First Impressions: Fifth Circuit Rules That Noninsider Claims Can Be Recharacterized As Equity

The ability of a bankruptcy court to reorder the priority of claims or interests by means of equitable subordination or recharacterization of debt as equity is generally recognized. Even so, the Bankruptcy Code itself expressly authorizes only the former of these two remedies. Although common law uniformly acknowledges the power of a court to recast a claim asserted by a creditor as an equity interest in an appropriate case, the Bankruptcy Code is silent upon the availability of the remedy in a bankruptcy case. This has led to uncertainty in some courts concerning the extent of their power to recharacterize claims and the circumstances warranting recharacterization. The Fifth Circuit Court of Appeals recently had an opportunity to weigh in on this issue as an apparent matter of first impression in that court. In Grossman v. Lothian Oil Inc. (In re Lothian Oil Inc.), 650 F.3d 539 (5th Cir. 2011), the court ruled that a bankruptcy court's ability to recharacterize debt as equity is part of the court's authority to allow and disallow claims, and the remedy is not limited to claims asserted by corporate insiders.

Equitable Subordination and Recharacterization

Although the distinction between courts of equity and law has largely become irrelevant in modern times, courts of equity have traditionally been empowered to grant a broader spectrum of relief in keeping with fundamental notions of fairness, distinguished from principles of black-letter law. One of the tools available to a bankruptcy court in exercising its broad equitable mandate is "equitable subordination." Equitable subordination is a remedy developed under common law prior to the enactment of the current Bankruptcy Code to remedy misconduct that results in injury to creditors or shareholders. It is expressly recognized in Bankruptcy Code section 510(c), which provides that the bankruptcy court may, "under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest." However, the statute explains neither the concept nor the standard that should be used to apply it. This has been left to the courts. In In re Mobile Steel Co., 563 F.2d 692 (5th Cir. 1977), the Fifth Circuit Court of Appeals articulated what has become the most commonly accepted standard for equitable subordination of a claim. Under the Mobile Steel...