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PEM Entities v. Levin, Does a Circuit Split Really Matter? – Analyzing Competing Approaches to Debt-to-Equity Recharacterizations in Chapter 11.

Corporate reorganizations through bankruptcy can be a messy business. When the parties who have loaned money in an attempt to rescue a company have multiple interconnected relationships, it can become even messier and the job faced by bankruptcy courts can be daunting. That is why PEM Entities v. Levin, which was granted certiorari in 2017 only to be dismissed as improvidently granted six weeks later, merits examination.1

The case is indicative of tools companies, their constituents, and creditors may utilize in times of financial distress as well as the circuit split regarding debt-to equity recharacterization, which highlights a sizable and important gap in US bankruptcy jurisprudence. While the concept of debt-to-equity recharacterization is intended to create more equitable outcomes in a reorganization, it is a practice which may regularly prove redundant and inefficient in its current form. Due to a lack of consensus across jurisdictions on the authority from which its concepts stem, recharacterization is susceptible to having the wrong standards hastily adopted and having good standards tarnished by inconsistent application. Other vehicles enumerated by the Bankruptcy Code–such as equitable subordination and fraudulent transfer–already exist and are clearly codified at the federal level to uniformly combat the issue of bargaining not being carried out at arm’s length across all of the fifty states.2 Their consistency lends credibility to their use by courts, and aligns with federal preemption principles.3 Conversely, implying the existence of general federal law-based tests for recharacterization, in the manner currently adopted by a plurality of jurisdictions, introduces inappropriate ambiguity, activism, and uncertainty into Chapter 11 proceedings.

As the remainder of this post will demonstrate, the need for debt-to-equity recharacterization in Chapter 11 proceedings certainly may exist. However, premature adoption of an implied federal rule of authority harms both the standard and reorganization jurisprudence generally. Inconsistency resulting from such a practice has the potential to make it harder for companies to secure much needed financing by introducing uncertainty into the market and, at a high level, may ultimately push companies towards bankruptcy by making rescue loans unnecessarily risky for potential lenders. Clear rules, and clear bases for the authority behind those rules, are critical to ensuring just outcomes and appropriate development of the federal Bankruptcy Code. The federal rule applied in PEM by the Fourth Circuit courts and by other jurisdictions fails in achieving this development.

I. Facts of the Case: When is Recharacterization Used in Chapter 11, and Why Does It Matter?

While the exact series of events leading up to the PEM case are perhaps not particularly exceptional and the amounts in controversy are relatively small, the case proves useful for establishing an understanding of the circumstances in which debt-to-equity recharacterization claims are most regularly raised.

In PEM, the debtor proved unable to recover from the 2007 economic downturn and filed for Chapter 11 in March of 2013, at which time two investors each filed $500,000 claims in the proceeding.4 Because their claims were subordinate to the PEM debt claim, the investors moved to have the PEM loans recharacterized as equity investments in the debtor company. When this request was granted, the $7 million claim submitted by PEM was rendered void.5 The investors’ argument for requesting this recharacterization stemmed primarily from the fact that PEM had been formed two years earlier by the debtor shareholder’s father and had been invested in by a number of related parties.

In addition to a claim asking for recharacterization of the debt, the investors made claims for equitable subordination as well as fraudulent transfer.6 It is especially important to note that both of these claims failed.7 The bankruptcy court was unable to find any, “. . . evidence that rises to the level of misconduct or inequitable conduct as a matter of law”, and granted summary judgment for the defendants on the claim for equitable subordination.  The court further asserted that there was, “. . . [N]o evidence that the negotiation with Paragon for the settlement of the $6,465,000.00 Debtor’s Paragon Loan was anything but an arm’s length transaction . . .”8  Nonetheless, the bankruptcy court and ultimately the Fourth Circuit determined that, “The Debtor used PEM as an extension of itself . . .”.9 Citing poor adherence to best practices in a situation with overlying personal relationships, the court found that the loan was in fact likely to be fairly characterized as “. . . an equity contribution made to keep the Debtor from losing its sole asset in foreclosure.”10 These factors were applied through the federal rule of authority described in greater detail below, and it is also important to note that in this case no state rule of authority was found to be applicable.

