In re Lothian Oil Inc. Non-Insider Debt Claims May Be Recharacterized as Equity Under Section 502(b)(1)

Shifting the focus of the recharacterization analysis, the Fifth Circuit in Grossman v. Lothian Oil Inc. (In re Lothian Oil Inc.)[1] relied upon section 502(b)(1) and applicable state law, instead of the section 105(a) federal equitable power, to recharacterize non-insider debt claims as equity.[2] In doing so, the Fifth Circuit reversed the district court, which had found that recharacterization is only appropriate where the claimant is a corporate insider.[3]   

 

Although the question of whether bankruptcy courts can recharacterize debt as equity pursuant to section 502(b)(1) was a case of first impression for the Fifth Circuit, the issue of recharacterization is not novel.[4] Indeed, in its analysis, the court noted that recharacterization is relatively common, although recharacterization typically occurs under a court’s equitable power pursuant to section 105(a) of the Bankruptcy Code.[5] For example, the Fourth and Sixth Circuits both relied upon the bankruptcy court’s general equitable powers to recharacterize debt claims.[6] The Fifth Circuit’s decision differs from other circuits because it used state law to recharacterize debt claims as equity pursuant to section 502(b)(1) of the Bankruptcy Code rather than using section 105(a). [7] The court found resort to the federal equitable power unnecessary by virtue of section 502(b)(1)’s explicit grant of authority to bankruptcy courts to disallow claims under applicable law.[8] Thus, the focus is on state law, rather than the federal equity powers. 

 

Lothian Oil Inc. is important because variations between state laws could yield different outcomes in recharacterization cases based on the underlying state laws. For example, here, although the district court found that it could not recharacterize non-insider debt claims under federal law, the Fifth Circuit reversed because Texas law had no per se rule limiting recharacterization to the claims of corporate insiders.[9] It should be noted, however, that the state law test the court used is virtually indistinguishable from the multi-factor tests used by courts that recharacterize debt as equity under their general equitable powers.[10]  Thus, because the applicable state law directs the court to apply the prevailing multi-factor test, the results achieved will likely be substantially similar to the results reached by courts that recharacterize debt claims as equity pursuant to section 105(a). Significant differences could emerge, however, if the applicable state law does not distinguish between the treatment of insider and non-insider debt claims. Lothian Oil Inc. is an example of the impact of this state law difference, where the lack of distinction between claims of corporate insiders and non-insiders under Texas law proved to be dispositive.