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In a recent unpublished opinion, the Fourth Circuit Court of Appeals shed some light on the circumstances under which recharacterization of debt to equity may be appropriate.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.

In the beginning of the opinion he wrote for Stern v. Marshall, Chief Justice Roberts referenced Charles Dickens’ Bleak House, in which Dickens gives a grim description of a lawsuit litigated in a foggy courtroom.[1] In resolving the tumultuous Stern dispute, the Supreme Court created a new fogginess in bankruptcy courtrooms as to the exact contours and scope of a bankruptcy courts’ authority. As our readers are aware, the Supreme Court and the various Circuit Courts have issued a number of opinions in the wake of Stern to clarify the exact parameters of a bankruptcy court powers and the recent opinion by the Fourth Circuit in In re Lewis addressing the specific power of a bankruptcy court to discipline attorneys further helps clear the proverbial fog surrounding the bankruptcy courts’ powers.[2]

In In re Lewis, Mr. Lewis was the attorney to a debtor in bankruptcy.[3] The Bankruptcy Administrator observed several discrepancies in Mr. Lewis’ representation, prompting the Bankruptcy Court to sanction and temporarily suspend Mr. Lewis from further proceedings.[4] On appeal, Mr. Lewis contended that the court did not have the authority, as an Article I tribunal, to suspend his bar privileges or to sanction him.[5] Relying on Stern, he argued that the court did not possess the authority to rule on disciplinary matters against him.[6] The Fourth Circuit disagreed.[7]

The Court of Appeals explained that the Bankruptcy Court appropriately exercised its authority to sanction Lewis for his misconduct.[8] Bankruptcy courts have inherent power, “‘incidental to all courts’ to ‘discipline attorneys who appear before it,’”[9] including “issu[ing] any order, process, or judgment that is necessary or appropriate to carry out the provisions of [Title 11] or to prevent an abuse of power”[10] and suspending or disbarring attorneys from their court.[11] So, despite any Constitutional restrictions prescribed upon Article I courts, all courts may admonish and discipline those who appear before them.

[1] Stern v. Marshall, 131 S. Ct. 2594 (2011)

[2] In re Lewis, 2015 WL 3561277 (E.D. N.C. June 9, 2015).

[3] In re Lewis, 2015 WL 3561277 at *1.

[4] Id.

[5] Id. at *2.

[6] Id.

[7] Id.

[8] Id.

[9] Id. (quoting Chambers v. NASCO, Inc., 501 US 32, 43 (1991).

[10] Id. (quoting 11 USC § 105(a)).

[11] Id. (citing In re Snyder, 472 U.S. 634, 643 (1985)).

The recipient of funds that a trustee seeks to recover by means of a fraudulent transfer claim may avoid liability by establishing that it took “for value and in good faith,” under section 548(c) of the Bankruptcy Code.  The Bankruptcy Code does not define “good faith,” and case law does not provide a clear precedent of what constitutes good faith; rather courts generally consider whether the transferee knew or should have known of the debtor’s financial distress at the time of the transfer.  In its recent decision in In re Taneja (Gold v. First Tennessee Bank National Association), a divided Fourth Circuit Court of Appeals considered the meaning and proper application of the good faith defense in actions to avoid and recover fraudulent transfers under section 548. No. 13-1058, 743 F.3d 423 (4th Cir. Feb. 21, 2014).  The Fourth Circuit’s decision in Taneja does not provide a “bright line” legal precedent, but it does appear to lower the bar with respect to a transferee’s factual burden.  In Taneja, the court held that a transferee need not present evidence that its every action concerning the relevant transfers was objectively reasonable in light of industry standards.  Rather, the court’s inquiry regarding industry standards serves only to establish the correct context in which to consider what the transferee knew or should have known, and expert testimony is not necessarily required to establish that context.

In Taneja the debtor, Vijay K. Taneja, originated home mortgages through his company Financial Mortgage Inc. (“FMI”) and sold them to secondary purchasers who, in turn, aggregated and securitized the loans to create “mortgage-backed securities.”[1]  Taneja and FMI financed these loans by borrowing funds from warehouse mortgage lenders, including the defendant First Tennessee Bank National Association (the “Bank”).  Prior to filing for bankruptcy, Taneja and FMI transferred funds to the Bank in repayment of outstanding loans.  The bankruptcy trustee for Taneja and FMI brought an action to void and recover the repaid loan amounts as fraudulent transfers under section 548.  In response, the Bank asserted a good faith defense under section 548(c).  The Bankruptcy Court found that the Bank had accepted the transfers for value and in good faith, and the District Court affirmed.

On the trustee’s appeal, the Fourth Circuit considered the proper context in which to evaluate the reasonableness of a transferee in accepting funds later deemed to constitute a fraudulent conveyance.  Both lower courts had relied on the standard articulated in In re Nieves, 648 F.3d 232,237 (4th Cir. 2011), which bifurcated the good faith requirement into two components.  The first, a subjective component, relates to the transferee’s “honesty” and “state of mind,” while the second, objective, component relates to the transferee’s “observance of reasonable commercial standards.”  Notably, Nieves made clear that a transferee does not act in good faith if it “fails to abide by routine business practices.”