At some level, the court’s findings and conclusions make perfect sense–PEM and Lakebound were far from a model of independence. Conversely, however, there exists a nagging concern over subordinating a secured claim which had been found by the bankruptcy court to have been purchased at an economically appropriate fair price and at arm’s length without substantial evidence of any unfair dealing.11 While this post does not attempt to examine the merits of the arguments made by either side, it is important to recognize that there is something strange going on in the court’s decision to recharacterize the debt. The court proves unable to concretely apply the facts of the case to any of the instances where the Bankruptcy Code or state law identify recharacterization as appropriate. Concerned about the interests of the investors nonetheless, the court exercised an inferred power. The question is ultimately whether or not this power actually exists, and if it does, whether it should.

II. Competing Tests for Recharacterization: Who Applies What?

The authority split on the preceding question is clear enough to identify. In the Third, Fourth, Sixth, Tenth, and Eleventh Circuits, the reasoning for the adoption a recharacterization test is broadly based upon the general, independent, and equitable powers granted by Section 105(a) of the Bankruptcy Code.12 This ostensible federal rule of authority was the basis for applying the recharacterization remedy in PEM.

In two circuits, the Fifth and Ninth, this line of authority is expressly disavowed, instead holding that the bankruptcy courts must determine the allowance of claims under state law.13 This view asserts that while recharacterization may be an appropriate remedy, reliance on Section 105(a) of the code alone is insufficient to justify exercising such a power.14 This “state test” looks not only to the equitable powers granted to the courts, but also to the more holistic proposition set out by the Supreme Court in Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co. that there exists a long-held belief in bankruptcy of the “basic federal rule” of deference to states in the absence of specific rules promulgated through the Bankruptcy Code.15

When the standards for analyzing facts are applied under these sources of authority, the real problem with the federal rule of authority and the current state of affairs surrounding recharacterization becomes readily apparent. While the Fourth, Fifth, and Sixth Circuits apply an eleven-factor test, they do so on different authorities.16 Meanwhile, the Ninth adopted the Fifth Circuit basis for recharacterization, the Tenth Circuit decided to apply its own thirteen factor test, and the Third did the same adopting seven factors.17 To add to the confusion, the Eleventh Circuit applies a two-pronged approach also aimed at looking into the same question of substance underlying transactions between related parties.18 In short, to describe the present state of the law surrounding recharacterization as muddled would be generous.

III. Why Does It Matter?

With state law used as the source of authority, inconsistent rules of this nature present only limited challenges to parties and courts, and the inconsistencies are theoretically only temporary. The rule, or lack thereof, may be applied to the facts in the particular state. If the rule is a bad one, the state may choose to change it through legislation. Precedent based on any state law and jurisprudence may be clearly applied, and if a consensus can be reached a best practice may be adopted by the Bankruptcy Code which will preempt any existing state precedent on the matter. Moreover, when considering which standard to codify, the practices of every state may be considered. This process encourages the states to work as incubators for developing legal concepts and aligns well with a multi-tiered federalist system. In this framework, inconsistency exists only so long as it serves the useful purpose of identifying which practices should be codified at the federal level. It is the reasonable cost of developing good law.

In adopting federal implied bases for authority, however, the efficacy of this process is stripped away. Rather than working along clearly demarcated lines of federalism, the federal rule allows courts to find solutions on their own when the facts seem to support taking such action. This is ultimately what occurred in PEM when the bankruptcy court took it upon itself to infer a solution which will be used as precedent in future cases. Instead of highlighting a gap in law to be considered by the states, this form of judicial activism masks the need for consideration of the matter by those constitutionally tasked with doing so–the state and federal legislatures. Moreover, while federal common law may serve to protect important constitutional issues in some instances, none are implicated surrounding the matter of debt-to-equity recharacterization.19 Adoption of implied standards has the further potential to blur authoritative lines unnecessarily in instances where states do later decide to enact their own standards, and does little more than add a layer of confusion to the rules which should be applied in bankruptcy cases. As PEM highlights, especially in highly complex business interactions, it takes a substantial amount of time and resources to figure out facts even if a settlement is the most likely outcome. Applying a judicially created standard has the potential to draw this out, rather than encourage expedience as a clear-cut Bankruptcy Code provision would. While some level of inefficiency is perhaps unavoidable, under a state rule it may be temporary. Under the federal rule of authority, the prospect of drawing disputes out in the judicial system is entrenched, perhaps indefinitely.

