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. Â FHIâ€™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. Â The payoff of Pacific Western Bankâ€™s prior secured loan had the effect of releasing Hancock Park from its guarantee. Â FHIâ€™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 Parkâ€™s debt and alleging that the debt ought, in fact, to be re-characterized as â€śequityâ€ť (and that the â€śrepaymentâ€ť of the â€śdebtâ€ť ought therefore to be avoided as a constructively fraudulent transfer
, since FHI allegedly received â€śless than equivalent valueâ€ť in exchange for the payments).
The Committee’s complaint was dismissed; however, FHIâ€™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. Â The District Court affirmed the dismissal, finding that under longstanding precedent of the Ninth Circuit Bankruptcy Appellate Panel
, Hancock Parkâ€™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 Courtâ€™s decision and remanded for further findings. Â In doing so, the Ninth Circuit held that in an action to avoid a transfer as constructively fraudulent under Â§ 548(a)(1)(B), if any party claims that the transfer constituted the repayment of a debt (and thus was a transfer for â€śreasonably equivalent valueâ€ť), the court must determine whether the purported â€śdebtâ€ť constituted a right to payment under state law. Â If it did not, the court may re-characterize the debtorâ€™s obligation to the transferee under state law principles.
The decision is worth noting because:
â€˘ Prior case law in the Ninth Circuit held that re-characterization of â€śdebtâ€ť as â€śequityâ€ť was impermissible (see In re Pacific Express, 69 B.R. 112 (B.A.P. 9th Cir. 1986)). Â This decision overrules that earlier precedent.
â€˘ The Ninth Circuit joined the Fifth Circuit (In re Lothian Oil, 650 F.3d 539, 542â€“43 (5th Cir. 2011)) in holding that state law â€“ and state law alone â€“ controls in determining when, and whether, alleged â€śdebtâ€ť ought to be re-characterized as â€śequity.â€ť
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. Â 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.