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Fourth Circuit Approves Recharacterization of Secured Debt Into Equity

A Brief Summary of PEM Entities​: Unsecured Creditors Pulled Down a Secured Creditor

In its recent unpublished opinion PEM Entities, LLC v. Province Grande Old Liberty, LLC, 2016 WL 4254917, (4th Cir. Aug. 12, 2016), the Fourth Circuit Court of Appeals affirmed the bankruptcy court’s award of summary judgment to certain unsecured creditors (the “Plaintiffs”) who had sued a putative holder of a very large secured debt –who would rank ahead of the Plaintiffs’ unsecured claims in payment priority — to have its claim recharacterized into an equity interest — which would rank behind the Plaintiffs’ unsecured claims.

The Plaintiffs persuaded the bankruptcy court that there was no dispute of material fact that the substance of the transaction between the putative holder of secured debt and the Debtor was not a secured loan but rather an equity contribution (concluded upon the settlement and satisfaction of a previous secured loan). The Plaintiffs thus improved their prospects of a meaningful return on their aggregate unsecured claims of over $1 million by getting the court to transform higher priority secured claims against the Debtor into lower priority equity interests in the Debtor.

Sources on Recharacterization in Commercial Bankruptcy Investor

Before further discussion of PEM Entities, let’s review the lode of reference material on recharacterization available on Commercial Bankruptcy Investors. In “90 Second Lesson: What is the Difference Between Recharacterization and Equitable Subordination?“, we summarized the law as follows: “recharacterization rests entirely on the substance of the transaction giving rise to the claim, i.e., ‘whether a debtor actually exists.’” In support of that proposition, we cited, among other cases, In re Official Comm. Of Unsecured Creditors for Dornier Aviation (North America), Inc., 453 F.3d 225, 232 (4th Cir. 2006), on which the PEM Entities Court relied.

In PEM Entities, unsecured creditors deployed recharacterization to push of head of lenders who in fact invested. In “How Unsecured Creditors Push Ahead of Lenders Who In Fact Invested, Part I — What is Recharacterization?“, Lawrence V. Gelber and James T. Bentley portray a higher priority debt claim against the debtor as “an elegant swan” in contrast to the “clumsy duck” of a lower priority equity interest in the debtor. The article focuses on how recharacterization is brought to bear in bankruptcy cases and how courts undertake the analysis, including the 11-factor test later applied in PEM Entities.

In “How Unsecured Creditors Push Ahead of Lenders Who in Fact Invested, Part II — Clawback of “Loan Repayments”, Gelber and Bentley both look at how recharacterization is used by trustees and creditors’ committees to sue the “lender” in order to claw back money paid by the debtor to the “lender,” and compare such actions to the avoidance and recovery of constructive fraudulent transfers to lenders.

In “How Unsecured Creditors Push Ahead of Lenders Who in Fact Invested, Part III — Equitable Subordination vs. Recharacterization“, Gelber and Bentley distinguish recharacterization of debt to equity from the equitable subordination of debt claims, where bad behavior by the creditor causes a debt claim to be subordinated to its fellow debt claims. When a higher priority claim is equitably subordinated, we may say that the elegant swan remains a swan, but far less elegant.[1]

PEM Entities: The Secured Claim​ by Insiders of the Debtor​

Back to PEM Entities, with respect to which we will leave out unnecessary detail. The Debtor, a limited liability, was formed in order to purchase real property (the “Real Property” — a golf course and residential development). The Debtor borrowed $6,465,000 from a bank (“Bank”), secured by a deed of trust on the Real Property and purchased the Real Property. In time the Debtor defaulted on the loan and Bank commenced foreclosure on the Real Property. Debtor and Bank entered into a settlement agreement (the “Settlement Agreement”), which got the Bank out as lender to the Debtor and permitted Debtor to keep the Real Property – and which later proved key to the PEM Entities recharacterization analysis.

Under the Settlement Agreement, Bank agreed to sell its loan to a new limited liability company, PEM Entities, LLC (“PEM”) for a discounted price. PEM is owned by members who are insiders of the Debtor (including Stanley Jacobson, father of Howard). The Settlement Agreement was negotiated by Debtor’s principals (including Howard Jacobson, son of Stanley), whom Bank regarded as having authority to bind PEM, and was neither negotiated by members of PEM nor executed by PEM. At no point thereafter did PEM or Debtor maintain any ledger or account of the “loan” PEM acquired from Bank (or of “re-advances” PEM would make to Debtor from time to time).

