In an opinion issued April 30, In re Fitness Holdings International, 2013 U.S. App. LEXIS 8729, the U.S. Court of Appeals for the Ninth Circuit joined a number of other circuit courts in recognizing the authority of courts to recharacterize purported debt owed by a corporation as equity. The case serves as reminder to shareholders and other corporate insiders that an insiders contribution of funds to a debtor must be treated as a loan, and not an equity contribution, if it is to give rise to a claim in bankruptcy rather than a mere equity interest.
The distinction between debt and equity is critical in bankruptcy in a couple of ways. One is that equity interests in a debtor are subordinate to the claims of creditors in the bankruptcy priority scheme. Equity interests cannot be paid unless creditors claims are paid in full. A second potential consequence, and the one at issue in Fitness Holdings, is that while a pre-petition payment of debt cannot constitute a constructively fraudulent transfer that is avoidable in bankruptcy, the pre-petition payment of an equity interest may be subject to avoidance because it is not made in exchange for reasonably equivalent value for the debtor, in the form of the satisfaction of an existing debt.
