The Court of Appeals for the Ninth Circuit has joined other circuits around the country in holding that the bankruptcy court has the authority to re-characterize a debt obligation as equity in the context of a fraudulent transfer avoidance action under the Bankruptcy Code. The decision by the Ninth Circuit in Official Committee of Unsecured Creditors v. Capital II, L.P. (Matter of Fitness Holdings Int’l, Inc.), __ F.3d ___, 2013 WL 1800000 at *1 (9th Cir. April 3, 2013) (Fitness Holdings) is consistent with published decisions of several other federal circuit courts, all of which agree that the bankruptcy courts have the power to re-characterize an obligation as equity in determining whether a payment to the transferee is an avoidable fraudulent transfer under 11 U.S.C. §548. However, the courts differ on the appropriate standard to apply to determine whether the obligation stated to be debt is in fact equity.

The Legal Context

Section 548 of title 11 allows a trustee to avoid fraudulent transfers by the debtor made within one year of the debtor’s bankruptcy filing. The statute is similar but not identical to the provisions of the Uniform Fraudulent Transfer Act which has been adopted, with variations, in most states.

In general, §548 allows the trustee to avoid as a constructive fraudulent transfer payments made by the debtor within one year of the petition date for less than reasonably equivalent value while the debtor was insolvent or where the debtor was rendered insolvent by the transfer. The statute defines “value” as including payments made on a present or antecedent debt. 11 U.S.C. §548 (d)(2)(A). The cases construing that provision hold that reasonably equivalent value is given where the debtor receives a dollar-for-dollar credit on the debt for the amount of the payment made. What constitutes a “debt” is defined under the Bankruptcy Code as “liability on a claim,” and a “claim” in turn is defined as “a right to payment whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured or unsecured.” 11 U.S.C. §101(5)(A).

The Case

In Fitness Holdings, the debtor’s books and records showed it owed over $11 million to its parent/sole shareholder, Hancock Park Capital II, L.P. (Hancock). The debtor also owed over $8 million to an institutional lender, Pacific Coast Bank. The debtor refinanced these obligations with a loan from the bank, and the loan proceeds were applied to pay off the outstanding debts to the parent Hancock and to the bank. After the debtor filed for Chapter 11 protection, a committee of unsecured creditors was authorized to sue for recovery of the payments to Hancock and the bank as constructive fraudulent transfers. The suit also included claims for declaratory relief requesting that the debt to Hancock be re-characterized as equity. If the payment made to Hancock were deemed a payment on account of equity, the payment would not come within the statutory definition of “value” as a satisfaction of an antecedent debt and could be deemed recoverable as a constructive fraudulent conveyance.

The defendants filed a motion to dismiss the fraudulent transfer complaint, relying on a Ninth Circuit Bankruptcy Appellate Panel decision holding a bankruptcy court does not have authority to re-characterize debt as equity in a fraudulent transfer action under §548 and that re-characterizing a debt as equity was governed by the equitable subordination statute, 11 U.S.C. §510(c). See In re Pacific Express, 69 B.R. 112, 115 (9th Cir. BAP 1986). The bankruptcy court followed that precedent and dismissed the action, and the debtor’s case was converted to Chapter 7 shortly thereafter. The Chapter 7 trustee appealed the ruling to the district court, which affirmed the dismissal based on the holding in Pacific Express which the district court deemed itself bound to follow. The trustee appealed the district court decision to the Ninth Circuit.

The Ninth Circuit Decision

The Ninth Circuit first held that the district court, as an Article III court, was not bound to follow a decision of the Ninth Circuit Bankruptcy Appellate Panel and therefore that the district court was not bound by the holding in Pacific Express. As to the merits of the appeal, the court overruled Pacific Express, finding error in its holding that the re-characterization of debt as equity is governed by equitable subordination under §510(c) rather than non-bankruptcy law principles as what constitutes a “debt” and a “claim.”

The bankruptcy appellate panel decision in Pacific Express had taken the position that the bankruptcy court’s authority to address the status of debt was limited to equitable subordination under §510. The Ninth Circuit held that the equitable subordination under §510 is a distinct remedy from re-characterization of debt as equity in the context of a fraudulent transfer action. Instead, the court looked to the language of the statute and relied on the U.S. Supreme Court precedents of Butner v. United States and Travelers Cas. & Sur. Co. of Am. v. Pacific Gas & Elec. Co. for the proposition that what constitutes a “claim” or a right to payment under the Bankruptcy Code is determined under applicable non-bankruptcy law. Therefore, in fraudulent transfer avoidance action where the transferee contends that the transfer was a payment on a debt and made for reasonably equivalent value as a result, “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.” Fitness Holdings, 2013 WL 1800000 at *4.

In concluding that the bankruptcy court had the authority to determine whether an obligation is properly characterized as equity rather than debt in an action to avoid a payment on the obligation as a fraudulent transfer, the Ninth Circuit’s decision is consistent with the holdings in published decisions of the Third, Fourth, Fifth, Sixth and Tenth Circuits. The Ninth Circuit also explained the distinction between re-characterization of debt as equity and equitable subordination under §510. It explained that equitable subordination under §510 is a remedy under the Bankruptcy Code that permits the court to “subordinate ‘all or part of an allowed claim to all or part of another allowed claim.'” However, in a fraudulent transfer suit where the trustee seeks to avoid a payment and the transferee asserts as a defense that the payment was made on a claim, the court must determine if the obligation was in fact a “claim.”

Courts Vary on Analysis of Debt Versus Equity

Although these circuits have held re-characterization of debt as equity is authorized and in fact required where justified by the facts in a fraudulent transfer action, the circuits have applied different legal standards to the determination what constitutes equity versus debt. For example, the Sixth Circuit has created an eleven factor test based on federal tax law to evaluate whether the obligation should be deemed equity. Another circuit describes the test is an equitable analysis of whether the obligation is more like equity than debt. The Fifth Circuit has held that the determination should be made based on whether state law would treat the obligation as equity or debt. The Ninth Circuit in Fitness Holdings also adopted the state law approach based on the Butner and Travelers decisions, holding that the court should look to state law to determine whether the obligation would be treated as debt or equity under the applicable non-bankruptcy law.

Lessons of Fitness Holdings

For third party, non-insider creditors, the Fitness Holdings decision should be welcomed as a helpful tool to restore assets to the debtor’s estate which were transferred to the holder of an equity interest in the guise of a debt repayment. The facts of the Fitness Holdings case itself illustrate the importance of the decision for the protection of creditor interests and enhancement of the funds available for creditors as millions of dollars may be brought into the bankruptcy estate in that case if the trustee prevails on his claims.

Lesley Anne Hawes, a partner in the Los Angeles office of McKenna Long & Aldridge, LLP, specializes in the representation of secured and unsecured creditors in bankruptcy proceedings and in the representation of federal equity receivers appointed in civil enforcement actions by federal agencies such as the Federal Trade Commission and Securities and Exchange Commission. Hawes is a regular contributor to the Monitor and other journals, and she has lectured for the National Business Institute and other organizations. She graduated Order of the Coif from University of Southern California law school and earned her undergraduate degree in political science magna cum laude from University of Southern California.