The Supreme Court recently granted certiorari to review a case that will require the Court to decide the question of whether bankruptcy courts should apply federal or state law when deciding how to recharacterize a debt claim as a capital contribution. The manner in which this case is decided will have a significant influence on how bankruptcy cases proceed.

The Role of Recharacterization

Recharacterization presents an important role to lenders and investors in companies facing financial difficulties. Current bankruptcy law allows secured creditors to receive top priority while equity interests have a lower priority and are frequently wiped out during bankruptcy. Applicable federal law currently results in the recharacterization of debt to equity, while state law does not always result in this type of recharacterization.

The Circuit Split on Recharacterization of Debt

Many circuits follow the federal rule in recharacterization of debts and apply a variety of multi-factor tests when determining whether to recharacterize debt as equity. The Third, Fourth, Sixth, Tenth, and Eleventh Circuit Courts hold the perspective that debt should often be recharacterized as equity, while the Fifth and Ninth Circuit apply state law. As a result, Oklahoma is part of the Tenth Circuit Court which characterizes debt as equity.

The Case to be Heard by the Supreme Court

The case to be heard by the Supreme Court comes from an appeal to the Fourth Circuit in the case of PEM Entities LLC v. Eric M. Levin & Howard Shareff.  The question presented in this case is whether a federal or state rule answers the questions of whether insider debt should be recharacterized as capital or equity. In this case, a group of investors wanted to develop a golf course with residences in North Carolina through the use of company called Province Grand Old Liberty LLC. To finance the investment, Province Grand Old Liberty LLC took out a bank loan secured by this real estate. When the loan was defaulted on, members of the equity investment group purchased the loan from the third-party bank at a significant discount for fear of losing the property due to foreclosure. Province Grand Old Liberty eventually filed a Chapter 11 bankruptcy petition in the Eastern District of North Carolina. Insider equity sponsors sought to enforce the claim in bankruptcy, but disgruntled junior creditors initiated a lawsuit. The bankruptcy court responded to the case by applying the Fourth Circuit’s test and classified the third party loan as capital. A higher court, however, then recharacterized the debt as equity.

Obtain the Assistance of a Talented Bankruptcy Lawyer

There are still some uncertainties about how bankruptcy attorneys should handle various issues that can arise in bankruptcy cases. While federal rules give bankruptcy courts the power to decide how to recharacterize debt as equity, state rules are often contrary. How the Supreme Court decides this case will have some substantial impact on business owners who make debt investments from distressed companies. By contacting the law office of Jim A. Lyon, you can obtain the assistance of attorney who can help you navigate the various issues that arise during the bankruptcy process.