Tag Archives: debt

June 21, 2016

Supreme Court Expands Creditors’ by Allowing Denial of a Discharge Under Sec. 523(a)(2)(A) if Debtor Transfers Assets in Violation of State Fraudulent Transfer Statute

Section 523(a)(2)(A) of the Bankruptcy Code allows a creditor to obtain a judgment denying its debtor a discharge of debts incurred by false pretenses or actual fraud. However, if the debt itself was not incurred by actual fraud, but the debtor subsequently transfers his assets with the intent prevent its creditors from obtaining payment, may the creditor still obtain a judgment denying the debtor’s discharge under § 523(a)(2)(A)? The United States Supreme Court answered that question in the affirmative in its recent decision in Husky International Electronics, Inc. v. Ritz, 2016 WL 2842452 (2016).

Chrysalis Manufacturing Corp. incurred a debt to Husky International arising from Chrysalis’s purchase from Husky of components used in electronic devices. Over a period of four years, Chrysalis incurred a debt to Husky totaling over $160,000. There was no contention that this debt was incurred as the result of false representations or actual fraud. However, during the latter part of this same period, Daniel Ritz, a director and owner of Chrysalis, caused Chrysalis to transfer virtually all its assets to other companies Ritz also controlled. Husky sued Ritz under a Texas statute which allows creditors to hold shareholders responsible for corporate debts under circumstances involving actual fraud. After Ritz filed a personal bankruptcy petition under chapter 7, Husky brought an adversary proceeding against him seeking denial of the dischargeability of its debt under § 523(a)(2)(A). The District Court concluded the Ritz was liable under the Texas statute but also concluded that the debt was not obtained by actual fraud could be discharged. The Fifth Circuit affirmed, agreeing the debt could be discharged since it was not incurred by actual fraud as required by § 523(a)(2)(A).

The Supreme Court reversed, holding the term “actual fraud” in § 523(a)(2)(A) “encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation.”

The Court commenced its analysis by first looking to the prior Bankruptcy Act, which prohibiting debtors from discharging debts obtained by false pretenses or false representations, but contained no provisions relating to situations which might constitute “actual fraud” but not fall within the meaning of false pretenses or false representations. Congress added the term “actual fraud” when it enacted the Bankruptcy Code in 1978. The addition of the words “actual fraud” were presumed by the Court to have “real and substantial effect.” The Court believed the words “actual fraud” were intended to mean something other than “false representation.” The Court then analyzed the historical meaning of the terms “actual fraud” and concluded the words have long included the type of fraudulent transfer scheme in which Ritz engaged. First, the Court noted the word “actual” has a simple meaning in the common law, and denotes any fraud that “involves moral turpitude or intentional wrong,” and stands in contrast to implied fraud or fraud in law. The Court stated “Thus, anything that counts as ‘fraud’ and is done with wrongful intent is ‘actual fraud.’”

The Court found analyzing the history of the word “fraud” to be more challenging, and although it “connotes deception or trickery generally,” was more difficult to precisely define. However, the Court noted the term “fraud” had long been used by courts to describe a debtor’s transfer of assets which impairs a creditor’s ability to collect a debt. The Court further noted that fraudulent conveyances at common law did not require a misrepresentation by a debtor to his creditor. The fraudulent conduct was not in inducing the creditor to extend credit but rather was in the act of concealment and hindrance. As a result, the Court determined the actual fraud need not be present at the inception of a credit transaction.

October 13, 2015

Tenth Circuit Holds that U.S. Supreme Court Decisions in Law v. Siegel and Travelers Casualty v. Pacific Gas & Electric do no Change Established Tenth Circuit Law on Recharacterization of Debt to Equity

Recently, the Tenth Circuit considered a case involving the question of whether the U.S. Supreme Court’s decisions in Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co., 549 U.S. 443 (2007) and in Law v. Siegel, 134 S. Ct. 1188 (2014) affected established Tenth Circuit precedent that a bankruptcy court’s authority to recharacterize debt as equity arises under 11 U.S.C. § 105(a).  In its decision in Redmond v. Jenkins, et al (In re Alternate Fuels, Inc.), 789 F.3d 1139 (10th Cir. 2015), the Tenth Circuit held that neither Supreme Court decision eliminated a bankruptcy court’s authority under § 105(a) to recharacterize debt as equity.  In so ruling, the Tenth Circuit reiterated the continued application of its decision in In re Hedged-Invsetments Assocs., Inc., 380 F.3d 1292 (10th Cir. 2004) and its factors for determining when debt should be recharacterized as equity.

