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In an unpublished opinion in August, In re Province Grande Old Liberty, LLC, Case No. 15-1669, 2016 WL 4254917 (4th Cir. Aug. 12, 2016), the Fourth Circuit Court of Appeals shed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.
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