Substance over Form in the Bankruptcy Courts

Some courts, including the Ninth Circuit that controls the western United States, are not so sure. They believe that a bankruptcy court's equitable powers can only be exercised within the confines of the Bankruptcy Code. Since the Bankruptcy Code specifically allows for subordination, which can be used to rearrange the priorities of claims but not substantively change their nature, the latter is simply not permitted. Pacific Express Holding, Inc. v. Pioneer Commercial Funding Corp. (In re Pacific Express, Inc.) 69 B.R. 112, 115 (BAP 9th Cir. 1986).

Yet, even where the power to recharacterize is not seen as an inherent power a bankruptcy judge possesses, no one contends that a bankruptcy judge cannot apply state or other law. A few non-bankruptcy examples of recharacterization are discussed later. In addition, bankruptcy courts routinely enforce Uniform Commercial Code '2-401, which provides that despite the retention of title by a seller of goods in the contract, the seller's interest will be treated as a security interest.

Someday, the U.S. Supreme Court may decide the issue of whether bankruptcy courts may recharacterize as their sense of equity dictates, or whether they are limited to what has been preset by the state legislatures or by Congress. In the interim, businesses and business people contracting with financially unstable enterprises need to be prepared to have their transactions considered and treated as something much different than they thought.

Debt As Equity and Equity As Debt

For obvious reasons, an insolvent enterprise may not be able to obtain financing from anyone other than a shareholder. There is nothing inherently wrong or improper in a loan from an insider. Yet, if the other creditors think the company was undercapitalized and the loan was really to protect the shareholder's equity position, they may argue that the loan should be treated as an equity infusion and not receive the same distribution that they receive.

On the other hand, a cash-needy entity may be limited by contract, tax or other considerations in borrowing money. Preferred stock but with debt-like characteristics may be the vehicle used by the issuer and the investor to avoid those restrictions. Following the failure of the investment, the preferred stockholder may seek creditor status to improve its distribution.

Borrowing from tax law, which developed to determine whether an advance created “bona fide indebtedness” under the Internal Revenue Code, the bankruptcy courts have looked at a number of factors to define whether what is labeled debt is really equity, or what is labeled equity is really debt. See, e.g., In re Autostyle Plastics, Inc., 259 F3d at 749-53, citing Roth Steel Tube Co. v. Commissioner of Internal Revenue, 800 F2d 625, 630 (11th Cir. 1986). Those factors include:

• The name the parties gave to the instrument;
• The intent of the parties;
• Whether there is a maturity date and a schedule of payments;
• Whether there is an interest rate and a schedule of interest payments;
• The right to enforce payment of principal and interest;
• The source of payments;
• Conversion features;
• Whether the borrower was thinly capitalized;
• The ratio of shareholder loans to capital;
• Whether the creditor and the shareholder have an identity of interest;
• Whether there are any guarantees or security for the obligation;
• The availability of financing from outside lenders;
• Whether the advances were subordinated to outside creditors;
• Whether the advances were used to acquire capital assets;
• The amount or degree of shareholder control;
• Whether there was a sinking fund to provide repayment.

No one factor will be dispositive, and it is unlikely that all factors will point the same way. If the factors pointing to an equity investment are strong and the factors pointing to debt are weak, the court will recharacterize the debt as equity. If, on the other hand, only a few factors lean toward equity, the court may likely give credence to the parties' label of debt.

In a bankruptcy case, the impact on characterizing debt as equity (or vice versa) can be the difference from payment ' in whole or in part, in cash or in stock in the reorganized debtor ' and nothing. In addition, the impact on other stakeholders can be significant. The greater the level of debt, the less will be the pro rata share of other creditors. Conversely, the movement of debt to equity, particularly if the debt was secured, may greatly enlarge their share.

Next month's installment will cover personal property leases and security agreements, and true sales and loans.

Part One of a Two-Part Series

The old saw is that if it walks like a duck and sounds like a duck, it must be a duck. Although bankruptcy is sometimes viewed by its detractors as defiant of common sense, the common sense duck adage is alive and well in bankruptcy courts. No matter what the parties or their lawyers may call an agreement or transaction, the courts are inclined to change the label and treatment to match what they see as the parties' true intention, risk retention, or economic reality. In bankruptcy parlance, the duck rule is called “recharacterization” and it is most commonly seen when courts are asked to consider shareholder loans, personal property leases, factoring arrangements, and asset backed securitizations. Through recharacterization, loans become capital contributions, leases become security agreements, and claimed true sales (the linchpin of factoring and securitizations) become loans. The impact of relabeling an agreement or transaction is significant. What was intended to be “bankruptcy remote” may find itself at bankruptcy central. The purpose of this article is to canvass just those situations where a lender, lessor and buyer could be very surprised, and how the recharacterization can affect the parties' expectations.

