The Bankruptcy Code contains specific provisions that permit the subordination or disallowance of claims of insiders or others that may not, at equity, be entitled to the same status as a regular prepetition claim holder. For example, such claims may be equitably subordinated under section 510(c) or disallowed under certain subsections of section 502. In addition, some courts have held that section 105 affords bankruptcy courts authority to reorder the priority of claims, even if the provisions of the Code that permit subordination or disallowance would not otherwise apply.  In such circumstances, Courts have recharacterized debt as equity investments, effectively subordinating the claims.

In a recent unpublished opinion, the Fourth Circuit Court of Appeals shed some light on the circumstances under which recharacterization of debt to equity may be appropriate. In In re Province Grande Old Liberty, LLC, Case No. 15-1669, 2016 WL 4254917 (4th Cir. Aug. 12, 2016), the debtor financed the acquisition of its principal asset, a golf and residential real estate development, through a loan from Paragon Commercial Bank (“Paragon”).  The debtor subsequently defaulted on the loan and Paragon initiating foreclosure proceedings.  In an effort to resolve the foreclosure proceedings, the debtor and Paragon entered into a settlement agreement pursuant to which Paragon agreed to sell its loan to a new company, PEM, at a significant discount.  PEM was owned by insiders of the debtor and funded its purchase of the loan through a combination of equity contributions from its members and outside debt.

The debtor filed its bankruptcy petitions in the United States Bankruptcy Court for the Eastern District of North Carolina on March 11, 2013, and its petitions listed PEM’s claim at $7,000,000, which included the principal of the original Paragon loan (as opposed to the loan purchase price) and accrued interest. Two creditors of the debtor, seeking to increase recoveries on their own claims, initiated an adversary proceeding to have PEM’s debt equitably subordinated or reclassified as an equity interest in the debtor.

The bankruptcy court granted summary judgment in favor of the creditors, concluding that PEM’s loan purchase was, in effect, a settlement and satisfaction of the Paragon loan and that the portion of the loan purchase price funded by equity contributions should be recharacterized as equity. The effect was to invalidate PEM’s claim for the principal amount of the loan originally owed to Paragon.

PEM appealed the bankruptcy court’s order to the United States District Court for the Eastern District of North Carolina, which affirmed the bankruptcy court’s judgment. PEM then filed an appeal to the Fourth Circuit Court of Appeals.

The issue before the Fourth Circuit was not one of first impression — the Fourth Circuit had long recognized that a bankruptcy court’s equitable powers include “the ability to look beyond form to substance,” and had previously articulated the factors to consider in evaluating a request for recharacterization. See Fairchild Dornier GMBH v. Official Comm. of Unsecured Creditors (In re Official Committee of Unsecured Creditors for Dornier Aviation (North America), Inc.), 453 F.3d 225 (4th Cir. 2006).

In Dornier Aviation the Fourth Circuit held that in evaluating whether a debt claim should be recharacterized as equity, the court must evaluate: (1) the names given to the instruments, if any, evidencing the indebtedness; (2) the presence or absence of a fixed maturity date and schedule of payments; (3) the presence or absence of a fixed rate of interest and interest payments; (4) the source of repayments; (5) the adequacy or inadequacy of capitalization; (6) the identity of interest between the creditor and the stockholder; (7) the security, if any, for the advances; (8) the corporation’s ability to obtain financing from outside lending institutions; (9) the extent to which the advances were subordinated to the claims of outside creditors; (10) the extent to which the advances were used to acquire capital assets; and (11) the presence or absence of a sinking fund to provide repayments. Id.

 In Province, the bankruptcy court weighed these factors and found that all of them weighed in favor of recharacterization.  In particular, the bankruptcy court emphasized certain facts, including that (1) the agreement to settle the Paragon loan was a settlement agreement and was entered into “in settlement of the loan,” (2) PEM was not a signatory to the settlement agreement and was not involved in negotiations of the agreement; instead the Debtor’s principals negotiated the settlement agreement and note purchase on behalf of PEM and Paragon believed the Debtor’s principals had the authority to bind PEM, (3) the failure of the Debtor and PEM to observe any formalities regarding loan repayment and (4) the identify of interests between the Debtor and PEM.  In its review, the Fourth Circuit reiterated the bankruptcy court’s findings and held that “the bankruptcy court properly ‘looked beyond form’ to determine that the ‘substance of the transaction’ was in fact the settlement agreement in which the Debtor used PEM as an extension of itself to complete what was, in effect, a satisfaction of the Paragon loan.” Province, 2016 WL 4254917 at *3.

The Fourth Circuit decision is notable however, because it dispensed of a specific challenge to the bankruptcy court’s decision. Namely, PEM contended that the bankruptcy court misapplied the Dornier factors by applying them to the wrong transaction.  PEM argued that the bankruptcy court should have limited its analysis to the inception of the Paragon debt, rather than to the later settlement agreement.  The Fourth Circuit disagreed, noting that “[t]he recharacterization decision itself rests on the substance of the transaction” involved.” Id. citing Dornier, 453 F.3d at 232 (emphasis in original).  In Province, the Fourth Circuit concluded that the settlement agreement was the “substance of the transaction,” notwithstanding the fact that PEM was not a signatory to the agreement, because it was the basis of the note purchase and gave rise to PEM’s claims. In this respect the Fourth Circuit’s decision in Province is particularly noteworthy as precedent for a court evaluating recharacterization to look beyond the facts giving rise to the underlying claim and ultimately to the economic substance of the entire context of the transaction, even if the creditor whose claim is at issue was not a party to all components of that context.