In PEM Entities, LLC v. Province Grande Olde Liberty, LLC (In re Province Grande Olde Liberty, LLC), the US Court of Appeals for the Fourth Circuit affirmed a decision recharacterizing as equity a portion of a creditor's purchase of a loan made to a debtor, holding that the debtor, who used the purchaser as an extension of itself to satisfy the loan in a settlement, could not hide behind the original debt transaction.
On August 12, 2016, in PEM Entities, LLC v. Province Grande Olde Liberty, LLC (In re Province Grande Olde Liberty, LLC), the US Court of Appeals for the Fourth Circuit affirmed a decision recharacterizing as equity a portion of a creditor's purchase of a loan made to a debtor, holding that the debtor, who used the purchaser as an extension of itself to satisfy the loan in a settlement, could not hide behind the original debt transaction ( (4th Cir. Aug. 12, 2016)).
In 2010, Province Grande Olde Liberty, LLC (Debtor or Province), defaulted on a loan of $6,465,000 from Paragon Commercial Bank (Paragon) it used to finance its purchase of a golf course and real estate development in Franklin County, North Carolina (Golf Club). Howard Jacobsen (Howard) formed Province as an entity for the purpose of this purchase, and managed Lakebound Fixed Return Fund, LLC (Lakebound), from whom Province obtained $188,000 to finance the acquisition of the Golf Club. Lakebound's investors included Eric M. Levin and Howard Shareff (Appellees), who each invested $500,000.
Paragon initiated foreclosure proceedings the year following Province's default on the Paragon loan. Howard, Province, and other related entities, then entered into a settlement agreement with Paragon to resolve the loans. Under that agreement, Paragon agreed to sell its $6,465,000 loan to a new company, PEM Entities, LLC (PEM), owned by, among others, Howard's father, Stanley Jacobsen, for $1,242,000. PEM did not negotiate the settlement agreement, but Paragon understood that Howard had the authority to bind PEM. To fund the settlement, PEM used contributions from its members totaling $300,000, borrowed $650,000 from Joseph Deglomini and Joseph Simone (collectively, D&S), and borrowed $292,000 from Paragon. Each of these PEM loans was secured by real estate owned not by PEM, but by Province.
Province filed for bankruptcy on March 11, 2013, and listed PEM's claim at $7,000,000, which included principal and accrued interest on the Paragon loan. Appellees filed claims for $500,000 each, and made claims against PEM for equitable subordination, recharacterization, and avoidance and recovery of allegedly fraudulent transfers. The parties moved for summary judgment on all claims.
The bankruptcy court relied on Dornier, which adopted the 11 factors of AutoStyle Plastics, to determine whether or not to recharacterize a claim, noting that none of the factors are dispositive and each one's significance varies depending on the circumstance. The factors are:
The names given to the instruments, if any, evidencing the indebtedness.
The presence or absence of a fixed maturity date and schedule of payments.
The presence or absence of a fixed interest rate and interest payments.
The source of repayments.
The adequacy or inadequacy of capitalization.
The identity of interest between the creditor and the stockholder.
The security, if any, for the advances.
The corporation's ability to obtain financing from outside lending institutions.
The extent to which the advances were subordinated to the claims of outside creditors.
The extent to which the advances were used to acquire capital assets.
The presence or absence of a sinking fund to provide repayments.
PEM appealed the bankruptcy court's order, and the district court affirmed. PEM then appealed to the Fourth Circuit.
The Fourth Circuit affirmed the district court's judgment to recharacterize the $300,000 portion of PEM's claim as equity and render PEM's $7,000,000 claim void, holding that:
The settlement agreement was the "substance of the transaction" because it was the basis of the note purchase and gave rise to PEM's claims.
There was "no clear error" in the bankruptcy court's determination that each of the factors in regard to the settlement agreement weighed in favor of recharacterization.
Settlement Agreement Was the Substance of the Transaction
The Fourth Circuit rejected PEM's argument that the bankruptcy court should have applied the Dornier factors to the inception of the Paragon debt rather than to the later settlement agreement because the recharacterization decision "rests on the substance of the transaction." The settlement agreement was the substance of the transaction giving rise to PEM's claims because:
Paragon believed the Debtor had authority to bind PEM even though PEM was neither a party nor a signor of the settlement agreement.
The settlement agreement obligated Paragon to sell the loan to PEM.
The settlement agreement outlined the sources of PEM's funding, even obligating Paragon to loan PEM $292,000.
The Fourth Circuit held that while PEM was not obligated by the settlement agreement, the settlement agreement obligated Paragon to PEM. Therefore, the bankruptcy court properly "looked beyond form" to determine that the substance of the transaction was the settlement agreement in which the Debtor used PEM, as an extension of itself, to, in effect, satisfy Paragon's loan.
No Clear Error in the Bankruptcy Court's Factual Findings
The Fourth Circuit agreed with the bankruptcy court's determination that each of the Dornier factors weighed in favor of recharacterization, noting that the bankruptcy court emphasized the following facts to adequately support its recharacterization decision:
The naming of the settlement agreement and the fact that it was entered into "in settlement of the loan."
The fact that the Debtor's principals negotiated the settlement agreement and note purchase on behalf of PEM.
No observance of formalities such as payment schedules, actual interest payments, or a ledger, between the Debtor and PEM.
The Debtor's reliance on PEM for expenses and inability to obtain any other financing.
The identity of interests between the Debtor and PEM.
PEM used the Debtor's property to secure about $900,000 of the $1,242,000 for the purchase of Paragon's loan.
The Fourth Circuit reviewed the bankruptcy court's factual findings for any clear error and found none. Of the six errors PEM alleged, the Fourth Circuit found one minor mistake, which it held did not rise to the level of clear error.
This decision demonstrates that bankruptcy courts look beyond the form of a transaction to its substance to determine whether a debt actually exists, affirming their power to examine the economic reality of a transaction to reclassify what is purported to be debt and treat it as equity. Claims purchasers cannot argue that their claim should be treated as debt merely because the underlying claim is debt. Instead, they must show that the economic substance of the purchase also represents debt and should not be recharacterized.