Before examining some of the implications of recharacterization up close, it is worth noting that there is no provision of the Bankruptcy Code that gives bankruptcy judges the specific power to recast a business deal. Restructure it, but not recharacterize it. Courts justify their acts by pointing to their general equitable powers embodied in Section 105 of the Bankruptcy Code, which gives bankruptcy judges the authority to “issue any order, process or judgment that is necessary or appropriate to carry out the provisions” of the Bankruptcy Code. Despite the growing view in bankruptcy circles that reliance on Section 105 should never be enough, a majority of the courts of appeal support a bankruptcy judge's ability to recharacterize. The majority rule applies in the New York, Delaware and Chicago bankruptcy courts, where many of the larger Chapter 11 cases are filed. See, e.g., Summit Coffee Company v. Herby Foods, Inc. (In re Herby's Foods, Inc.), 2 F3d 128 (5th Cir. 1993), Bayer Corporation v. Mascotech, Inc. (In re Autostyle Plastics, Inc.), 269 F3d 726 (6th Cir. 2001); Estes v. N&D Properties (In re N&D Properties), 799 F2d 726 (11th Cir. 1986).

Some courts, including the Ninth Circuit that controls the western United States, are not so sure. They believe that a bankruptcy court's equitable powers can only be exercised within the confines of the Bankruptcy Code. Since the Bankruptcy Code specifically allows for subordination, which can be used to rearrange the priorities of claims but not substantively change their nature, the latter is simply not permitted. Pacific Express Holding, Inc. v. Pioneer Commercial Funding Corp. (In re Pacific Express, Inc.) 69 B.R. 112, 115 (BAP 9th Cir. 1986).

Yet, even where the power to recharacterize is not seen as an inherent power a bankruptcy judge possesses, no one contends that a bankruptcy judge cannot apply state or other law. A few non-bankruptcy examples of recharacterization are discussed later. In addition, bankruptcy courts routinely enforce Uniform Commercial Code '2-401, which provides that despite the retention of title by a seller of goods in the contract, the seller's interest will be treated as a security interest.

Someday, the U.S. Supreme Court may decide the issue of whether bankruptcy courts may recharacterize as their sense of equity dictates, or whether they are limited to what has been preset by the state legislatures or by Congress. In the interim, businesses and business people contracting with financially unstable enterprises need to be prepared to have their transactions considered and treated as something much different than they thought.

Debt As Equity and Equity As Debt

For obvious reasons, an insolvent enterprise may not be able to obtain financing from anyone other than a shareholder. There is nothing inherently wrong or improper in a loan from an insider. Yet, if the other creditors think the company was undercapitalized and the loan was really to protect the shareholder's equity position, they may argue that the loan should be treated as an equity infusion and not receive the same distribution that they receive.

On the other hand, a cash-needy entity may be limited by contract, tax or other considerations in borrowing money. Preferred stock but with debt-like characteristics may be the vehicle used by the issuer and the investor to avoid those restrictions. Following the failure of the investment, the preferred stockholder may seek creditor status to improve its distribution.

Borrowing from tax law, which developed to determine whether an advance created “bona fide indebtedness” under the Internal Revenue Code, the bankruptcy courts have looked at a number of factors to define whether what is labeled debt is really equity, or what is labeled equity is really debt. See, e.g., In re Autostyle Plastics, Inc., 259 F3d at 749-53, citing Roth Steel Tube Co. v. Commissioner of Internal Revenue, 800 F2d 625, 630 (11th Cir. 1986). Those factors include:

• The name the parties gave to the instrument;
• The intent of the parties;
• Whether there is a maturity date and a schedule of payments;
• Whether there is an interest rate and a schedule of interest payments;
• The right to enforce payment of principal and interest;
• The source of payments;
• Conversion features;
• Whether the borrower was thinly capitalized;
• The ratio of shareholder loans to capital;
• Whether the creditor and the shareholder have an identity of interest;
• Whether there are any guarantees or security for the obligation;
• The availability of financing from outside lenders;
• Whether the advances were subordinated to outside creditors;
• Whether the advances were used to acquire capital assets;
• The amount or degree of shareholder control;
• Whether there was a sinking fund to provide repayment.

No one factor will be dispositive, and it is unlikely that all factors will point the same way. If the factors pointing to an equity investment are strong and the factors pointing to debt are weak, the court will recharacterize the debt as equity. If, on the other hand, only a few factors lean toward equity, the court may likely give credence to the parties' label of debt.

In a bankruptcy case, the impact on characterizing debt as equity (or vice versa) can be the difference from payment ' in whole or in part, in cash or in stock in the reorganized debtor ' and nothing. In addition, the impact on other stakeholders can be significant. The greater the level of debt, the less will be the pro rata share of other creditors. Conversely, the movement of debt to equity, particularly if the debt was secured, may greatly enlarge their share.

Next month's installment will cover personal property leases and security agreements, and true sales and loans.