On April 30, 2013, the United States Court of Appeals for the Ninth Circuit held that the bankruptcy court has authority to recharacterize as equity, rather than debt, advances of funds made purportedly as a loan to the recipient prior to its bankruptcy. In re Fitness Holdings International, Inc., --- F.3d ----, 2013 WL 1800000 (9th Cir. 2013). The Ninth Circuit, in reversing the district court, held that the fact that the same result of recharacterization can be obtained through the statutory remedy of equitable subordination under section 510 of the Bankruptcy Code does not deprive the bankruptcy court of the authority to employ the separate and distinct remedy of recharacterization.

The dispute in Fitness Holdings concerned a constructively fraudulent transfer claim under section 548(a)(1)(B) of the Bankruptcy Code, seeking to undo certain pre-bankruptcy transfers made in payment of a purported loan. In analyzing the fraudulent transfer claim, the Ninth Circuit addressed two related issues: (i) whether the debtor “received less than a reasonably equivalent value in exchange for such transfer or obligation,” and (ii) whether the court has the authority to recharacterize the debtor’s obligation.

With respect to the first issue, the Court concluded that a transfer is made for a “reasonably equivalent value” if it is made in repayment of a claim that the Court concluded to be a “right to payment” determined under state law.

Regarding the second issue, the Court held that “a court may recharacterize an obligation that does not constitute ‘debt’ under state law.” In so holding, the Court disagreed with the decision of the Ninth Circuit BAP in In re Pacific Express, Inc., 69 B.R. 112, 115 (B.A.P. 9th Cir.1986)), which held that bankruptcy courts were limited to the statutory remedy of equitable subordination under 11 U.S.C. § 510. The Court found the BAP’s conclusion to be incorrect because “recharacterization and equitable subordination address distinct concerns.”

In holding courts have the authority to recharacterize claims, the Ninth Circuit joins other circuits, including the Fifth Circuit that reached a similar conclusion in In re Lothian Oil, 650 F.3d 539, 542-43 (5th Cir. 2011). The Ninth Circuit also approved of the Fifth Circuit’s approach to recharacterization. According to the Ninth Circuit, Lothian Oil’s multi-factor approach based on state law for distinguishing between debt and equity, rather than a federal test based on the court’s equitable power under 11 U.S.C. § 105, is the approach more consistent with the Supreme Court precedent.

Fitness Holdings lends significant strength to a claim of recharacterization in the Ninth Circuit, which was previously perceived to be difficult to maintain. It is now possible to make a claim for recharacterization separate from and in addition to a claim for equitable subordination under section 510 of the Bankruptcy Code. In contrast to equitable subordination, recharacterization does not usually require a finding of inequitable conduct. As such, the lack of inequitable conduct by parties extending credit to a potentially troubled company can no longer insulate their claims from being relegated to a lower priority in the company’s potential bankruptcy case. In addition, such parties should be vigilant in ensuring that the terms of such credit are properly documented in compliance with the applicable state law requirements for creating a “right to payment.”