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 insider’s 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.

Background

In Fitness Holdings, the Ninth Circuit vacated the district court’s judgment affirming the bankruptcy court’s dismissal of a complaint alleging that a debtor’s pre-bankruptcy transfer of funds to its sole shareholder, in repayment of a purported loan, was a constructively fraudulent transfer under Section 548 of the Bankruptcy Code. In doing so, the court broke from Ninth Circuit precedent and joined with the Third, Fourth, Fifth, Sixth and Tenth circuits in holding that a court has the authority to recharacterize a purported loan as an equity investment.

Fitness Holdings International Inc. was a home fitness corporation. Prior to its bankruptcy, the company received significant funding from Hancock Park Capital II L.P., its sole shareholder. Between 2003 and 2006, Fitness Holdings executed 11 separate subordinated promissory notes to Hancock Park for a total of approximately $24 million. Each note required Fitness Holdings to pay a specified principal amount to Hancock Park, plus interest of 10 percent per year, on or before the note’s maturity date. In June 2007, Fitness Holdings refinanced its existing bank debt and disbursed approximately $12 million of the new loan proceeds to Hancock Park to pay off its notes.

Fitness Holdings filed for Chapter 11 bankruptcy in October 2008. The committee of unsecured creditors appointed in the case filed a complaint against Hancock Park in the bankruptcy court, asking the court to characterize the financing Hancock Park provided to Fitness Holdings in connection with the promissory notes as equity investments in Fitness Holdings, rather than extensions of credit. As a result, the complaint alleged, the transfer of approximately $12 million to Hancock Park did not satisfy a debt and was therefore constructively fraudulent.

The bankruptcy court dismissed the complaint for failure to state a claim upon which relief could be granted. The bankruptcy case was subsequently converted to a Chapter 7 case in April 2010, and a Chapter 7 trustee was appointed. The trustee appealed the bankruptcy court’s dismissal of the complaint to the district court, which affirmed the dismissal. The district court held that, under longstanding precedent of the Ninth Circuit Bankruptcy Appellate Panel, it was barred from recharacterizing Hancock Park’s advances to Fitness Holdings as equity investments. The trustee timely appealed to the Ninth Circuit, claiming that the district court should have recharacterized Hancock Park’s payment of the $12 million to Fitness Holdings as a payment in satisfaction of an equity interest rather than a debt, and then avoided Fitness Holdings’ $12 million transfer to Hancock Park as a constructively fraudulent transfer under Section 548 of the Bankruptcy Code.

Debt/Equity Determination Turns on Right to Payment

Hancock Park’s liability for receiving a constructively fraudulent transfer turned on whether the $12 million payment was in exchange for reasonably equivalent value to the debtor. Under Section 548(a)(1)(B) of the Bankruptcy Code, a transfer is constructively fraudulent if the debtor made the transfer on or within two years of the petition date, the debtor “received less than a reasonably equivalent value in exchange for such transfer,” and one of four circumstances reflecting the insolvency or other financial impairment of the debtor is present.

The Bankruptcy Code does not define “reasonably equivalent value,” but “value” is defined so as to include “the satisfaction or securing of a present or antecedent debt of the debtor.” As a result, payment of a pre-existing debt is value, and if the payment is in dollar-for-dollar reduction of debt, full value is given. The Bankruptcy Code defines “debt” to mean “liability on a claim.” “Claim,” in turn, is defined to mean “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.” Thus, under the Bankruptcy Code, a debt encompasses virtually any right to payment.

The question in Fitness Holdings therefore was whether Fitness Holdings’ transfer of $12 million to Hancock Park satisfied a debt, or right to payment, or instead represented a distribution to equity; if the latter, Fitness Holdings received no value in return for the payment. The Ninth Circuit determined that the district court erred when it concluded that it was barred from even considering whether Hancock Park actually had made equity investments, rather than loans, to Fitness Holdings and therefore held equity interests rather than debt. The Ninth Circuit did not reach the merits, but instead vacated the district court’s dismissal of the constructively fraudulent transfer claim and remanded for further proceedings consistent with its opinion.

Circuit Split

Despite the broad agreement among a number of courts of appeals that the Bankruptcy Code authorizes courts to recharacterize purported claims, the circuits have taken different approaches in identifying the legal framework for this recharacterization.

With Fitness Holdings, the Ninth Circuit has now joined the Fifth Circuit in holding that state law governs the issue of whether a “right to payment” has been created. These circuits have reasoned that, under the Supreme Court precedent of Butner v. United States, 440 U.S. 48 (1979), unless Congress has otherwise provided, the nature and scope of a right to payment must be determined by reference to state law.

In contrast, the Third, Fourth, Sixth, and Tenth circuits have held that federal tests should be applied in determining whether a transaction is more like “debt” or “equity.” Some of these courts have identified specific factors to consider, such as how the parties have labeled the purported debt; the payment terms, including maturity date, interest rate and payment schedule; whether the loan is secured; and whether the company is able to obtain financing from outside lending institutions. Others, including the Third Circuit, have rejected multi-factor tests as being too rigidly formulaic and instead prescribe a common-sense evaluation of parties’ intent through a review of all of the case-specific circumstances.

Observations

Shareholders and other insiders should be mindful of the possibility for recharacterization when providing financing to a corporate entity. What are the nature and scope of rights that the parties intend to create through the financing? Is the transaction an extension of credit by the insider, with a clear expectation of repayment on certain defined terms? Or is an equity contribution instead being made? All too often, insiders do not think in terms of whether a debt (i.e., right to payment) or equity interest exists, but rather in the too-vague construct of whether “putting money in” to a company later justifies “taking money out” of a company. Where a true loan is intended by an insider, the transaction should be documented carefully, with consideration given toward the legal standards that may be applied to determine whether a claim or equity interest has been created.

Eric Scherling is a member of Cozen O’Connor, where he practices in the firm’s bankruptcy, insolvency and restructuring practice group. He can be reached at 215-665-2042 or escherling@cozen.com.