The Supreme Court now has three bankruptcy cases on the docket for the term to begin in October. Immediately before the summer recess, the high court granted certiorari in PEM Entities LLC v. Levin, 16-492 (Sup. Ct.), to resolve a split of circuits by deciding whether bankruptcy courts should employ state or federal law in recharacterizing debt as equity.
All circuits addressing the issue agree that bankruptcy courts have power to recharacterize debt as equity. Although their tests may vary, the Third, Fourth, Sixth, Tenth and Eleventh Circuits employ federal law, relying on Section 105(a). The Fifth and Ninth Circuits follow state law and Section 502. The federal rule of decision emanated from the Sixth Circuit in 2001. The Fifth Circuit first created the split in 2011.
The Case in North Carolina
A real estate project was encumbered by a $6.5 million secured loan provided by a bank. With the loan in default, some of the debtor’s insiders formed an LLC that purchased the loan from the bank for about $1.25 million. Part of the purchase price for the loan was paid with loans secured by the debtor’s property. After the purchase, the original loan remained on the property.
The debtor eventually filed a chapter 11 petition. Arguing that the loan was a “transparent effort by lenders to strip equity from the debtor,” creditors filed an adversary proceeding seeking to recharacterize the debt as equity or equitably subordinate the loan. On cross motions for summary judgment, the bankruptcy court found no basis for equitable subordination, because there was no evidence of inequitable conduct and the loan was purchased for a fair price at arm’s length.
Invoking federal law as required by Fourth Circuit precedent, the bankruptcy court did recharacterize the loan as equity, utilizing 11 factors adopted from the Sixth Circuit. The bankruptcy court focused on the deep discount on the sale of the loan, the buyer’s failure to enforce the loan before bankruptcy, the debtor’s poor financial condition, and the buyer’s insider status.
The petitioner contends that North Carolina law would not have permitted recharacterization.
The district court and the Fourth Circuit upheld the bankruptcy court. None of the decisions were officially reported.
Following denial of rehearing en banc, the purchaser of the loan filed a petition for certiorari.
The Supreme Court granted certiorari on June 27 to resolve a split of circuits where two circuits employ state law and five invoke federal law. The case will likely be argued in the Supreme Court in November or December.
The Opposing Camps
The case pits Section 502 against Section 105(a).
Courts using federal law focus on the constitutional power of Congress to make uniform laws on bankruptcy. Emphasizing the need for uniformity throughout the country, those courts rely on Section 105(a) to develop federal standards governing recharacterization.
The opposing camp believes that Butner v. United States, 440 U.S. 48 (1979), and Section 502 require following state law. Butner mandated state law to determine the allowability of claims, except where Congress specified otherwise.
Section 502(b), in the opinion of the petitioner, supplies the only federal grounds for disallowing a claim that is otherwise allowable under state law. Since recharacterization does not fit within Section 502(b), the petitioner believes that courts must follow state law.
On the other hand, disallowance and recharacterization may not be the same, making Section 502(b) inapplicable and giving bankruptcy courts more leeway to promote uniformity from state to state in the outcome of reorganizations. Stated in other terms, perhaps reclassification of a proof of debt to a proof of equity does not involve the disallowance of a claim, just proper classification under federal principles.
The case might also be seen as turning on whether the Supreme Court, as currently constituted, is more favorably inclined toward Law v. Siegel, 134 S. Ct.1188 (2014), or Marrama v. Citizens Bank of Mass., 549 U.S. 365 (2007).
In Law, a unanimous opinion, the justices barred courts from departing from the mandates of the Bankruptcy Code. As interpreted by a Third Circuit opinion this month, Marrama, a 5/4 decision, means that a court can use Section 105 unless there is something in the statute “that prohibited the bankruptcy court’s order.” In re Ross, 15-2222 (3d Cir. June 6, 2017). To read ABI’s discussion of Ross, click here.
The outcome of the case will make no practical difference in states that follow federal law.
On May 1, the Supreme Court granted certiorari in Merit Management Group LP v. FTI Consulting Inc., 16-784 (Sup. Ct.), to decide whether the “safe harbor” for securities transactions applies under Section 546(e) when a financial institution acts only as a “mere conduit.” To read ABI’s discussion of Merit Management, click here.
In late March, the justices agreed to hear U.S. Bank NA v. The Village at Lakeridge LLC, 15-1509 (Sup. Ct.), and decide whether the purchaser of a claim automatically takes on the seller’s insider status. To read ABI’s discussion of Lakeridge, click here.