In the Matter of: Fitness Holdings Int'l

Bankruptcy courts may recharacterize loans as an equity investment for the purpose of § 548 and must apply state bankruptcy law to determine if a creditor has a "right to payment."

Fitness Holdings received many promissory notes from Hancock Park, whose director was also a majority shareholder of Fitness Holdings. Fitness Holdings then received a substantial loan and a revolving line of credit from Pacific Western Bank from which it used to satisfy the promissory notes from Hancock Park. Fitness Holdings then filed for Bankruptcy. Trustee creditors sued alleging that the payments to Hancock Park were fraudulent. The bankruptcy court denied the complaint by the trustees against Fitness Holdings, its two major shareholders, Hancock Park, and Pacific Western Bank. The complaint alleged that payment of funds used to satisfy a debt from Hancock Park were fraudulent under 11 U.S.C. § 548(a)(1)(B). The complaint requested that the bankruptcy court recharacterize the promissory notes from Hancock Park as an equity investment as opposed to a loan, which negates a legal obligation for repayment. The bankruptcy court dismissed the complaint believing that it could not recharacterize the debt. The Ninth Circuit found that recharacterization was consistent across most circuits and therefore held that the bankruptcy court could recharacterize the debt as equity, as opposed to a loan. The test for this determination is based upon state law which yields when a creditor is owed payment under state law. The panel found that the complaint successfully met its burden in the complaint by alleging that the repayment to Hancock was in response to an investment and therefore the payment prior to bankruptcy was fraudulent. VACATED AND REMANDED.