Tag Archives: equity

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.

March 17, 2015

Ninth Circuit BAP Holds Law v. Siegel Precludes Barring a Debtor’s Amendment of Exemptions on Grounds of Bad Faith or Equity

In its opinion in Gray v. Warfield (In re Gray), 523 B.R. 170 (9th Cir. BAP 2014), the Ninth Circuit BAP held that the U.S. Supreme Court’s decision in Law v. Siegel, 134 S. Ct. 1188 (2014) precludes a bankruptcy court from denying a debtor’s amendment of his claim of exemption on equitable grounds.

Prior to filing bankruptcy, the Grays prepaid three months of rent on their residence, but did not list the prepaid rent as an asset in their schedules.  At the 341 meeting the trustee questioned their payment of $2707 to their landlord, at which time the debtors disclosed they had prepaid several months rent, including rent for the first two months after their bankruptcy filing.  Following the 341 meeting, the debtors amended their schedules to disclose the prepaid rent and also to assert an exemption in it, an exemption allowed by applicable state law.  The trustee filed an objection to the amended exemption, contending the debtors’ failure to list the asset initially constituted equitable grounds for denying the exemption, arguing the debtors acted in bad faith in failing to disclose the asset in the first place.  The bankruptcy court sustained the objection, and the debtors appealed. 

On appeal the BAP analyzed the question in light of the U.S. Supreme Court’s opinion in Law v. Siegel.  The BAP noted two pre-Law v. Siegel opinions which held that a debtor could be denied the right to amend his exemption schedule if the debtor’s failure to initially disclose the asset was done in bad faith:  (1) the Ninth Circuit’s opinion in Martinson v. Michael (In re Michael), 163 F.3d 526, 529 (9th Cir. 1998 (“Whether the [debtors] could amend their schedules post-petition is separate from the question whether the exemption was allowable.”); (2) Doan v. Hudgins (In re Doan), 672 F.2d 831, 833 (11th Cir. 1982).  The BAP initially concluded that the distinction noted by the Ninth Circuit in Michael is meaningless—denying a debtor the right to amend an exemption schedule on equitable grounds has the identical effect of disallowing the exemption. 

The BAP then looked to well-settled case law to the effect that a claimed exemption is presumptively valid, and also that Fed. R. Bankr. Proc. 1009(a) gives a debtor the right to amend any schedule “as a matter of course at any time before the case is closed” without court approval.  The court also noted that, prior to Law v. Siegel, courts had crafted judicially created exceptions to limit the right to amend on a showing of either the debtor’s bad faith or prejudice to creditors. 

The BAP concluded that Law v. Siegel changed the landscape, and that courts no longer may deny a debtor’s right to amend his claims of exemption on findings of bad faith or other equitable grounds:  “The Supreme Court’s definitive position that the Bankruptcy Code does not grant bankruptcy courts ‘a general, equitable power . . . to deny exemptions based on a debtor’s bad-faith conduct’ is clearly irreconcilable with the use of judicially created remedies either to bar amendments or to disallow amended exemptions.” 

However, the BAP noted the Supreme Court in Law v. Siegel, recognizes that exemptions created under state law are governed in their allowance by state law.  Consequently, the BAP remanded the case to the bankruptcy court to determine if applicable state law provided equitable grounds for denial of the exemption.

March 5, 2014

SCOTUS Tells the Ninth Circuit to Follow the Law: Section 105(a) Is Not a Means to Contravene Other Provisions of the Bankruptcy Code

Stephen Law filed a chapter 7 petition in California.  His only valuable asset was his home, which he scheduled at a value of $363,348.  Washington Mutual Bank held a lien against the home to secure a loan in the amount of $156,929.  Law asserted a homestead exemption under California law of $75,000.  In order to prevent the bankruptcy trustee from selling his home, Law fabricated a second lien against his home which consumed his entire equity, and obtained the cooperation of a Chinese national named Lili Lin to assert that she was actually owed money by the debtor.  The bankruptcy trustee brought an adversary proceeding to avoid the lien, an action which Law and Lin vigorously opposed.  In what some might call a poor financial decision, the bankruptcy trustee incurred $500,000 in legal fees overcoming Law’s fraudulent misrepresentations regarding his $363,000 home.  The bankruptcy court approved a surcharge of the debtor’s $75,000 homestead exemption to pay a portion of the trustee’s legal fees, a holding which was affirmed by the Ninth Circuit BAP and the Ninth Circuit.

The Supreme Court reversed in its opinion in Law v. Siegel, 2014 WL 813702 (March 4, 2014).  The Supreme Court held that neither 11 U.S.C. § 105(a) nor the bankruptcy court’s inherent powers provided a basis for a bankruptcy court to contravene the express language of § 522 of the Bankruptcy Code allowing debtors to claim exemptions in certain assets. In addressing § 105(a), the Court stated  “A bankruptcy court has statutory authority to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of” the Bankruptcy Code. . . But in exercising those statutory and inherent powers, a bankruptcy court may not contravene specific statutory provisions,” and that “It is hornbook law that § 105(a) ‘does not allow the bankruptcy court to override explicit mandates of other sections of the Bankruptcy Code.’” (citing 2 Collier on Bankruptcy ¶ 105.01[2], p. 105-6 (16th ed. 2013).  Consequently, because § 105(a) confers on bankruptcy courts the authority to “carry out” the provisions of the Bankruptcy Code, “it is quite impossible to do that by taking action that the Code prohibits.” 

The Court also rejected the trustee’s argument that the surcharge did not contravene § 522 of the Code.  The trustee argued that a bankruptcy court has equitable power to deny an exemption in response to a debtor’s misconduct.  The Court first held that the trustee’s failure to object to the debtor’s homestead objection within the time required by the Code prevented him from challenging the exemption through seeking a surcharge.  In addition, the Court held that the plain language of § 522 prevented the surcharge.  Section 522(b) provides that the debtor may exempt property, and the Court interpreted this provision as vesting the debtor, not the bankruptcy court, with the discretion on whether the exemption can be claimed.  Section 522 contains various bases on which an exemption can be limited or disallowed, some of which relate to misconduct by the debtor.  The Court held that § 522’s “meticulous—not to say mind-numbingly detailed” list of restrictions and limitations on a debtor’s right to assert an exemption “confirms that courts are not authorized to create additional exceptions.”  Consequently, the debtor’s misconduct in fabricating a lien was not grounds to deny his exemption.

Finally, the Court held that its prior decision in Marrama v. Citizens Bank, 549 U.S. 365 (2007) did not require a different result.  The Court explained its decision in Marrama as one where a chapter 7 debtor could be denied his statutory right to convert his bankruptcy case to a chapter 13 proceeding because his bad faith conduct prevented him from qualifying for relief under chapter 13, and should not be read as providing bankruptcy courts with an equitable right to take action which contravenes the express provisions of the Bankruptcy Code.

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.