The Supreme Court has granted certiorari to decide the question of whether bankruptcy courts should apply state law or a federal rule of decision when determining whether to recharacterize a debt claim as a capital contribution.

Recharacterization presents a critical issue for lenders and investors in distressed companies. Under the bankruptcy priority scheme, secured creditors get top priority, while equity interests have the lowest priority and are often completely wiped out.  A federal rule of decision more often leads to recharacterization of debt to equity than application of underlying state law.

Most circuits follow the federal rule of decision and apply a variety of multi-factor tests when analyzing whether to recharacterize debt as equity pursuant to the equitable powers granted bankruptcy courts by section 105 of the Bankruptcy Code. The Third, Fourth, Sixth, Tenth and Eleventh Circuits hold this majority view, while only the Fifth and Ninth Circuits apply state law.

In the case at issue, PEM Entities v. Levin, the Fourth Circuit affirmed the lower courts’ use of a federal rule of decision in permitting an insider’s secured loan to be recharacterized as a capital contribution.  Had the courts instead applied North Carolina state law, the debt would not have been recharacterized as equity.

The United States Bankruptcy Court for the Eastern District of North Carolina did not consider the fixed maturity date, required payments, third-party nature of the loan and first-lien security given for the loan as controlling the analysis. Rather, the Court focused on the discounted price paid for the distressed loan, the lender’s failure to enforce the original loan terms prior to bankruptcy, the debtor’s poor financial position at the time of the loan purchase, the lender’s insider status, the fact that the insider made additional capital contributions to the debtor and the inability of the debtor to obtain outside financing at the time the insider purchased the loan.

We will be following the proceedings and blog the decision of the Supreme Court on this important issue.