Late last month, the Supreme Court granted a petition for certiorari review of the Fourth Circuit Court of Appeals’ decision in PEM Entities LLC v. Eric M. Levin & Howard Shareff.  At issue in PEM Entities is whether a debt claim held by existing equity investors should be recharacterized as equity.  The Supreme Court is now poised to resolve a split among the federal circuits concerning whether federal or state law should govern debt recharacterization claims.  The Court’s decision may have a significant impact on the likelihood of so-called rescue loans extended by existing equity.

In an earlier post we analyzed the Fourth Circuit’s opinion in PEM Entities.  To summarize the facts, Province Grande Old Liberty, LLC (the “Debtor”) borrowed approximately $6.5 million from a bank (the “Loan”).  The Debtor subsequently defaulted on the Loan and the lender instituted foreclosure proceedings.  In order to settle the foreclosure action, the Debtor, its principal and other related entities entered into a settlement agreement with the lender.  Under the settlement, the lender sold the $6.5 million Loan to PEM Entities, LLC (“PEM”) for approximately $1.2m.  PEM was owned by insiders of the Debtor.

The Debtor subsequently filed bankruptcy and scheduled PEM with a $7,000,000 claim, including principal and accrued interest. Two creditors of the Debtor filed an adversary proceeding seeking to equitably subordinate and/or recharacterize PEM’s claim. The bankruptcy court granted summary judgment in favor of the creditors, holding that PEM’s loan purchase was a settlement and satisfaction of the Loan and recharacterized the $300,000 portion of the purchase price contributed by PEM as an equity investment in the Debtor.  The bankruptcy court held PEM’s $7,000,000 claim void.  The district court affirmed the bankruptcy court’s ruling.  The Fourth Circuit also affirmed, applying an eleven factor federal test to the question of whether to recharacterize PEM’s debt.

The issue now before the Supreme Court is whether the lower courts should have applied a federal rule of decision or state law of decision to the recharacterization claim.  The Third, Fourth, Fifth, Sixth, and Tenth Circuits all apply federal law to recharacterization claims.  In contrast, the Second and Seventh Circuits apply state law.  Under the federal recharacterization test, bankruptcy courts have broad power to recharacterize debt into equity, while many state laws are more protective of debt holders, and impose a higher burden to be met before debt can be treated as equity.

The Supreme Court’s decision in PEM Entities could have far-reaching consequences.  If the Court determines that state law applies, existing equity holders may be more inclined to invest, through debt instruments, in struggling companies, essentially in a last-ditch effort to avoid a bankruptcy filing.  If, however, the Court decides that federal law applies, bankruptcy courts will have more authority to recharacterize debt into equity and this may deter existing equity holders from investing additional funds in order to prop up the company.  At the very least, a decision by the Court that federal law applies will increase the need for careful lawyering to ensure that the loan will stand up to increased scrutiny should creditors subsequently seek to recharacterize the loan as equity.

We will keep our readers up to date on developments in this case.