Analysis of these competing sources of authority is not meant to suggest that recharacterization may never be an appropriate remedy. In fact, the fact that recharacterization has become a common occurrence in tax settings already suggests that it may serve important equitable purposes when other remedies fall short. Nonetheless, in the bankruptcy context the ambiguity surrounding the federal test demonstrates that the practice has not reached the level of clarity in application that other vehicles, like equitable subordination and fraudulent transfer, have through their application and ultimate codification. This matters because, by applying a federal non-codified equitable standard, courts are in effect overstepping their authority to interpret and apply the law. In doing so, courts using the federal rule introduce an additional, unnecessary level of uncertainty into bankruptcy proceedings. Not only does this potentially add cost to the proceedings itself, muddling separation of powers makes it harder and more expensive for parties to contract and risk-adjust among themselves before bankruptcy even occurs.20 Quantifying the economic effects of judicial activism are beyond the scope of this post, but the introduction of risk or uncertainty to the market increases the cost of doing business.21 This, in turn, ultimately makes it harder to remain profitable and heightens the likelihood of bankruptcy or of players exiting the market based on generally higher transaction costs.

In conclusion, the justification behind the current federal rule of decision is shaky at best and may perhaps be better viewed as an abbreviated means of getting at more fundamental questions of arms-length negotiation when facts are lacking. This desire for expedience is understandable, especially on an individual, case-by-case basis. However, the practice ultimately circumvents the need for parties to make strong showings of improper dealing sufficient to trigger federal codified standards or to work within the bounds of evolving state law. This denies states their opportunity to determine first if more flexible standards for subordination than those laid out by the Bankruptcy Code are appropriate, and simultaneously undermines a critical federalist process for developing good, economically efficient law.


  1. PEM Entities LLC v. Levin, 138 S. Ct. 41 (2017). 

  2. See Shu-Yi Oei, Context Matters: The Recharacterization of Leases in Bankruptcy and Tax Law, 82 Am. Bankr. L.J. 635 (2008). 

  3. U.S. Const. art. VI, cl. 2, See also Altria Group v. Good, 555 U.S. 70 (2008) (A federal law that conflicts with a state law will trump, or “preempt”, that state law). 

  4. In re Province Grande Olde Liberty, LLC, 655 F. App’x 971, 972 (4th Cir. 2016). 

  5. Id. 

  6. In re Province Grande Olde Liberty, LLC, 2014 WL 6901052, at 1 (Bankr. E.D.N.C., 2014). 

  7. Id. at 8. 

  8. Id. 

  9. Id. at 6. 

  10. Id. 

  11. See id. at 7. 

  12. Br. in Opp’n to Pet. for Writ of Cert. at 6, PEM Entities LLC v. Levin, No. 16-492, 2017 WL 3429146 (U.S. Aug. 10, 2017). 

  13. Reply Br. of Pet’r at 2, PEM Entities LLC v. Levin, No. 16-492, 2017 WL 3429146 (U.S. Aug. 10, 2017). 

  14. Pet. for a Writ of Cert. at 14, PEM Entities LLC v. Levin, No. 16-492, 2017 WL 3429146 (U.S. Aug. 10, 2017). 

  15. Travelers Cas. and Sur. Co. of America v. Pacific Gas and Elec. Co., 549 U.S. 443, 450 (2007). 

  16. See Reply Br. of Pet’r at 2, supra note 15. 

  17. Id. 

  18. Id. 

  19. See Charles Wright et al., Areas of Competence for the Formulation of Federal Common Law—Conflicts Between State Law and Federal Interests, 19 Fed. Prac. & Proc. Juris. § 4514 (3d ed.). 

  20. See T.C.A. Anant & Jaivir Singh, An Economic Analysis of Judicial Activism, 37 Econ. & Pol. Wkly. 43 (2002). 

  21. See Karen A. Horcher, Essentials of Financial Risk Management 1-3 (2012).