Where did PEM get the funds to buy the Bank loan? Contributions from PEM members, plus loans from certain individuals and Bank, secured by the Real Property that PEM did not own (the Real Property was owned by Debtor). PEM agreed to subordinate its position in the security to those of the lenders to PEM.

Debtor filed its chapter 11 bankruptcy petition on March 11, 2013. In its schedules of assets and liabilities, the Debtor listed PEM as a creditor with a secured claim of $7,000,000, including principal of the loan acquired from Bank plus interest. Evidently, it was PEM’s position that it had purchased the Bank loan and had stepped into the shoes of Bank as secured lender.

PEM En​tities​: The Challenge to the Secured Claim and Recharacterization Factors Applied

Two creditors (the “Plaintiffs”), who filed unsecured claims of $500,000 each, disagreed, sued, and persuaded the bankruptcy court to grant them summary judgment on their recharacterization count. The bankruptcy court concluded that the putative loan purchase by PEM “was, in effect, a settlement and satisfaction of the [Bank] loan.”[2] All funds paid by PEM pursuant to the Settlement Agreement – about $1,242,000 — the bankruptcy court recharacterized from loan to equity investment. Upshot: PEM is no longer entitled to $7,000,000, and whatever it is entitled to (perhaps $1,242,000) is no longer a “claim” on a debt, but rather an equity interest of lower payment priority than all unsecured creditors’ claims.

The PEM Entities Court reviewed the bankruptcy court’s application of the 11 factors set forth in Bayer Corp. v. Masco Tech., Inc. (In re AutoStyle Plastics, Inc.), 269 F.3d 726, 747-48 (6th Cir. 2001), which are also set forth and discussed in the Gelber and Bentley articles linked above. Briefly, the bankruptcy court concluded that none of the factors weighed against recharacterization, and the following weighed in favor: 1) the Settlement Agreement was entered into “in settlement of the loan”; 2) the Debtor’s principals (and not PEM’s) negotiated the Settlement Agreement and putative note purchase by PEM; 3) neither Debtor nor PEM observed any formalities such as payment schedules, interest payments, “or even a ledger”; 4) Debtor’s “total reliance” on funds from PEM (including the “re-advances”) to meet expenses and inability to get other financing; 5) the identity of interests between PEM and Debtor; and (6) that much of the amount PEM “lent” was funded by the pledge of the Real Property – owned by the Debtor.[3]

In short, the Court agreed with the bankruptcy court that the Settlement Agreement is the “‘substance of the transaction’” — consistent with the Court’s approach in Dornier, quoted above — because it was the basis of the alleged note purchase that gave rise to PEM’s alleged claim.[4] “Thus,” per the Court, “the bankruptcy court properly ‘looked beyond form’ to determine that the ‘substance of the transaction’ was in fact the settlement agreement in which Debtor used PEM as an extension of itself to complete what was, in effect, a satisfaction of the [Bank] loan.”[5]

​Next Chapter in PEM Entities?​

Final Note. On October 11, 2016, the losing side in PEM Entities, LLC v. Province Grande Old Liberty, LLC, 2016 WL 4254917, (4th Cir. Aug. 12, 2016) filed a petition for certiorari with the United States Supreme Court. If certiorari is granted, the Supreme Court will hear the appeal.

[1] In the bankruptcy court case affirmed by PEM Entites, which is captioned Levin v. Province Grande Olde Liberty, LLC (In re: Province Grande Olde Liberty, LLC), 2014 WL 6901052 (Bankr. E.D.N.C. Dec. 5, 2014), the Plaintiffs included a count of equitable subordination and another to claw-back certain amounts paid by Debtor to lenders to PEM. The bankruptcy court awarded summary judgment to the defendant on both counts because the Plaintiffs had not presented material facts showing bad behavior on the part of the transferees, and because the Plaintiffs lacked standing to seek claw-back of payments to transferees (such standing being reserved to the Debtor and the creditors’ committee).

[2] PEM Entities, LLC v. Province Grande Old Liberty, LLC, 2016 WL 4254917, (4th Cir. Aug. 12, 2016) at *2.
[3] Id. at *3.
[4] Id.
[5] Id.

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