Fifth Circuit Rejects Per Se Rule That Recharacterization Applies Only To Insiders

In a recent ruling, the Fifth Circuit Court of Appeals rejected a per se rule that only corporate insiders can have their debt claims recharacterized as equity. Instead, in In re Lothian Oil Inc., 2011 WL 3473354 (5th Cir. Aug. 9, 2011), the Court of Appeals held that "recharacterization extends beyond insiders and is part of the bankruptcy courts' authority to allow and disallow claims under 11 U.S.C. § 502." Thus, all creditors, regardless of their insider status, are susceptible to having their claims recharacterized as equity.

The Facts of the Case

While the case involved extensive litigation between the parties, the issue decided by the Court of Appeals – whether a bankruptcy court can recharacterize a claim as equity rather than debt – focused on two agreements between the debtor Lothian Oil Inc. ("Lothian") and a non-insider third-party, Israel Grossman ("Grossman"). Specifically, on each of April 27 and May 12, 2005, Grossman and Lothian signed documents pursuant to which Grossman "loaned" Lothian $200,000 and $150,000, respectively. Both agreements provided that Grossman would receive a royalty of one percent of Lothian's share of gross production of oil and gas on certain properties and that each of the loan amounts would be repaid from the proceeds of an equity placement made in Lothian.

Lothian filed for chapter 11 protection on June 13, 2007, and Grossman filed various claims in the case, including claims based on the two "loans". The Bankruptcy Court for the Western District of Texas rejected the claims, finding that they "assert[ed] common equity interests at best and that insufficient evidence of the value of the interests was presented." The District Court, however, reversed the recharacterization of the two claims as equity, "declin[ing] to extend the concept of debt recharacterization to a non-insider creditor."

Recharacterization of Debt Under Section 502 of the Bankruptcy Code

The Court of Appeals found that bankruptcy courts have the authority to recharacterize debt claims as equity as part of their authority to disallow claims under section 502 of the Bankruptcy Code. Specifically, section 502 provides that "the court, after notice and a hearing, shall determine the amount of such claim ... and shall allow such claim in such amount, except to the extent that—(1) such claim is unenforceable against the debtor and property of the debtor, under any agreement or applicable law . . ." 11 U.S.C. § 502(b). Applicable law is...