United States: Fraudulent Transfer: "Reasonably Equivalent Value" Meets Debt Recharacterization

Official Comm. of Unsecured Creditors v. Hancock Park Capital II, L.P. (In re Fitness Holdings International, Inc.) , 714 F.3d 1141 (9th Cir. 2013) –

A chapter 11 unsecured creditors' committee sought to recover payments made to the debtor's shareholder as a fraudulent transfer.  The bankruptcy court dismissed the claims, and the district court affirmed.  On appeal the 9^th Circuit focused on whether there was "reasonably equivalent value" for the payments, and remanded the matter to the district court for further proceedings.

Over the course of several years, the debtor executed 11 subordinated promissory notes to its shareholder (Hancock Park) totaling ~$24 million.  During this period, the debtor also obtained a $7 million revolving credit loan and a $5 million installment loan from a bank secured by all of its assets and guaranteed by Hancock Park.

After various modifications of the bank debt the parties agreed to refinance.  The refinancing consisted of a $17 million term loan and an $8 million revolving line of credit from the bank.  At closing ~$9 million was used to pay off the original bank loan and ~$12 million was used to pay off the Hancock Park subordinated notes.  This also had the effect of releasing Hancock Park's guaranty.

Fitness Holdings filed bankruptcy a little more than a year later.  The unsecured creditors committee brought an action on behalf of the bankruptcy estate to recover the money paid to Hancock Park as a constructive fraudulent transfer.

As outlined by the 9^th Circuit, a constructive fraudulent transfer requires a showing that the debtor (1) "received less than a reasonably equivalent value in exchange for such transfer or obligation," and (2) was insolvent, was left with unreasonably small capital, believed that it incurred debts beyond its ability to pay as they matured, or made a transfer to or for the benefit of an insider under an employment contract and not in the ordinary course of business.  Consequently, if the debtor received reasonably equivalent value, the payments would not be constructive fraudulent transfers.

Although the Bankruptcy Code does not define reasonably equivalent value, Section 548(d)(2)(A) defines "value" to include "satisfaction or securing of a ... antecedent debt;"  Section 101(12) defines "debt" to mean "liability on a claim;" and Section 101(5)(A) defines "claim" to include a "right to payment."

Taking to heart a prior U.S. Supreme Court rebuke of the court for relying on a rule of its "own creation," the 9^th Circuit cited Butner v. U.S., 440 U.S. 48, 99 Sup. Ct. 914, 59 L. Ed. 2d 136 (1979) for the proposition that in a bankruptcy case property interests are generally defined by state law.  (The court also commented in a footnote that "state law" is often used to mean all non-bankruptcy law, including substantive federal law.)

After laying this foundation, the 9^th Circuit framed the question as follows:

The district court did not reach this issue because it believed that it was bound by longstanding precedent of the 9^th Circuit Bankruptcy Appellate Panel that bankruptcy courts are barred from recharacterizing loans as equity investments, and are limited to the statutory remedy of equitable subordination under Section 510 of the Bankruptcy Code.  (See Equitable and Mandatory Subordination: The Disappearing Claim.)  Although this would have allowed subordination of the shareholder's claim if the notes had still been outstanding at the time the debtor filed bankruptcy, it does not provide a basis for attacking a pre-petition payment.

The 9^th Circuit first noted that BAP decisions are not binding on district courts and they are free to decline to follow BAP decisions.  More importantly in this case, the 9^th Circuit disagreed with the BAP decisions, concluding that a court may recharacterize an obligation that is not a "debt" under state law.

The court noted that its conclusion was consistent with other circuit courts – including the 4^th, 5^th, 6^th and 10^th Circuits, although these circuits have used different legal frameworks to analyze the issue.  Some circuits have concluded that courts should analyze claims under state law pursuant to Butner,so that the claims can be recharacterized as equity if that would be the result under state law.  Other circuits have concluded that a court has equitable authority to recharacterize a claim.

The 9^th Circuit agreed with the Butner based approach.  Since the district court did not consider whether the subordinated notes should be recharacterized as equity under state law, the 9^th Circuit remanded the matter for further consideration.

This case indirectly highlights some of the differences between a preference and a fraudulent transfer claim.  For a preference, repayment of a prior debt would satisfy one of the basic elements of a preference claim (i.e. a transfer "for or on accounta of an antecedent debt").  However, in the context of a fraudulent transfer claim, payment on account of an antecedent debt is specifically condoned as providing reasonably equivalent value.  Similarly, the fact that the shareholder's unsecured debt was repaid using the proceeds of what became secured debt could potentially give rise to a potential preference claim, while that fact was not relevant for fraudulent transfer purposes (as noted by the 9^th Circuit in response to an argument to that effect).

Thus, transactions that don't constitute fraudulent transfers may be preferences.  However, the look back period for a preference claim is generally only 90 days, and one year for an insider.  In contrast, a fraudulent transfer claim brought under Section 548 of the Bankruptcy Code has a look back period of two years, and the look back period for a state fraudulent transfer claim asserted using Section 544 "strong arm" powers is typically at least four years.

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