A recent decision by the Fifth Circuit Court of Appeals addresses the power of the court to determine and allow claims in bankruptcy. The case, In the Matter of Lothian Oil Inc. (Grossman v. Lothian Oil Inc.), __ F. 3d __, 2011 WL 3473354 (5th Cir. August 9, 2011), determines what the Fifth Circuit describes as a “novel question of law on which this court has yet to speak.” In the Matter of Lothian Oil Inc., 2011 WL 3473354 at *1.

The Fifth Circuit concluded that the power to determine claims in bankruptcy under §502 of the U.S. Bankruptcy Code is not limited to merely allowing or disallowing the claim, but can include the power to determine the proper treatment of the claim, including recharacterization of the claim as debt or equity. More important for creditors, the Fifth Circuit rejected as a matter of law the claimant’s contention, and the ruling of the district court, that recharacterization of a debt as equity is only available as a matter of law with respect to a claim held by an insider. It held that the bankruptcy court properly determined that the non-insider creditor’s asserted “loans” should be deemed equity interests.

The issue arose out of two loans made by an individual, Israel Grossman, to the debtor Lothian Oil Inc. The loans were reflected in two brief writings that stated the amount of the loans and provided that in consideration of the loans, the debtor would grant Grossman a small percentage royalty from oil and gas produced by certain properties and that the loans would be repaid from one or more equity placements. One of the loans provided that the repayment from the proceeds of equity placements would be subject to the obligations of a credit agreement with an institutional lender. There was no dispute that Grossman was not an officer, director or person in control of the debtors and therefore was not an “insider” of the debtors within the meaning of the Bankruptcy Code. See 11 USC §101(31)(B) for definition of insider where the debtor is a corporation.

Roughly two years after the loans were made, the debtor and other affiliated companies filed voluntary Chapter 11 petitions. The debtors proposed and confirmed a joint Chapter 11 plan of reorganization approximately one year later. Grossman filed numerous separate proofs of claim, many of which were resolved through a settlement with the debtors. The remaining claims, including claims based on the two “loans” described above, were designated the “Undetermined Claims,” and were subject to litigation before the bankruptcy court to determine their allowance.

In the litigation over claims allowance in the bankruptcy court, the bankruptcy court rejected all of Grossman’s Undetermined Claims, finding that some of the claims were claims against non-debtor entities and therefore should not be allowed as the debtors were not liable for them. As to the other claims, including in particular the two proofs of claim founded on the two loan agreements (for convenience referred to herein as the loan claims), the bankruptcy court rejected those claims on the basis that they asserted “common equity interests at best” and insufficient evidence of the value of those interests had been presented. The issue addressed on appeal is the authority of the bankruptcy court to recharacterize the loan claims as “equity interests” when the loan claims were founded on documentation describing the obligations as “loans” and when Grossman was admittedly not an insider of the debtors.

Grossman appealed the bankruptcy court’s disallowance of the loan claims to the district court, and the district court reversed the bankruptcy court’s ruling recharacterizing the loan claims. In reaching its ruling, the district court relied on the leading Fifth Circuit decision of Jones v. United States, 659 F. 2d 618 (5th Cir. 1981), which sets forth an 11-part test for determining whether a claim should be treated as debt or equity in the context of a claim by an insider. The district court interpreted that decision as precluding recharacterization of an obligation denominated as debt except where the debt is held by a corporate insider and ruled as a matter of law that the bankruptcy court could not recharacterize debt of a non-insider as equity. This precise issue had never been addressed by the Fifth Circuit.

The Fifth Circuit reversed the district court’s ruling on that issue. In defense of the district court’s ruling, Grossman argued that under Bankruptcy Code §502, the bankruptcy court could only allow or disallow his loan claims since he was not a corporate insider of the debtors. The Fifth Circuit disagreed.

The Fifth Circuit noted that other circuits had reached a similar result — that the bankruptcy court has the power not just to disallow a claim but to recharacterize the claim of a non-insider as equity rather that debt — but reached its decision based on the language of the Bankruptcy Code claims allowance provisions and Butner v. United States, 440 U.S. 48 (1979). The case required the bankruptcy court to look to underlying state law to define the nature of a creditor’s property rights in the debtor’s assets. This analysis distinguishes the Fifth Circuit’s decision from decisions in other circuits that have reached the same result but have relied instead on either the equitable subordination provisions of Bankruptcy Code §510, which can pose troublesome hurdles by focusing on improper conduct or reliance by third parties on the status of a particular claim or nature of the relationship with the debtor, or the general equitable powers of the bankruptcy court granted under §105(a), which also has potential limits on the bankruptcy court’s powers in the absence of express authority under the Code.

The Fifth Circuit found sufficient authority for the bankruptcy court to not just disallow a claim but to determine the non-insider’s claim should be treated as an equity interest based on the claims allowance statute itself. The Fifth Circuit pointed to the language of §502(b)(1), which directs the bankruptcy court to allow a timely filed claim “except to the extent that — 1.) such claim is unenforceable against the debtor and property of the debtor, under any agreement or applicable law.” The court held that there was no basis under the language of the Bankruptcy Code to create a per se rule barring recharacterization of non-insider debt as equity.

The court then analyzed Texas state law, the law controlling the underlying “loan” agreements in that case, as well as the Jones v. United States decision and the multiple factors articulated at that case. The court concluded that the inclusion of the royalty payment changed the character of the transactions from “loans” to equity and that Texas law “would not have recognized Grossman’s claims as asserting a debt interest.” See In the Matter of Lothian Oil Inc., 2011 WL 3473354 at *4. Ruling that both insider and non-insider claims were subject to recharacterization from debt to equity, the Fifth Circuit affirmed the bankruptcy court’s judgment.

The Lothian Oil decision is important as a precedent in the Fifth Circuit on an issue of first impression and is also important to consider as debt instruments become more creative and complex in their terms of repayment and rights granted to the lender. This decision reconfirms the bankruptcy court’s authority to closely scrutinize loan documentation to analyze the true nature of the transaction and to make equitable adjustments in the lender’s rights against the debtor by recharacterizing the debt as equity where the facts and terms of the documents warrant. Lenders cannot rely on their arm’s length, non-insider status alone to shield them from such a recharacterization, as the Lothian Oil decision makes clear.

Lesley Anne Hawes, a partner in the Los Angeles office of McKenna Long & Aldridge, LLP, specializes in the representation of secured and unsecured creditors in bankruptcy proceedings and in the representation of federal equity receivers appointed in civil enforcement actions by federal agencies such as the Federal Trade Commission and Securities and Exchange Commission. Hawes is a regular contributor to the Monitor and other legal journals, and she has lectured for the National Business Institute and other organizations. She graduated Order of the Coif from University of Southern California law school and earned her undergraduate degree in political science magna cum laude from University of Southern California.