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Bankruptcy court re-characterizes debt at expense of creditor

A recent ruling out of the U.S. Court of Appeals for the Fourth Circuit is gaining attention for its decision supporting a bankruptcy court's holding that a portion of a loan could be re-classified.

Background: Is classification of money owed important?

In short, the answer is yes - the classification of money owed by the debtor is important.

Generally, when going through a bankruptcy proceeding, the various forms of money owed to a creditor by the petitioner are classified. Payment is then doled out based on the classification hierarchy.

Two forms of classification at issue in this case are equity and debt. This distinction is important, as equity is at the bottom of the repayment food chain. As such, if the petitioner runs out of money while making repayment, creditors that have money classified as equity are not likely to receive payment.

The current case: What was the issue?

This case, PEM Entities v. Province Grande Olde Liberty, LLC and Eric M. Levin; Howard Shareff, involves several loans used for real estate investments.

The U.S. Court of Appeals for the Fourth Circuit clarified that bankruptcy courts have the power to recharacterize a claim. In this case, the court reviewed several factors established in a precedent case, In re: Official Committee of Unsecured Creditors for Dornier Aviation (North America), Inc. that should be taken into consideration when determining if a contribution to capital should receive a lower repayment priority than a loan. Ultimately, the court held contributions to capital, or equity, are repaid only after other obligations are met.

Eleven factors are provided in Dornier to help the court determine if a loan is a debt or equity. These factors include the ability to take into consideration any name given to the instrument, whether the loan agreement includes scheduled repayments or an interest rate as well as whether any security was given for the loan.

In this case, the court found that the analysis of these factors supported recharacterization. Examples of the analysis used to come to this decision includes the fact that formalities like a repayment schedule were not in place and the fact that the debtor was unable to obtain any other form of financing elsewhere.

This case was also complicated by the fact that there was an insider relationship between the business entity purchasing the debt and the debtor himself. The court took this relationship into consideration when making its determination.

Lessons for creditors: What is the impact of this case?

One lesson from this case is the fact that businesses must tread carefully when structuring agreements when an insider relationship is present. Another is the importance of the language used to put together a loan agreement. An poorly worded agreement can hurt the creditor's interests. Such issues can be mitigated by discussing the transaction with an experienced attorney.

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