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.). 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.