In Taneja, the Fourth Circuit affirmed the application of the binary standard of Nieves compelling the consideration of what the transferee “should have known . . . taking into consideration the ‘customary practices of the industry in which [it] operates’.”  However, the court held that a transferee relying on section 548(c) is not required to demonstrate that it abided by “routine business practices”, stating, “[w]e decline to adopt a bright-line rule requiring that a party asserting a good faith defense present evidence that his every action concerning the relevant transfers was objectively reasonable in light of industry standards.”  Instead, the court stated, “our inquiry regarding industry standards serves to establish the correct context in which to consider what the transferee knew or should have known.”  Relying on the bankruptcy court’s finding that the bank’s witnesses presented credible testimony concerning the bank’s practices “. . . and the mortgage warehouse industry,” the Fourth Circuit held that the district court did not clearly err in holding that the transferee Bank had carried its burden of showing that it received payments from FMI in good faith.[2]

Practical Implications

While the opinion does not go so far as to pronounce a clear legal standard by which to assess whether a fraudulent transfer is received in good faith, courts following the guidance of the Fourth Circuit’s precedent may apply relaxed standards of proving a good faith defense under section 548(c), particularly with respect to the objective component regarding the transferee’s observance of reasonable commercial standards.  Significantly, the panel unanimously agreed that the objective component of 548(c) could be satisfied through lay witness testimony from the transferee, and that expert testimony was not required.


[1].      Details of the fraud are provided in the court’s decision in In re Taneja (Gold v. First Tennessee Bank Nat’l Assoc.), No. 13-1058, 2014 WL 661065 (4th Cir. Feb. 21, 2014).  The Fourth Circuit reviewed the District Court decision for clear error, and as a result concluded it was not required to render any decision regarding whether the trustee was entitled to a ‘Ponzi scheme presumption’ with respect to the alleged fraudulent conveyances.

[2].      In re Taneja, 2014 WL 661065 at *12.  Although the objective good faith standard articulated by the Fourth Circuit in Taneja considers the “routine” or “customary” practices of the industry in which the transferee Bank operated, the Bank in Taneja presented scant, if any, evidence of customary industry practices, to the vexation of both the trustee and lone dissenting circuit judge James A. Wynn, Jr.  Instead, the case turned on evidence presented by the Bank of a downturn in the mortgage warehouse industry at the time it received the transfers.

On December 3, 2013, the Court of Appeals for the Fourth Circuit upheld, in  Jaffe v. Samsung Electronics Co., the power, and the duty, of a United States Bankruptcy Court to condition the grant of Bankruptcy Code section 1521(a)(5) relief to a foreign insolvency administrator on conditions sufficient to protect the interests of all interested parties affected by the relief.

Jaffe v. Samsung concerned approximately 4,000 U.S. patents owned by Qimondo AG when it entered insolvency proceedings in 2009.  These patents related to various kinds of semiconductor technology, and were subject to numerous cross-license agreements with other semiconductor manufacturers that allowed each cross-licensee to design freely without risk of running afoul of the dense “thicket” of overlapping intellectual property rights.  The Fourth Circuit characterized these cross-licenses as, essentially, promises made by Qimondo not to sue the licensors.  In exchange, Qimondo received a similar promise.  The cross-licensees, who were the appellees  (Samsung Electronics Company, Infineon Technologies, IBM, Hynix Semiconductor, Inc. Intel Corporation, Nanya Technology Corporation, and Micron Technology) are among the biggest semiconductor manufacturers in the world.

Michael Jaffe, the German insolvency administrator for Qimondo, successfully petitioned the Bankruptcy Court for the Eastern District of Virginia to recognize the German insolvency proceeding as a “foreign main proceeding” under Chapter 15 of the Bankruptcy Code.  Specifically, Jaffe requested that the Bankruptcy Court entrust to him the administration of all of Qimondo’s U.S. assets, principally consisting of the 4,000 U.S. patents.  The Bankruptcy Court granted Jaffe’s petition, but conditioned this discretionary relief on Jaffe affording the licensees the same treatment they would have received under Bankrupty Code section 365(n).  Section 365(n) allows the licensee of a right to intellectual property under a rejected executory contract to elect to retain its rights under the license, just as they existed immediately before the bankruptcy case commenced.

Jaffe, however, sought to cancel unilaterally the cross-licenses, pursuant to section 105 of the German bankruptcy code, in order to relicense them for annual cash payments that would flow to and benefit Qimondo’s creditors.  The cross-licensees argued that the Bankruptcy Court correctly conditioned Jaffe’s power to administer the U.S. assets of Qimondo on the protections in section 365(n), and that enforcing section 365(n) would not make the U.S. patents valueless, since they could still be sold to entities that had not yet licensed them.

The Fourth Circuit held that Chapter 15 requires courts to weigh the interests both of debtors and creditors, and particularly local creditors, when granting discretionary relief to foreign estate administrators under section 1521.  This is required both by section 1506, which forbids the application of foreign bankruptcy law when granting comity would be manifestly contrary to the public policy of the United States, and by section 1522 which requires the Bankruptcy Court balance the interests of all interested parties before awarding any section 1521 relief.

In reaching this conclusion, the Fourth Circuit weighed the risk that allowing Jaffe to use German law to override section 365(n) and reject the cross-licenses could destabilize the semiconductor industry leading to decreased innovation, confidence, and competition against the benefits of an improved recovery for Qimondo’s other creditors.  The court also posited that other licensors might transfer their patents to German entities created only to allow them to reject the licenses in bankruptcy.  Although these risks were difficult to quantify, the court determined that the Bankruptcy Court’s decision granting the cross-licensees the protection of section 365(n) was a reasonable exercise of its discretion.

Chapter 15 of the Bankruptcy Code strikes an important balance between advancing international comity and providing fair and efficient insolvency proceedings for international businesses and protecting the national interests of the United States.  The Fourth Circuit’s decision in Jaffe v. Samsung shows the result of that balance: the German insolvency administrator was granted control over the U.S. assets of Qimondo, but subject to conditions that protected the public policy of the United States and the interests of Qimondo’s American creditors.