Lothian Oil: Fifth Circuit Recharacterizes Non-Insiders' Debt Claim As Equity

By Stefan W. Engelhardt and John A. Pintarelli1

On August 9, 2011, the United States Court of Appeals for the Fifth Circuit held that a non-insider's debt claim can be recharacterized as equity in Grossman v. Lothian Oil Inc. (In re Lothian Oil, Inc.).2 The Fifth Circuit, in reversing the district court, held that: (i) there is no per se rule limiting to insiders the recharacterization of debt claims as equity and (ii) non-insider debt claims may be recharacterized as equity under section 502(b) of the Bankruptcy Code.

With the court's extension of the recharacterization test to non-insiders, lenders must ensure that they properly structure and document a loan transaction. Lenders can no longer rely on the perception of a per se rule limiting debt recharacterization to insiders.

BACKGROUND

Israel Grossman ("Grossman") filed several proofs of claim in the bankruptcy cases of Lothian Oil and its affiliates (collectively, "Lothian Oil"). One of these claims, in the amount of $250,000, was based on a handwritten agreement dated April 27, 2005 between Grossman and Lothian Oil (the "Initial Loan") that stated "Grossman loans $200,000 U.S. to Lothian Oil, Inc."3 In exchange, Grossman was to receive a one percent royalty on the debtors' gross production of oil and gas from its properties in New Mexico, an area known as Webb Properties. The principal was to be repaid from proceeds of an anticipated $0.75 equity issuance or any other equity issued by Lothian Oil.4

A second claim, also for $250,000, was based on a "Loan Agreement" between Grossman and Lothian Oil dated May 12, 2005 (the "Additional Loan" and together with the Initial Loan, the "Loans") that stated "Grossman shall loan the sum of $150,000 to Lothian Oil"5 and in consideration for the loan, Grossman was to receive a royalty of one percent of Lothian Oil's share of gross production of oil and gas on the Webb Properties in New Mexico, without further investment to be made by Grossman. Principal was to be repaid from the proceeds of an anticipated $0.75 equity issuance, or from the proceeds – subject always to a certain Sterling Bank credit agreement – of any other equity issued by Lothian Oil.6

The United States Bankruptcy Court for the Western District of Texas (the "Bankruptcy Court") held a hearing on these claims and entered an order sustaining Lothian Oil's objections, disallowing each of the disputed claims in their entirety. The Bankruptcy Court found that Grossman asserted common equity interests at best, for which there was insufficient evidence of value.7 The Bankruptcy Court determined that although the Loans contained elements of debt and equity, the one percent overriding royalty interest in the Webb Properties was equity and should be treated as such.8

Grossman filed a motion for reconsideration that was denied by the Bankruptcy Court,9 and later filed an appeal to the United States District Court for the Western District of...