In Hedged-Investments, the Tenth Circuit held that recharacterization of debt as equity involves a mixed question of law and fact which a bankruptcy court addresses pursuant to its general equitable powers under § 105(a) of the Bankruptcy Code.  In recharacterizing debt as equity, a court “effectively ignores the label attached to the transaction at issue and instead recognizes its true substance.”  In re Hedged-Investments, 380 F.3d at 1297.  In Alternate Fuels, the appellant/creditor argued that the U.S. Supreme Court’s decisions in Travelers Casualty and Law v. Siegel eliminated a bankruptcy court’s ability to recharacterize debt under § 105(a), leaving a court to do so only under § 502(b).   The appellant urged the court to follow the conclusions of the Fifth Circuit in In re Lothian Oil, Inc., 650 F.3d 539 (5th Cir. 2011) and the Ninth Circuit in In re Fitness Holdings Int’l, Inc., 714 F.3d 1141 (9th Cir. 2013), both of which rejected reliance on § 105(a) as a source of authority to recharacterize debt.  The Tenth Circuit declined and instead reiterated its conclusions in In re Hedged-Investments.  First, the Tenth Circuit noted that the Supreme Court did not expressly overrule Hedged-Investments in either opinion, nor did either opinion mention—much less deal with—recharactierization of debt.  The Tenth Circuit stated that disallowance of claims and recharacterization of debt require different inquiries and serve different functions.  In fact, the court noted that a claim can be allowed under § 502 and still recharacterized as equity as appropriate under the court’s equitable powers of § 105(a).  The court held that disallowance is appropriate where the claimant has not right of recovery against the debtor, whereas recharacterization is not an inquiry into the enforceability of the claim but rather an inquiry into the nature of the transaction between the claimant and the debtor. 

For these reasons, the Tenth Circuit held that courts continue to have equitable power under § 105(a) to recharacterize debt as equity.

July 22, 2013

Debt May Now Be Recharacterized as Equity in the Ninth Circuit

In a recently issued decision, the Ninth Circuit reversed long-standing precedent and held that, at least in the context of constructively fraudulent transfers, courts have the power to recharacterize debt as equity.  See Official Comm. of Unsecured Creditors v. Hancock Park Capital II, L.P. (In re Fitness Holdings Int’l, Inc.), 714 F.3d 1141 (9th Cir. 2013).  More precisely, in Fitness Holdings, the Ninth Circuit held that a transfer is for value, and therefore is not avoidable, if it is made in repayment of a “claim,” i.e., a right to payment under state law. 

In Fitness Holdings, the company executed several subordinated notes in favor of its sole shareholder, Hancock Park Capital.  In 2007, the company refinanced its debt.  It paid off Hancock Park’s
unsecured notes using secured debt.  About 16 months later, the company filed for bankruptcy protection.  Its unsecured creditors committee brought suit to recover the payments made to Hancock Park as constructively fraudulent transfers pursuant to Bankruptcy Code § 548(a)(1)(B). 
That section allows the bankruptcy trustee to recover transfers made within two years of bankruptcy if the debtor was insolvent and did not receive “reasonably equivalent value” in exchange for the transfer. 

Hancock Park claimed that the Debtor received reasonably equivalent value for the payments because
they reduced dollar-for-dollar the Debtor’s obligations to Hancock Park.  The committee argued that Hancock Park’s interest in the Debtor was not a debt, but an equity interest.  Thus, the payments to Hancock Park did not reduce a debt, and the Debtor received no value for the transfers.  The bankruptcy court and the district court agreed with Hancock Park, each holding that under Ninth Circuit Bankruptcy Appellate Panel precedent, they had no power to recharacterize debt as
equity.  See In re Pacific Express, 69 B.R. 112, 115 (B.A.P. 9th Cir. 1986).

The Ninth Circuit reversed.  It held that the Bankruptcy Code authorizes recharacterization. 
This authority is not derived, as other courts have found, from the court’s power to equitably subordinate claims (§ 510(c)) or its broad equitable powers (§ 105(a)).  Instead, it is found in the
Bankruptcy Code’s “interlocking definitions” of value, debt and claim.  Construing those definitions together, reasonably equivalent value is given when a debtor makes a transfer that satisfies a creditor’s “right to payment.” 

The Ninth Circuit thus joins several other circuits, including the Tenth Circuit, which explicitly recognize the doctrine of recharacterization.  Notably, however, the Ninth and Tenth Circuits apply different tests for recharacterization. The Tenth Circuit applies a multi-factor test derived from federal tax law to determine whether an interest is more like equity or debt.  See In re Hedged-Investments Associates, Inc., 380 F.3d 1292, 1298 (10th Cir. 2004); see also In re Autostyle Plastics, Inc., 269 F.3d 726, 748 (6th Cir. 2001).  The Ninth Circuit, in contrast, looks to underlying state law to determine whether a party holds a “right to payment.”  See Fitness Holdings, 714 F.3d at 1146; see also In re Lothian Oil, 650 F.3d 539, 543 (5th Cir. 2011). 

The Fitness Holdings decision opens new strategic avenues for creditors in the Ninth Circuit,
especially those that are undersecured or hold unsecured claims.  First, if the debtor has made pre-petition payments on purported “loans” to insiders, creditors should consider whether those payments could be avoided as payments to equity.  Second, to the extent Fitness Holdings can be read to apply beyond the fraudulent transfer context, creditors with unsecured claims
can enhance their distribution by arguing for recharacterization of claims that have equity-like characteristics.  In this scenario, no additional funds are brought into the estate, but a true creditor’s relative priority is enhanced as equity-like claims are functionally subordinated.

The Fitness Holdings decision also suggests a reason for caution: creditors receiving pre-petition transfers from the debtor need to be certain the transfers are made on account of a clear
“right to payment” under state law.  This may require research of underlying state law to be sure the transfer is insulated from avoidance.