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Substance over Form in the Bankruptcy Courts

By Pamela Kohlman Webster
May 26, 2005

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).

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