $17 million term loan and an $8 million line of credit. The payoff of Pacific Western Bank’s prior secured loan had the effect of releasing Hancock Park from its guarantee. FHI’s efforts to restructure were ultimately not successful, however, and in 2008, the company sought protection under Chapter 11.
A Committee of Unsecured Creditors in FHI’s case sued Hancock Park, seeking to recover the earlier pay-off of Hancock Park’s debt and alleging that the debt ought, in fact, to be re-characterized as “equity” (and that the “repayment” of the “debt” ought therefore to be avoided as a constructively fraudulent transfer
, since FHI allegedly received “less than equivalent value” in exchange for the payments).
The Committee’s complaint was dismissed; however, FHI’s case was subsequently converted from one under Chapter 11 to one under Chapter 7, and the trustee appealed the dismissal to the US District Court. The District Court affirmed the dismissal, finding that under longstanding precedent of the Ninth Circuit Bankruptcy Appellate Panel
, Hancock Park’s advances to Fitness Holdings were loans and, as a matter of law, it was barred from re-characterizing such loans as equity investments.
The trustee appealed to the Ninth Circuit, which vacated the District Court’s decision and remanded for further findings. In doing so, the Ninth Circuit held that in an action to avoid a transfer as constructively fraudulent under § 548(a)(1)(B), if any party claims that the transfer constituted the repayment of a debt (and thus was a transfer for “reasonably equivalent value”), the court must determine whether the purported “debt” constituted a right to payment under state law. If it did not, the court may re-characterize the debtor’s obligation to the transferee under state law principles.
The decision is worth noting because:
• Prior case law in the Ninth Circuit held that re-characterization of “debt” as “equity” was impermissible (see In re Pacific Express, 69 B.R. 112 (B.A.P. 9th Cir. 1986)). This decision overrules that earlier precedent.
• The Ninth Circuit joined the Fifth Circuit (In re Lothian Oil, 650 F.3d 539, 542–43 (5th Cir. 2011)) in holding that state law – and state law alone – controls in determining when, and whether, alleged “debt” ought to be re-characterized as “equity.”
The 3-judge panel’s ruling suggests that it is “substance” – and not “form” – which ultimately determines whether an obligation is an equity investment
(rather than debt) under applicable state law. The crucial question is “whether that obligation gives the holder of the obligation a ‘right to payment’ under state law.”
A copy of the decision is attached.