Recharacterization of Debt as Equity in the Fourth Circuit

posted in: Cramdown and Priority | 0

By Gabrielle Glemann (Hughes Hubbard & Reed)

In an unpublished opinion in August, In re Province Grande Old Liberty, LLC, Case No. 15-1669, 2016 WL 4254917 (4th Cir. Aug. 12, 2016), the Fourth Circuit Court of Appeals shed some light on the circumstances under which a court may recharacterize debt as an equity investment, effectively subordinating the claim.  The issue before the Fourth Circuit was not one of first impression — the Fourth Circuit had long recognized that a bankruptcy court’s equitable powers include “the ability to look beyond form to substance,” and had previously articulated the factors to consider in evaluating a request for recharacterization. See Fairchild Dornier GMBH v. Official Comm. of Unsecured Creditors (In re Official Committee of Unsecured Creditors for Dornier Aviation (North America), Inc.), 453 F.3d 225 (4th Cir. 2006). The Fourth Circuit decision is notable however, because the court looked beyond the facts giving rise to the underlying claim at issue and ultimately to the economic substance of the entire context of the transaction.  In Province, the creditor whose claim was at issue was a company owned by insiders of the debtor.  The creditors’ claim was based on a loan that was used by the debtor to settle other obligations.  The court held that the settlement agreement was the “substance of the transaction” and a basis for recharacterization, notwithstanding the fact that the creditor was not a party to the settlement agreement.

The full memo is available here.

United States Court of Appeals for the Second Circuit Holds That Claims Arising from Securities of a Debtor’s Affiliate Must Be Subordinated to Senior or Equal Claims of the Same Type as the Underlying Securities

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By Fredric Sosnick, Douglas P. Bartner, Joel Moss, Solomon J. Noh and Ned S. Schodek of  Shearman & Sterling LLP

 

Lehman Brothers Inc. (“LBI”) was lead underwriter for unsecured notes issued by Lehman Brothers Holdings Inc., LBI’s affiliate and parent. A Master Agreement Among Underwriters governed the relationship between LBI and the offering’s junior underwriters, and created among them a right of indemnification for liabilities resulting from securities fraud claims related to the offerings.

 

Following the bankruptcy of Lehman Holdings and the SIPA proceeding of LBI, investors filed securities fraud lawsuits alleging material misstatements and omissions in the offering documents, and asserted claims for contribution against LBI. The SIPA trustee objected, arguing that the claims were subject to mandatory subordination under § 510(b) of the Bankruptcy Code. The underwriters argued that because Lehman Holdings, not LBI, issued the securities, § 510(b) did not apply to the underwriters’ claims.

 

The Second Circuit held that claims arising from securities of a debtor’s affiliate must be subordinated to all claims senior or equal to claims of the same type as the underlying securities. As a result, the claims for contribution and reimbursement for losses incurred in the course of defending and settling securities fraud lawsuits brought by investors in securities issued by LBI’s affiliate were subordinated to the claims of LBI’s general unsecured creditors pursuant to § 510(b).

 

This Court of Appeals’ decision was based on precedent, textual support and legislative history, and it clarifies the appropriate classification of claims in the affiliate-securities context.

 

For the full memo is available here.